Welcome to the Accuray Incorporated Third Quarter Fiscal 2017 Earnings Conference Call. [Operator Instructions]. As a reminder, today's conference is being recorded. I'd now like to introduce your host for today's conference, Mr. Doug Sherk. Sir, please go ahead.

Thank you, Liz and good afternoon, everyone. Welcome to Accuray's conference call to review financial results for the third quarter of fiscal 2017 which ended on March 31, 2017, as well as recent corporate developments. Joining us today are Josh Levine, Accuray's President and Chief Executive Officer; and Kevin Waters, Accuray's Senior Vice President and Chief Financial Officer. Before we begin, I'd like to remind you that our call today includes forward-looking statements that involve risks and uncertainties, including statements regarding our business plans and strategies as well as our outlook for fiscal 2017. There are a number of factors that could cause actual results to differ materially from our expectations including, but not limited to, risks associated with the adoption of the CyberKnife, TomoTherapy, Onrad and Radixact Systems; commercial execution; future order growth; future revenue growth; and macroeconomic factors outside of the company's control. These and other risks are more fully described in the press release we issued after the market closed this afternoon as well as in our filings with the Securities and Exchange Commission. The forward-looking statements on this call are based on information available to us as of today's date and we assume no obligation to update any forward-looking statements. [Operator Instructions]. Now I'd like to turn the call over to Accuray's President and Chief Executive Officer, Josh Levine.

Thank you, Doug. Good afternoon, everyone and thank you for joining us on today's call. Following the market close today, we reported third quarter financial results highlighted by strong growth for both gross orders and backlog. Gross orders for the third quarter increased 49% year-over-year to $83.8 million while our backlog grew to a record $450 million which is approximately 21% higher than prior year. This built upon our second quarter gross order results that we reported in late January which were also ahead of our expectations. These order results help illustrate why we reiterated our gross order guidance for the full year back in January and are doing so again today. At the same time, our revenue results in the third quarter were moderated by the continued delay in the announcement of class A radiotherapy licenses in China and the long revenue conversion time associated with a higher mix of distributor source orders. We have pointed out during our Q2 earnings call that our full year revenue outlook could potentially be impacted by these 2 factors and this was proven to be the case. As a result, we're recasting our full year revenue outlook to a range of $380 million to $390 million. While we're encouraged by our continued momentum in order growth, we're not pleased with the trends related to the timing of revenue conversion and are announcing today a number of executive-level personnel and structural organization changes with a focus in 3 key areas, first, to ensure that we build on our recent order momentum; second, to improve our revenue conversion time lines in those regions where distributor-initiated orders have become a bigger part of the overall order mix in our backlog; and lastly, to drive a more streamlined executive-level structure to improve our overall market responsiveness.…

Thank you, Josh and good afternoon, everyone. As Josh highlighted, we ended the third quarter with backlog of $450 million, representing growth of 21% over the prior year. Our Q3 performance included gross orders of $83.8 million and net orders of $71.8 million, reflecting age-outs of $8.5 million, 1 cancellation for $2.8 million and $700,000 of negative foreign currency impact. Age-outs in the quarter were better than we anticipated, as an order which we expected to age-out ended up being shipped during the quarter. Gross order performance was favorably impacted by both our new Radixact System as well as significantly more CyberKnife System orders compared to the same prior year period. Order growth by geography was driven by strong performance in Asia Pacific, Japan and our European region. On a year-to-date basis order growth is up 13% over the first 9 months of prior year. Additionally, our replacement order rates have continued at a consistent pace during the first 9 months of fiscal 2017. Turning now to our income statement. Total revenue for the third quarter was $97.3 million, representing an increase of 11% on a sequential basis. This compares to revenue of $105.3 million in the year ago period. Product revenue for the quarter was $48 million. Product revenues in both the U.S. and Japan were significantly above prior year revenues. However, as Josh touched on, both China and the longer revenue conversion times, particularly in Europe, negatively impacted Q3 revenue performance. Service revenue for the third quarter was $49.3 million compared with $51.5 million in the year ago period which was slightly below our expectations due to less installation and training revenue which coincides with the shortfall in product revenues. Turning now to gross margins. Our overall gross margin for the quarter was 36.4% compared with the prior…

Thanks, Kevin. Before we open up the call for your questions, I'd like to thank the entire Accuray team for their focus and contribution this quarter. Our company's commitment to the important work we're doing in improving the lives of cancer patients by providing leading-edge treatment solutions remains central to our mission. And now, operator, we're ready to open it up for questions.

