Cerner Corp. Q3 2008 (Qtr End 09/30/08) Earnings Call Transcript

| About: Cerner Corporation (CERN)

Cerner Corp. (NASDAQ:CERN)

Q3 2008 Earnings Call

October 21, 2008 4:30 pm ET


Marc Naughton – Senior Vice President and Chief Financial Officer

Mike Valentine – Executive Vice President and General Manager of U.S.

Jeff Townsend – Executive Vice President and Chief of Staff

Trace Devanny - President

Neal Patterson – Chairman and Chief Executive Officer


Bret Jones - Leerink Swann

Atif Rahim – JP Morgan

Charles Rhyee – Oppenheimer

Glen Santangelo – Credit Suisse

Richard Close – Jefferies & Company

Anthony Petrone - Maxim Group

Sandy Draper - Raymond James


Welcome to the Cerner Corporation’s third quarter 2008 conference call. (Operator Instructions)

The company has asked me to remind you that various remarks made here today by Cerner’s management about future expectations; plans, perspectives and prospects constitute forward-looking statements for the purpose of the Safe Harbor Provisions of the Securities and Litigation Reform Act of 1995. Actual results may differ materially from those indicated by forward-looking statements.

Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements may be found under the heading Risk Factors under Item 1A in Cerner’s Form 10-K, together with the reports that are on file with SEC.

At this time I would like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation; please proceed.

Marc Naughton

Good afternoon everyone and welcome to the call. I will lead off today with a review of the numbers followed by sales and operational highlights by Mike Valentine, Executive Vice President and General Manager of the U.S. Trace Devanny, our President will discuss our global efforts and our physician practice business and Trace will be followed by Jeff Townsend, Executive Vice President and Chief of Staff who will discuss innovation. Neal Patterson, our Chairman and CEO will participate in the Q&A.

Now I will turn to our results. Bookings revenue, operating margin earnings and cash flow performance were all at or above expected levels and our outlook remains positive. Moving to bookings, our total bookings revenue was $383.6 million which is 8% above the $356.7 million of bookings in Q3 of 2007.

Moving to backlog our total backlog increased 9% year-over-year and ended the quarter at $3.4 billion. Contract revenue backlog ended the quarter with $2.8 billion which is 9% higher than a year ago. Support revenue backlog was $4.6 billion.

Our revenue in the quarter increased 13% over Q3 2007 to $422.7 million which is at the high end of our guidance. The revenue composition for Q3 was $137.5 million in system sales, $118.2 million in support and maintenance, $157.5 million in services and $9.5 million in reimbursed travel. The $137.5 million in system sales is a Q3 record and reflects a 19% increase compared to Q3 2007. This quarter reflected strong software growth with software revenue at a record level for a third quarter.

There is also good growth year-over-year in hardware largely due to an easier comparable in Q3 2007. Services revenue, which includes managed services and professional services, grew 7% compared to the year-ago quarter driven by continued strong managed services growth. Similar to our year-to-date performance our professional services revenue was flat in Q3. The lower growth rate of professional services continues to be the result of slightly lower billable headcount in the U.S. and a continued decline in services revenue in the southern region of England related to the exit of Fujitsu as a prime contractor. Further the growth in professional services will likely continue until we ramp back up in the United Kingdom.

In addition to the impact of the southern region it is worth noting that the success of our efficiency initiatives such as Bedrock, MethodM and our solutions center have limited professional services top line growth to some extent. These initiatives have allowed us to get more work done without increasing services headcount. This is a good thing as our clients are benefiting from lower cost and more predictable outcomes and we are also benefiting in that we are driving good margins from our professional services.

Further evidence of our services organization’s ability to deliver value to clients is our continued strong growth in support revenue which increased 16% in Q3 compared to the year ago quarter.

Looking at a geographic view of revenue, our domestic revenue grew 8% year-over-year and our global revenue increased 37%. Our gross margin for Q3 was 82.9%, which is up 70 basis points compared to Q2 and down compared to the record Q3 2007 gross margin of 84.5 percent which resulted from a multi year low level of hardware.

Moving on to operating expenses and earnings. Our operating expenses in Q3 were $278.8 million before options expense. This is up 10% over a year ago. Sales and client service expenses were up 9% with managed services growth being the primary driver. Software Development was up 4% which is in line with expected levels. G&A expense was up 27% year over year, but included a $5.6 million foreign currency translation loss. Excluding this loss G&A expense increased 6% year over year. The FX loss reduced EPS by $.04 for the quarter, a much higher impact than anticipated. While the quarterly fluctuations have been significant in 2008, for the year the impact of FX in the income statement is less than $300,000.

Moving to operating margins. Our operating margin in Q3 was 16.9% before options expense. This is an increase of 60 basis points over last year. This quarter, our operating margin was impacted by about 50 basis points due to approximately $12 million of zero margin revenue from our work in the London Region of England. It is also worth noting the FX loss had 140 basis point impacts on operating margins this quarter so our operating margin excluding the impact of the FX loss would be 18.3%. Based on our year-to-date performance, we remain on track for our goal of achieving 20% margins in 2009.

Our path to 20% continues to include the assumption that we will be able to recognize margin on our UK contracts. As I mentioned last quarter, we expect to be able to recognize margin by the end of this year on our contract in the London region which will likely lead to a one time catch up in Q4 for past margin on that project. In spite of this one time catch up, our current expectation is that the ongoing margin from the London region will still deliver its expected contributions to our path to 20% margins. The size of the catch up entry has not been determined, but we will break it out when it occurs and it is not included in our guidance.