[Operator Instructions]. Our first question comes from the line of Tycho Peterson with JPMorgan.

Josh, maybe on the distributor dynamics. I know you called this out last quarter, but you had reaffirmed guidance last quarter and kind of anticipated that this would be kind of a manageable issue. Can you maybe just talk about, to the extent that you are taking steps -- and I know you talked a little bit about this in the last earnings call in terms of trying to accelerate that conversion, maybe just talk about any incremental progress you've had there and how long do you think it takes to resolve these issues.

So I think we've made some progress, but I don't think that progress, Tyco, has been enough. It's one of the reasons why we're putting the role that we described in our prepared remarks in place and getting better focus on and better alignment. I think that -- you remember the conversation we had at the end of last quarter, this is a consequence, quite frankly, in terms of the mix -- the order mix in the backlog. It's primarily in the markets or regions where we have bigger distributor order growth taking place. And as a consequence, we basically don't have the same clear line of sight around those basic activities that are -- we're managing on our own in the direct business, like site planning, installation planning, coordination of contractors. We have a distributor in the middle of those conversations. We have an end user that we're trying to coordinate calendarization of those activities with which creates a longer revenue conversion cycle. The strategy and the thought process around the VP of Revenue role is that we have one person there at that point that drives the forecasting process, but the details that underpin the forecasting process such as the entire end-to-end order revenue conversion process, so coordination, working with our regional installation and service teams, coordinating with the distribution partners and the end-user facilities to ensure that we've got essentially the pieces moving in the right direction to improve installation cadence and execution. And so there are some process changes that I think that will take place. I don't see those as sweeping. But the creation of this dedicated role focused on this process from end to end, I think, will be a very, very helpful piece to improved forecast predictability. And I also think that having this position report to Kevin Waters puts added visibility and a sense of process discipline and urgency to it that, quite frankly, in my view, have been somewhat lacking. So that's the high-level thought process about the strategy with it.

Okay. And then for my follow-up, just on competitive dynamics. Last quarter, I think you talked about winning 75% to 80% of replacement orders. Is that kind of still holding? And as we think about early interest in Onrad, how do you think about just competitive dynamics there? Obviously, Varian is talking about launching a new lower-end system for emerging markets as well.

Yes. So nothing has changed with regards to the order mix and what's impacting it. We're still seeing roughly 10% to 20% of the order mix coming from the installed base replacement opportunities. The -- that means, by definition, the remaining roughly 80% to 90% of orders are coming either from greenfield opportunities or competitive opportunities. And so as I mentioned in my prepared remarks, we -- on a global basis, we're still seeing winning at a higher rate than we're giving up our own bunkers. So we feel good about that. Radixact has been a good contributor albeit early in that discussion. We have order activity in the third quarter that's Radixact related. And this is the first quarter of true full commercial launch. So we have basically all of our reference sites now up and running and actively treating patients which is going to help expand the sales process and the advancement in terms of sales funnel for this, in general. We've heard the market chatter about what Varian may or may not be coming to the market with an escrow. But at this point, it's too early to speculate on what that might mean or what the potential impact of that is. We've gotten really good feedback from the sites that are using Radixact in terms of tangible differences in the treatment planning capability and treatment speed. So we feel good about early functionality, early feedback on functionality at this point that Radixact has been getting.

Our next question comes from Josh Jennings with Cowen and Company.

I was hoping to follow up on the revenue conversion issue. And can you just help us think about as we get into fiscal '18 and you anniversary the revenue conversion lag times, how does that start to play out? Clearly, you have some new people in place and you're trying to optimize the path forward. But once you anniversary the lag times, will you be able to manage that better? Or does it just continue to cause issues in terms of revenue recognition?

Josh, this is Kevin. So we're not going to comment on 2018 guidance specifically. We'll do that on our next call. But just in a general sense, our revenue growth rates going forward should more appropriately reflect the growth in our product revenue backlog and that's not what's occurring this year. And we think by making some of these process changes, we could have the future more appropriately reflect those growth rates. I'd also use an analogy here. And if you look at a country like Japan which is 100% distributor, where we cited their increased revenue conversion process in fiscal 2016, we've been able to put a high level of focus there. And we're now seeing Japan, for example, perform significantly above plan and be a big contributor to our results. And that's the analogy I would use when I look moving forward in regards to us doing what we can do on distributor conversion.

Great. And the growth rates in that order delta, it was the smallest gap in many quarters. You talked about one order that you thought might fall out off of that, but that you -- that went -- turned into an installation. But are there any trends that we should be thinking about in terms of that gap narrowing as we move forward here?

Yes. I don't think there's any trend. I think -- I also pointed out that age-outs are going to be higher in our fiscal fourth quarter in our prepared remarks. But to put age-outs in perspective, we've highlighted increased revenue conversion times. We've seen others in the industry talk about this phenomenon as well. And we're going to end 2017 with approximately $40 million of orders that are older than 30 months. I'd like to point out that of those $40 million that have aged out, only $10 million of those have subsequently been canceled by the end user. So while we report age-outs, I do believe that the remaining $30 million do have the potential to be future revenue and we're seeing a bit of increased age-outs in our fourth quarter due to this increase in conversion timing.

Great. And my last question. Just on the service revenue not dramatically lower, but it trended lower in Q3 here than we've seen in numerous quarters. How should would be thinking about service revenue growth, maybe what happened in Q3 for the sequential downtick and then how we should be thinking about service revenue growth going forward?

Yes. So I'll speak to the sequential downtick. So service revenue is dependent on product revenue as well. So we record installation and training revenue at the same time as we have installs. And when we have a quarter like we did in this fiscal third quarter, where distributors in Japan, for example, perform very well, we're not responsible for installation in those markets. And therefore, we see a decline in installation and training revenue. On top of that, we also had less upgrade revenue in our fiscal third quarter. We think our service revenue growth rate should improve as we head into 2018 as we have more upgrades to offer and we can start to fill that pipeline again.

Our next question comes from Amit Hazan with Citi.

This is Phil [ph] on for Amit. I guess, I'll start with the other side of guidance. Maybe great order number from a gross perspective and through 3 quarters. Just what went into the decision, I guess, not to take that guidance level up for the rest of the year? Was there any pull forward that we saw or what went into that decision?

I think, just to be quite honest, given our trends and we're sitting on a call here where we've lowered revenue guidance, we're happy with our full year order guidance. However, Q4 would still suggest a number of approximately $85 million which would represent a quarterly high for us in 2017. We believe that's attainable due to the strength of our funnel, but we just didn't feel it was appropriate even though we're ahead of our expectations to look at raising that metric at the time. With that said, as we exit 2017, our second half growth rate orders would be kind of in the 11% to 12% range. And I think that's pointing to a lot of the initiatives that Josh highlighted in terms of the full Radixact launch and some of our success in the replacement cycle. But again, we're happy to be ahead where we expect it to be. But we just thought given the Q4 absolute numbers, it's still a large number. It wouldn't be appropriate to raise that metric.

Right. Understood. Sounds good. Maybe just a little bit higher level, any comment on either pricing or purchasing trends maybe in light of political AHCA uncertainty? Anything you've seen there would be great.

No impact, Phil [ph], at least from an AHCA discussion standpoint. And I'd say pricing has continued to operate or flow at the levels that we expected it to. We don't see any major degradation there, so I'd say it's fairly stable.

Our next question comes from the line of Brandon Henry with RBC Capital Markets.

So you guys lowered revenue guidance by $30 million. Can you help me parse out what the impact was from the continued delay from Chinese class A quotas and then what the impact was in the longer distributor conversions?