In the South region, we continue to work under a transition agreement to support and upgrade the eight trusts that are currently live. We are currently recognizing margin on this short-term transition agreement as we do the work. While the margin on this agreement is currently more than offset by expenses for personnel who became idle when the main contract was cancelled, we expect the margin to positively contribute by the time we get into next year.

Regarding the status of the remaining trusts in the south, the contractual changes are still in process and it is currently difficult to make any definitive statements as to the ultimate timing or outcome. But as we have said, we believe suppliers that are delivering value are well positioned to play an active role in the program going forward.

Moving to earnings and EPS our GAAP net earnings in Q3 were $45.0 million or $0.54 per diluted share. GAAP net earnings include stock options expense which had a net impact on earnings of $2.4 million or $0.03 per share.

Adjusted net earnings were $47.4 million and adjusted EPS was $0.57 which is $0.01 cent higher than the consensus estimate and our guidance range. Not included in adjusted net earnings or EPS but worth noting was a lower than expected tax rate of 34% which benefited net earnings by about $1.4 million. The lower tax rate was related to strong income levels from global regions that have lower tax rates. The benefit from this lower tax rate was more than offset by the unusually high FX loss of $5.6 million which after tax had a $3.7 million negative impact on net income.

If you normalize Q3 by using a 36% tax rate and excluding the FX loss, adjusted EPS would have been $0.59 for the quarter, an increase of 28% compared to adjusted EPS reported in Q3 2007.

One note on the tax rate, we do expect it to remain lower in Q4 due to the re-extension of the R&D tax credit. Using 34-35% is a reasonable range.

Now I’ll move to our balance sheet. We ended Q3 with $297 million of cash and short-term investments and $102 million of auction rate securities. The auction rate securities balance still reflects a reduction from par value of approximately $4 million. We continue to view this impairment as temporary due to the underlying credit rating of the securities and our intent and ability to hold the securities until the market recovers. In addition, UBS has indicated they will buy back our auction rate securities at par in 2010 which provides further assurance that we will be able to liquidate them. The average tax exempt yield on the IRS for the year is over 4.5%. Once again, that is a tax exempt rate.

Our total debt is $174 million. Since some of you have asked about our debt and the rates on it I’d like to remind you that all of our debt is privately placed and has fixed rates with a weighted average of 5.8%. We also have a $90 million line of credit on which we have no outstanding balance. The rate on the line is based on LIBOR or Prime so we would not be subject to the current elevated LIBOR rate if we used the line.

Total accounts receivable ended Q3 at $431 million. Contracts receivable or the unbilled portion of receivables was $121 million or 28% of total receivables, which is down from 38% last year and up slightly from an all time low of 25% last quarter. Third party financings were $25 million or 6% of the $436 million of total cash collections.

Note that our balance sheet still reflects billed and unbilled receivables related to the Fujitsu contract that represent over 10% of total receivables. While there will be some period of time before Fujitsu and the government unwind their contract and we settle with Fujitsu, we currently expect to fully collect these receivables. However, they will have a negative impact on DSO’s in the mean time.

Our DSO was 93 days in Q3 which was up three days compared to last quarter.

Operating cash flow for the quarter was $48 million. Q3 capital expenditures were $20 million and capitalized software was $17 million. Free cash flow is defined as operating cash flow less capital expenditures and capitalized software and was $11 million. As we previewed last quarter we expect operating and free cash flow to decline in Q3 compared to the record Q2 but we are still on track to meet our target of $80-100 million of free cash flow for the year with $58 million of year-to-date free cash flow and Q4 typically being a strong cash flow quarter.

A couple of other notes on cash flow. We did purchase about $4 million of stock back during Q3 and we still have $41 million remaining on the authorization we announced in April. Also, we spent $4 million on an acquisition during the quarter purchasing a small company with intellectual property that facilitates computer automated coding. As Jeff will discuss later there are several applications for this technology and we have already seen benefits from bringing it into Cerner.

Moving to capitalized software, the $17.1 million of capitalized software in Q3 represents 24% of the $72 million of total spending on development activities. Software amortization for the quarter was $13.2 million resulting in net capitalization of $3.98 million or 5% of the total.

As we indicated last quarter we expect the release of the next iteration of Millenium to become generally available in early 2009. This will trigger an increase in amortization expense of about $4-5 million per quarter. This increase will be partially offset by the completion of amortization of amounts capitalized in 2003 which will reduce amortization by about $3 million per quarter leaving a net anticipated increase in amortization expense of $2 million per quarter.

Now I’ll go through the guidance. Before going through the numbers I want to note that we have widened our guidance ranges this quarter to allow for any impact that potential financial market volatility might have. While our pipeline remains strong we believe healthcare is likely to be more resilient to tough economic conditions than most segments we think it is appropriate to allow for the possibility that some clients could delay decisions in this time of macroeconomic uncertainty and tightening credit markets.

That said, we are biased toward the high end of our guidance which is based on our normal forecast process and we have a good track record of delivering against our forecasts. We also believe our high level of recurring and visible revenue and our large and geographically diverse client base will help us minimize the impact of the economy.

Looking at Q4 revenue we expect revenue in the $435 to $460 million range which is about 13% growth over last year. We expect Q4 EPS before options expense to be $0.58 to $0.64 per share.

As I previously mentioned, guidance does not include any catch up of margin related to our contract in London so any catch up margin will be up side to our core results and guidance assume we have no material impact from foreign currency exchange.

The Q4 guidance is based on total spending before options expense of around $290 million. Note that our Q4 ends on January 3 which includes 14 weeks instead of 13 which is why there is a higher than normal sequential increase in expense and revenue. Our estimate for options expense for Q4 2008 and 2008 is approximately $0.03 and $0.12 per share respectively.

Moving to bookings guidance we expect bookings revenue in Q4 of $410-440 million with the midpoint of that range reflecting growth of about 4% over Q4 of last year which was an all time high bookings level.

Now I would like to provide our initial thoughts on 2009. Based on the early version of our 2009 plan the consensus estimates for revenue and earnings both appear reasonable. The top line growth of approximately 10% and bottom line growth of approximately 18%. I noted the achievement of our 20% operating margins in 2009 would drive greater than 18% earnings growth which positions us for up side but we believe it is prudent to remain conservative at this point.

I’d also like to give a sense for how we are looking at long-term cash flow generation. While we will spend less than $150 million on capital we originally estimated for 2008, I think modeling $150 million for capEx for the next several years is reasonable with it being likely lower than that in some years and slightly higher in others. With basically flat capEx and continued good earnings growth our free cash flow should continue to grow at strong rates over the next several years.

In closing we are very pleased with our results in Q3 including strong bookings growth, strong revenue growth including record system sales and software levels, continued progress on our margin expansion initiatives, strong earnings growth in excess of 20% and continued generation of free cash flow positioning us well for our full year target of $80-100 million. With that I will turn the call over to Mike.

Mike Valentine

Good afternoon all. Today I am going to cover sales, operational highlights, marketplace trends and our Cerner Health Conference. From a sales perspective, we had a strong quarter. In Q3 we had $383.6 million of bookings which is an all time high level of bookings for a third quarter that doesn’t include UK bookings. We had good size mix with 11 contracts over $5 million, 9 of which were over $10 million.

We had very strong bookings contributions from outside of our Millennium installed base with 37% of contract bookings coming from new Millennium footprints our highest level in over 4 years.

Our RFP activity and pipeline is strong with a good level of new footprint opportunities so I would expect to continue to see new footprints make a solid contribution to our total bookings. We also had another strong quarter of Vision Center activity and earlier this month we held our largest, best ever health conference in Kansas City which I will talk about a little later on.

While our core business remains strong and healthy, the new innovations are also beginning to drive new business in new market areas. Today I will comment specifically on how we are expanding our boundaries into the medical device area.

In the third quarter we continued to advance our Care Aware platform both from a capability standpoint and from a market awareness standpoint. Our Care Aware MDBus device connectivity solution allows medical devices to be connected to the EMR through a USB like plug and play connection and is beginning a new era of interoperability between the devices and the EMR. The level of client interest in this solution remains strong and we signed several new clients in Q3.

The third quarter also included good progress with Rx Station, our medication dispensing units. We completed our second implementation of Rx Station during the quarter and signed another large testing partner. Our pipeline has continued to grow and we are well positioned for contributions from Rx Station to accelerate after we get a core set of reference clients.

We are also using the Care Aware architecture to connect other technologies common in the healthcare environment including HVAC, lighting, entertainment and the Internet, creating a contextually sensitive smart room. It includes our recently introduced My Station making the patient and family an integral and informed part of the care process. We signed three clients for smart room pilots during the quarter. All of these pilots serve as pointers to their desired future state where our big opportunity is for entire facilities to be built or converted to smart rooms.

Our Smart Semi, better known as the traveling smart room, had another busy quarter visiting about 40 more locations. The Smart Semi has now made 64 stops with 4,600 client attendees since launching in May. We have been extremely pleased with the enthusiasm it has generated in our client base and

Many times with the CEO bringing their Board members for a private tour showing the direction IT is taking healthcare. The Smart Semi returned to Kansas City for our Health Conference and was a big hit inside the convention hall at our Solution Gallery. As a reminder, the Smart Semi is part of a unique marketing campaign for our Care Aware suite of solutions including MDBus, Rx Station, My Station and other solutions that collectively allow us to show smart hospital rooms of the future and a complete redesign of the care experience.

An interesting note is that recently a number of medical device organizations have approached us to form reseller agreements seeing our committed long-term strategic relationship with our clients and our ability to add tremendous value to their solutions. We plan to pilot a few of these relationships which will allow us to resell medical devices as part of connectivity bundles that will simplify purchasing for our clients and create another source of revenues for growing Cerner.

Now I will update you on some operational progress. We had a good quarter delivering solutions to our clients. I believe the advanced use of IT by many of our clients is creating a gap in the industry that will only widen as our clients continue to adopt more wide space solutions and services.

A good example of a client’s successful use of IT is Eastern Maine Medical Center, which recently announced they are this year’s only winner of the Nicholas E. Davies Organizational Award for Excellence. This prestigious award is given to select hospitals in the country for effectively using information technology to improve the safety, quality and efficiency of patient care. Examples of achievements through IT that contributed to them being selected include: Improving the ratio of electronic to written orders from 5:1 to 14:1; Eliminating 160 minutes from order writing to pharmacy receipt of orders and decreasing the average time for pharmacist review by 52%; Decreasing medication incidents by 27% over two years; Saving physicians and other providers 40 to 60 minutes on daily rounds; Improving core measure performance for AMI, Heart failure and pneumonia; Decreasing hours spent abstracting data by 50% and leveraging our Lighthouse clinical process optimization services to drive significant growth in case volume and improvements in average length of stay and percent of orthopedics patients requiring transfusions.