Yes. So it's roughly equal. So the China class A delay, we were anticipating approximately $10 million to $15 million in the back half of our fiscal year and probably more in the high end there. So you're looking at a $15 million shortfall from China class A. And then it'd be a roughly equal contribution from the delay of the distributor orders that Josh discussed. That distributor conversion, by the way, I'd point out, was primarily for orders in Eastern Europe due both to construction and end-user project delays.

Okay. And then separately, you guys mentioned that ASTRO and ACRO are working on bundled payment model for radiation oncology. Can you give us a sense regarding the potential timing of implementation of these initiatives and how quickly you think they'll be rolled out?

Brandon, we don't have -- we're tracking it, but we don't have any greater insights than you do on timing. We know that the inputs to CMS have been made and CMS is expected to release a report sometime fairly soon. But don't have visibility on exact timing of that. So I guess, it's a stay tuned kind of answer. But again, our takeaway on this is that when you think about episodic payment structures and models and you think about what really is implied there with regards to the opportunity both clinically for the patient, overall experience for the patient and the payer market impact in terms of the economics -- the health economic impact of this, all signs point to the fact that hypofractionated treatment, SBRT in a hypofractionated form is really a good solution for all of those constituencies that I just talked about. And we, quite frankly, think we're really well positioned with our current portfolio to help take advantage of that. I guess, from a timing standpoint, we think this is relatively soon, maybe this summer. But again, I don't know -- we don't have an exact time frame.

Our next question comes from Christian Moore with Jefferies.

Maybe one on Radixact. It seems like it's progressing well. We were just wondering if you could help quantify the contributions to the gross orders. And just by geography, a little color on what you're seeing in Radixact uptake. Obviously, it's in Japan now and how the ramp in Europe and U.S. is going as well.

Yes. This is Kevin. So we have said that roughly 50% of our orders were CyberKnife orders in Josh's remarks which means the other 50% are on the TomoTherapy platform. We're not going to break out what amount of TomoTherapy platform orders were the H Series versus Radixact. What I will say is that we did have -- Radixact was a significant contributor to that number. We did have initial placements in Japan with Shonin approval which we received in January which was above our expectations. And then we also have CE Mark for Radixact in the Eurozone and also obviously FDA approval. And so that's why continue to sell that product.

And then maybe one just on the upcoming ASTRO conference. Have you factored in anything from a competitive launch standpoint in terms of what Varian is expected to be bringing into the market for fiscal '17 or beyond in your models? And is there anything else that investor -- that you want us to be paying attention to?

Yes. I mean, I think the direct answer on factoring things into forward looking, in fact, is -- when I say forward looking, I guess, I'm referring to fiscal '18. We're not going to be talking about guidance or expectations on '18 until we get to our year-end earnings release. But we -- the forecast that we're running to, from an internal standpoint, are to take into account what we know right now. And again, I think I indicated before that we have heard some market noise, customer noise about a Varian product launch in escrow, but we don't have any further information than you do beyond what was communicated yesterday in Varian's release. It sounds like it's a product that may be more focused on emerging markets. But I think that's at this point speculation on what it means. And specific impact, it's too early to really predict.

Our next question comes from the line of Sean Lavin with BTIG.

This is actually Ryan on for Sean. So just one for Kevin. With the operational changes underway and the process improvements related to revenue conversion, should we be thinking about any onetime charges or nonrecurring charges over the next few quarters as you guys implement those processes?

No. In fact, all of the discussion -- changes that Josh referenced, any onetime severance thing is already factored into our operating expense guidance that we gave. I would expect that as we staff this function, there could be additional adds but nothing material. We'd still be able to adhere to kind of our operating expense run rate. So nothing unusual there.

Showing no further questions in queue at this time, I'd like to turn the call back to Mr. Levine for any closing remarks.

Thank you, operator and thank you, everyone, for your participation this afternoon. We look forward to talking with you on our fiscal fourth quarter earnings call. Thanks and have a good evening.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone, have a great day.