Another example of our clients’ advanced use of IT is their presence in the 2008 Leapfrog Top Hospitals list with 22 of the 33 named hospitals being Cerner clients.

A Leapfrog Top Hospital fully meets Leapfrog’s standards for CPOE, ICU staffing and fully meets or has made significant progress toward Safe Practice guidelines. To conclude on the operational front it said very simply, our clients are achieving more through their partnership with Cerner than others in their regions are with competitive solutions and it is having a meaningful impact to their businesses.

Now I would like to discuss our Cerner Health Conference which took place earlier this month. More than 7,000 total attendees including hospital clients, physician practices, industry partners and Cerner associates participated in our annual client conference. Attendees this year came from 47 states across the U.S., 13 countries and 5 continents.

This year’s conference theme was “Come Together,” which relates to how healthcare professionals, employers, government leaders and Cerner associates work together to achieve optimal benefits from IT. The conference amplified our All Together brand positioning where Cerner clients shared their industry leading experience firsthand with other attendees. This year we had 505 client speakers and 416 education sessions with more than 60% of the sessions qualifying for continuing education credits for physicians, nurses and other healthcare professionals.

This total not only greatly eclipses other comparable HIT supplier events it also exceeds the educational session counts for the largest industry events such as RSNA, HIMSS, CHIME or AMIA.

For many organizations this has become the event they attend each year.

In closing, I will make some comments on the status of the U.S. marketplace. Overall, we believe the fundamental drivers for IT demand and adoption remain firmly intact. The fundamental impact our solutions have on safety, efficiency and cost drives an internal commitment to rank our projects over just about every competing priority. Most of our clients also believe they must continue forward to meet current and future regulatory requirements. Just a few examples of these requirements and pressures on hospitals to adopt IT include: Facing a review of charges by Medicare Regulatory Audit Contractors (better known as RAC audits) and being required to pay back unsupported charges; Complying with ICD 10 diagnosis and procedure coding requirements; Improving processes and systems to reduce the impact of the never events which are conditions that are no longer reimbursed if caused after a patient is admitted and complying with pay for performance and pay for reporting requirements which are now starting to include HIT requirements such as the 9 HIT measures recently recommended by the National Quality Forum.

Overall with our help, our clients are making tremendous progress using our solutions to automate more of their processes across their enterprises and as Trace will discuss the current political environment does not seem to be a threat to healthcare IT because it has bi-partisan support due to the focus on rising healthcare costs and the widely known cost savings benefits of HIT.

Hospitals also remain operationally sound but as Marc mentioned we are monitoring the market closely for any impact of the credit market issues. In Q3 we did have a few contracts slow down due to these issues as the client management teams paused their contracting process to work on their short-term financing strategies. In all of these cases the clients have found solutions to their short-term problems and are proceeding with their initiatives.

Our quarter results were still very strong demonstrating the strength of and breadth of businesses, the size of our client base and our participation in the broad worldwide marketplace.

While times are full of uncertainty our clients are resolving the short-term issues with access to debt and our forecasts for the next few quarters are currently composed of the necessary components I believe it takes to deliver the predicted results but we certainly understand the possibility that a sustained recession and credit crunch could start to impact our clients’ ability to invest in IT. As Marc said we have tried to factor these risks into our guidance for Q4 by widening the range but overall we believe that we are well positioned to continue delivering solid results even in a tough broad economic environment.

With that I'll turn the call over to Trace.

Trace Devanny

Hello everyone. Today I will discuss some good progress in our international business and some thoughts on the upcoming election.

On the global front, demand for healthcare IT continues to strengthen driven by the same factors facing the US Healthcare System: safety, efficiency and productivity. This was illustrated at our healthcare conference earlier this month which included clients from twelve non-U.S. countries. Financially, we had strong global result in Q3 with our revenue growth rebounding after facing tough comparables in the first half of the year.

I would now like to comment on developments in the quarter beginning with the Middle East.

Last quarter, I highlighted several important go-lives in the emirate of Abu Dhabi and indicated that this success positioned us well for continued progress in the Middle East. I am pleased to report that we, in fact, did build on this success and we were recently selected by the Ministry of Health in the United Arab Emirates to provide a broad Millenium suite of clinical and administrative solutions.

The Ministry of Health sets medical regulations and healthcare policy for private and public hospitals in the UAE. It currently runs 12 public hospitals and 60 primary care healthcare centers in the Northern Emirates including Sharjah, Ajman, UAQ, Ras Al Khaimah, Fujairah and a portion of Dubai. This is a landmark opportunity for Cerner’s efforts in this region. Given the breadth of this important announcement I believe we have a chance to become the standard for care across the entire Middle East.

Another global highlight this quarter was continued progress in Australia, a very important market to Cerner with significant new potential. As you may remember from previous calls, we have been working in both New South Wales and Victoria for a number of years. In New South Wales we had a significant go-live under the New South Wales EMR Program at St. George Hospital, a 605 bed teaching facility and a major trauma center that is part of the southeastern Sydney and Illawarra Health system.

In Victoria, we finalized our state build work and executed an agreement to implement phase 1 of the EMR deployment at our first Health Service site. In addition, the Health SMART program, of which Cerner is the HCIT partner, has reached another major milestone with lead agencies Eastern Health and the Royal Victorian Eye and Ear Hospital committing to implement the Health SMART Clinical System solution.

Finally, in Queensland, we extended our relationship with Uniting Care Health, one of the largest not for profit private healthcare organizations in the country.

Moving to Europe, we had a milestone in France with the signing of our first ever hosted client outside the US. The private/public partnership between Ahnac and Valenciennes Community hospital. As we have discussed previously the French Government has introduced several significant new regulatory requirements. These requirements are designed to curb excessive medication use, modify reimbursement based upon DRG versus fee for service and to make a person’s medical record available upon request.

This has created demand for access to critical patient information via an electronic medical record. Our remote hosting offering is an important delivery mechanism in the current French Healthcare environment as it allows caregivers and critical hospital staff to focus on clinician adoption and change management without having to worry about managing the technology platform.

The target market for this offering is significant with approximately 3,000 small to mid sized hospitals in France that are likely to view our hosted ASP offering as a way to manage these ever changing regulatory and technology requirements. Also note that we are partnering with Hewlett Packard on the hosting component as we do not intend to build our own data center at this time.

In the United Kingdom both political parties held their annual conferences in recent weeks. Cerner’s executives that attended both events heard a set of public policy prescriptions where information technology solutions clearly will be a central enabler. The ongoing trend toward patient choice continues at the forefront of this agenda. Choose and Book, our national e-scheduling solution managed in conjunction with our partner, Atos Origin, has achieved more than 11 million bookings since its inception and set records for daily volume several days during Q3.

Much like markets in the rest of the world clinical quality indicators and increased performance measurement continue to be the policy mechanism for improvement. The pace of these expectations can only be achieved with a more robust clinical information platform which continues to drive the local demand for Cerner’s capabilities.

Working very closely with our partner, British Telecom, and our experience with the national program to date we continue to pursue opportunities to accelerate these benefits.

With the U.S. presidential election approaching, I’d like to briefly comment on U.S. politics and healthcare.

The United States is grappling with escalating consumer expectations and spiraling costs. The next President is facing the largest budget deficit in history with healthcare spending at over $2 trillion representing roughly 16% of our gross domestic product with no slowdown in sight.

For that reason, healthcare should be at the forefront of our domestic policy dialogue. Beyond just the spending challenges, coverage, access and quality will remain major themes in the healthcare debate.

Politicians and policy makers all agree that the current system is unsustainable and leaders of both parties express commitment to the intelligent use of information systems that improve health outcomes and correspondingly drive down cost. We believe this consensus and insight positions Cerner well in almost any policy climate. We believe that the fundamental transformation of healthcare delivery will include: New models of care delivery dealing with chronic conditions which are consuming an increasing amount of our healthcare dollar; New models of diagnostic medicine changing the boundaries of traditional silos such as laboratory, radiology, cardiology and pharmacy; The evolution of personalized medicine driven by the increased utilization of genetic diagnostic medicine; A new economic commerce model that will fix the misaligned incentive structures in today’s traditional medicine and rewards appropriate, high quality care; A modern surveillance system replacing the antiquated methods used today to protect public health and a fundamental change in knowledge discovery and the speed of dissemination of new knowledge into the main stream practice of medicine.

As you might have guessed, we believe strongly that healthcare IT will be the driver of each of these fundamental changes in the US as well as every country around the world.

In short, we believe the next decade looks both exciting and opportunistic for Cerner.

Before turning the call over to Jeff I wanted to provide a quick update related to our Health Employer Services organization. I am pleased to report that our first health center client, Cisco Systems of San Jose California, will be opening their Life Connections Health Center next month. This will be a fully automated, employee based health center based on Cerner's own successful on campus model. Cisco's health center will be staffed by 8 providers and numerous other staff and will be available to over 40,000 Cisco employees and dependents.

We are excited to help our partner achieve the same improvements in quality, efficiency and access to care that we have achieved with our clinic.

With that, I’ll turn the call over to Jeff.

Jeff Townsend

Today I am going to discuss some major progress on innovations we highlighted to our clients at our annual health conference as we use this venue to push the boundaries of our solution offerings, share successes with our clients and help create their future state roadmaps.

Throughout the event we used two platforms to collaborate and educate on both current and future innovations. The first being the education sessions with more than 95% of the 406 sessions being lead or co-lead by clients and industry partners. The other is through hands on interactions in our solutions gallery highlighting over 100 collaborative industry partners.

This year we introduced a very different experience for attendees showing care delivery in action across multiple smart venues. Consumer Health, Maternity, Critical Care, Physician Office and Diagnostic Medicine.

In addition, two venues were introduced to highlight the capabilities across rooms with a smart nursing unit that could track and monitor patient activity and context across all of the smart rooms and a device management venue to track and manage all equipment across the solutions gallery. As we’ve highlighted in previous calls, this setting brought to life several of our five-box initiatives.

One of the more complicated venues, maternity, was introduced during the conference and represents a collaborative development effort across 13 different client organizations. One of the initial testing partners for this solution is UAB Health System. Not only does this solution require the coordination of medical devices and multiple types of media it also involves a multi-patient set of scenarios to automatically move clinical information between mother and baby which could be as many as 60 independent clinical elements as well as the ability to perform clinical decision support across patients.

In the physician venue we highlighted a joint development initiative with the University of Missouri around the concept of a virtual home care delivery model they call the Medical Home. At the center of this innovation was the introduction of an embedded development platform within Millennium called M Pages.

As we’ve discussed before, we have reached a critical mass of information within the medical record turning the focus to getting the information out, creating the one contextual face up story of the patient. With the collaborative support of U of M physicians this is not only a view of clinical information but also includes expected plans of care and real time compliance for the patient, all patients under that physicians care and the targets for the entire physician group.

The most exciting part of this innovation is the ability to put this adaptive technology in the hands of our clients, unleashing the expertise at the point of care.

This is one of several technologies that we believe launch the next era with our clients where they will be directly involved in the development of the next generation of solutions. It has some parallel concepts with the Web 2.0 movement.

During the conference we announced the formation of Code Works, which is a development ecosystem that will allow our clients to develop, collaborate and share their innovations. The attraction of developers and their subsequent contributions will improve the value of existing solutions beyond what can be achieved organically inside Cerner.

Additionally, this approach should ultimately lead to new business opportunities for Cerner as we package and promote the collective learnings of the Code Works community.

Another technology which will be a contributor to the Code Works ecosystem is [iAware]. This was a solution was first prototyped and demonstrated at last year’s conference. Children’s Hospital of Pittsburgh demonstrated their use of this solution in Critical Care along with more recent enhancements such as hands free voice navigation and for those clients from outside the U.S. foreign language capabilities.

One of the more significant elements of this architecture was its quick install with the most recent implementation occurring in less than three weeks from code delivery to production use. As Mike highlighted in his Care Aware comments, the MDBus platform is playing a significant role in the expansion of our solutions moving the boundaries from the medical record centric workflows to the design of the entire care delivery process.

We have now moved from designing efficiency by removing clicks, to designing efficiency that removes steps. In other words, the number of times a nurse goes back and forth from the unit to the room and the delay that occurs in that process. This platform is much more than simplifying the connection and collection of data.

To highlight a few examples, with the collaboration of our industry partners we demonstrated programming IV pumps off of clinical orders in the electronic medical record. A patient falls prevention protocol interacting with a [Hillrom] and [iAware] alerting with the entire environment and care givers using My Station which is built on Microsoft’s X-Box.

Last I wanted to highlight a new open, layered technology that Marc mentioned which we acquired with the purchase of a company called Lingo Logix which strengthens our revenue cycle offerings immediately.

The solution was created through 15 years of research and development at Mayo Clinic and was tested and validated by Johns Hopkins University. Using natural language processing to part through clinical notes, it then applies contextual rules to drive more accurate and efficient reimbursement through automated coding.

In addition, at the conference we demonstrated how the NLP component of this technology can change the landscape for clinical search by bringing clinical meaning to unstructured clinical documentation, helping aid research, clinical trials and potentially provide a bridge to interoperability constraints as the personal health record becomes more pervasive.

Having the most active client base in the industry with constantly growing expectations has positioned us to push the boundaries. In 2008, we’ve been able to generate significant proof points for the next wave of innovations from solutions that live in the cloud to changes in care delivery at the bedside.

With that I will turn it over to the operator.

Question-and-Answer Session


(Operator Instructions) The first question comes from Bret Jones - Leerink Swann.

Bret Jones - Leerink Swann

On the credit market and what kind of impact, I know you said that it is in flux and it is hard to predict, but when we think about the two deals that slipped out in Q3 is it safe to assume those were more large deals and I was just curious now you have said they resolved their credit issues have those deals closed?

Mike Valentine

I didn’t actually say two. I said there were a couple of deals that moved out but there is also several that moved in. On their decision they were able to work through their financials to come up with a scenario that worked for them in each one of those cases so far. As to whether they signed yet or not we don’t comment on that so I will hold off on that until we get together in 90 days.

Bret Jones - Leerink Swann

When we do think about the credit market really I guess my biggest concern is the weaker hospital and operating metrics within the hospitals. Which segments of your business concern you the most in terms of deals pushed out or canceling? I’m talking add-on sales, poor clinicals or some of your other product lines.

Mike Valentine

We are worried about all of them. Obviously we want all the new business we can get. Specifically what we are developing a stronger radar around is the new business. We have strong relationships on the installed business side but we want to make sure we have extra sensitivity to net footprints coming in the door and we have had a series of meetings coming in the last few weeks that develop what we believe is a tighter radar around some of their actions and activities to keep them on the radar and keep us moving the ball downfield. So those are the ones I think I would describe we are most sensitive to.

Marc Naughton

I think that when we really look at our installed base probably more than 80% of that funding comes out of current operations and is not tied to a significant finance, it is part of the capital plan but normally part of the annual capital plan. New deals are the ones that are primarily part of not only an IT project in the hospital but they are doing some other activities. Between those for that purpose those are the ones to point out. As we talked in the past, a lot of our clients that are in the middle of doing a procurement and looking at some of these options already put their financing in place and once they have worked their way through the ARS issues we were confronted with at the start of the year we really I’d say getting down to where there is only a couple of deals that are impacted in the quarter that are basically the type the bond market completely dried up bodes well for us relative to being able to have our clients financed.

We are also offering and continue to offer the ability to finance through our partners. As most of you know we have used GE in the past. They were out of the market at the end of this quarter but we still placed our normal amount of funding through our other partners we have in that space and they are hungry for additional credits that these hospitals represent.

Bret Jones - Leerink Swann

Do you need the southern cluster to contribute to 2009 in order to achieve the 20% operating margin target?

Marc Naughton

I think what we indicated is that turning on margin in London and then the transition agreement that is in place and continuing to support the eight trusts that are live in the south and the ability to take margin on that contract gets us very close to the margins that we were expecting to generate in 2009 relative to our U.K. contracts. So I think with that as a backdrop and the likely resolution of the southern cluster some time in 2009 we feel pretty good maintaining our 20% outlook for 2009.

Bret Jones - Leerink Swann

I know you have a partial hedge in the U.K. I’m wondering where is the greatest foreign exchange exposure. How should we think about this looking forward as we are trying to assess what the potential impact will be as we progress throughout the rest of the year?

Marc Naughton

The reality is that the inter company accounts drive a lot of the FX impact and the biggest inter company accounts are in U.S. dollars, London British pound and Euros. So it is the interplay between those three currencies depending on our inter company balances. So it is actually very difficult to predict one way or the other with that interplay and based on the balances exactly what the impact is going to be. If we could we would certainly be letting people know what our best view is but it is something that for the most part it is a combination of so many things it is just very difficult to predict. That is why we have indicated certainly in this quarter we covered a very large loss and still delivered results. Our guidance doesn’t anticipate another large loss but it is difficult to predict.

Bret Jones - Leerink Swann

Do you anticipate a hedging more I guess? More of the exposure or no?

Marc Naughton

The income statement impact is not economic. It is all book keeping. We don’t hedge non-economic issues. The debt we took to hedge the payments we were going to receive in pounds down the road was truly an economic hedge and therefore we put that in place but just for the income statement to not have an FX impact through an economic hedge that would actually cost money doesn’t make any sense.


The next question comes from Atif Rahim – JP Morgan.

Atif Rahim – JP Morgan

Could you clarify for us whether the UAE deal was Q3 or Q4 deal?

Marc Naughton

It was a Q3 deal.

Atif Rahim – JP Morgan

I think the estimates that are out there for consensus 2009 assume a variety of contribution from the NHS in terms of operating profits. What is the company view on how much we should be modeling in for margin contribution there?

Marc Naughton

I think what we have indicated is the numbers that show up as consensus for earnings and revenues are numbers that we are comfortable with. I think you guys are the ones doing the modeling and my sense is that would probably be something you all have probably factored in to some extent. At this point really early in our 2009 planning process we can give you a high level of comfort with the numbers that are out there with an indication given they don’t reflect a 20% operating margin. We think there is some potential up side to them but I can’t really give you a specific given we are just indicating a comfort with consensus any sense of exactly what any element of our business is contributing to that.

Atif Rahim – JP Morgan

Would you give us that guidance next year perhaps in terms of the specific contribution from there?

Marc Naughton

We have never given the specific contribution relative to our guidance but certainly once we get more clarity with the U.K. we should give you enough that you can add to your models in that space.

Atif Rahim – JP Morgan

In terms of the deal with the hospital you said that did slow down there [inaudible]. Can you give us any idea of the demographics around those? What kind of hospitals those were or what geographies that happened in?

Mike Valentine

They were one a multi-entity facility or organization and another was academic. There were a handful of others I would describe as community that actually worked through their situation in a timely enough fashion to complete within the quarter. Geographically they are dispersed across the U.S. They all solved their problems in their own way. I think that answers your question.


The next question comes from Charles Rhyee – Oppenheimer.

Charles Rhyee – Oppenheimer

Just getting back to as you were talking about the expectations for next quarter and certainly as you have given your initial look on 2009 you talked about trying to build in some conservatism. Obviously with the current status of the market, when you think about the range you gave particularly on the down side can you give us more sense on what you are embedding or what would be that would get to the bottom end? What would you have to see in terms of bookings in the environment for your customers?

Marc Naughton

The key point we are making is we have gone through our forecasting process. We do a very thorough job of that and look at board approvals. We look at where the funding is relative to the deals we are forecasting and we feel very comfortable as I indicated at the high end of our guidance range. What the spread is just to indicate what we don’t know what we don’t know. There is unknowns in this quarter that are unique relative to the history of the company and we think from a credibility standpoint for us to laser in on a $0.02 range in this climate would indicate maybe we are not paying as much attention as we should. We see the business in our normal course as being strong. These health systems having access to capital and being on long-term projects to get to the benefits of automation and we think given the environment and given whatever new administration comes in the likelihood they will be supportive of that we feel very good about our position. But we want to let people know there are risks we aren’t aware of today that could impact us. There is nothing specific and I can’t really give you a break down in bookings to give you an answer of how we’d get the lower numbers but I can just tell you we like the high end of our guidance range but we want to be appropriately aware of the situation.

Charles Rhyee – Oppenheimer

Are you seeing any changes? Certainly you have visibility certainly in the third quarter and going into the fourth quarter. As we think about going into 2009 and in terms of your selling efforts have you seen any changes in the minds of the sales cycle? Is there any sense that people might be taking a little bit more time to think about things given the light of the current situation?

Mike Valentine

No we really aren’t. I think the processes remain pretty consistent. Some of the factors that are driving decisions have evolved over the last year but the processes are consistent and the time frames are pretty consistent.

Charles Rhyee – Oppenheimer

As you think about that 2009 guidance how much of your 2009 revenues would you say are pretty much booked given your current backlog?

Mike Valentine

Today we are really giving a general sense of where we are looking at relative to our plan. When we come out and do our Q4 call in Q1 we will have a much better idea and be able to give you some more details relative to that. We will also have our business model view of the year which will help you also in understanding those elements. At this point we can’t give you detailed information on that and we normally don’t do that as well. We certainly have done enough work that we are comfortable with where business is today. That is kind of the normal way we go put up the next year in Q3 with that indication if we think it is appropriate which we think we do.

Charles Rhyee – Oppenheimer

What is your assumption for tax rate in the fourth quarter? This quarter seemed a little bit lower.

Mike Valentine

I said it was 34-35%.


The next question comes from Glen Santangelo – Credit Suisse.

Glen Santangelo – Credit Suisse

I just wanted to follow-up on that guidance question. It kind of sounds like what you are saying in the fourth quarter is there is some level of uncertainty but are you kind of anticipating by promising 10% revenue growth and 18% EPS growth next year you think it is kind of going to be more of a temporary situation and so as you look at your pipeline in 2008 you feel the current credit environment probably plays or has that big of an effect next year?

Mike Valentine

Based on our normal forecasting process we go through four quarters. We have got a pretty good look into 2009 currently. These are 12-month sales cycles so we do have the ability to get some views out. Based on what we have done in our forecasting we are able to support our preliminary 2009 plans. We did put a wider range on our guidance for Q4 because we do think we are in a unique, potentially shorter term environment relative to credit markets.

Glen Santangelo – Credit Suisse

As you look at that at the backlog you are looking at for 2009 are you seeing any change in your historical patterns in the sense could more of that growth be coming from international sources versus domestic or vice versa? Basically what you are seeing in the near-term here is it impacting all of our international markets kind of similar to what you are seeing in the United States?

Marc Naughton

Our international markets have a different set of issues in some cases and in most cases they are government funded. There is significant access to capital in those. They are quite, at least the clients we are working with certainly aren’t subject to the vagaries of the credit market as much as our U.S. clients are. We look to the global market to be a certain growth area for us going forward so our 2009 plan will look to continue to grow our global business especially as Trace mentioned some of the successes we have had globally as we look to roll out of 2008.

Glen Santangelo – Credit Suisse

Was that UAE deal in the third quarter backlog? Did I hear that correct?

Marc Naughton

It was a booking for the third quarter.


The next question comes from Richard Close – Jefferies & Company.

Richard Close – Jefferies & Company

I was wondering if you could update us on how much revenue in the quarter comes from bookings sold in that particular quarter? It has trended down towards 10% correct?

Marc Naughton

It is pretty consistent with what we have seen historically. 10%-ish.

Richard Close – Jefferies & Company

If we look at the new footprint obviously that was very good in the quarter. If we X out the UAE contract would that have been more in line in terms of percentage of bookings with respect to new footprints?

Mike Valentine

It would have been consistent with where we were for the last 3-4 quarters which is in mid to upper 20%. So the bump with the UAE transaction definitely put us in to a different set of digits.

Richard Close – Jefferies & Company

If we look at the contracts over $5 million and $10 million just remind me, are those all new clients or does that include existing clients as well?

Marc Naughton

That includes existing as well.


The next question comes from Anthony Petrone - Maxim Group.

Anthony Petrone - Maxim Group

On housekeeping if I look at the cash balance what was the average price of the buy backs this quarter?

Mike Valentine

We’ll have that in our Q. As you know we announced our buyback and the price went up pretty dramatically with our results. I would say that it had to be probably in the low $40’s.

Anthony Petrone - Maxim Group

Walking through the cash balance here last quarter you had about 291 available cash and at close out here 297. Cash was actually up. You generated operating cash during the quarter yet if we do the math on 4 million shares at around $40 I’m just trying to figure it out.

Mike Valentine

$4 million, not shares.

Anthony Petrone - Maxim Group

In terms of if I go down in terms of the UAE contract it seems that is a larger contract than what you are usually used to doing. If it is what is the outlook for the implementation cycle on that contract?

Marc Naughton

The UAE contract is equivalent to a large health system deal in the U.S. It is not unique in any way. It is from an implementation standpoint we are going to apply all the new efficiency tools we have. We are going to use the new solution center for a lot of the build, methodM. We are actually well set up to be successful in getting that implemented. It is not unique in any way relative to a large health system in the U.S.

Anthony Petrone - Maxim Group

There was an announcement during the quarter out of CNS that they had launched a new incentive program in conjunction with some federal and state health agencies that was geared toward the small and mid-sized physician practice office. Obviously it seems that you are well positioned to benefit from this program with [Palworks]. How much of that is included in the guidance? There is a November 26 application deadline for that program. If you could quantify the fourth quarter impact and more importantly into 2009 and also as a follow-up what is your outlook on the small physician practice side of the market given the tightness in the underlying credit markets at this time?

Marc Naughton

For us we deliver on the ASP model so that really has essentially zero impact for us on the quarter.

Anthony Petrone - Maxim Group

Not in the current quarter. I mean it is not instituted until the fourth quarter and beyond.

Marc Naughton

It still would be anticipated to have a very small effect. We don’t see it driving a lot of business to us at least at this time. We apologize for the length of our comments today. You can probably tell we are excited about the results and wanted to talk about them at length.


The next question comes from Sandy Draper - Raymond James.

Sandy Draper - Raymond James

I missed the opEx guidance for the fourth quarter. What number did you say?

Marc Naughton

We said we would be at the 80-100 for the year and we were at 58 now.

Sandy Draper - Raymond James

For your operating expenses, sorry.

Marc Naughton


Sandy Draper - Raymond James

Any reason the support backlog was flat sequentially? Anything to sort of explain that? Obviously you stepped up. You had good support revenue. I’m just trying to figure out why maybe the backlog didn’t fill there. I had on my spreadsheet you support backlog was $600 million for both this quarter and last quarter. I’m just trying to figure out why there wasn’t a step up in support. Was that just maybe some of the U.K. coming out following after the other from last quarter?

Marc Naughton

It is going to vary. It is a calculated number so it is really based on a variety of things. We can check back with you after the call. I don’t have that number.

Sandy Draper - Raymond James

Nothing you are aware of to read to that there is anything going on?

Marc Naughton


Sandy Draper - Raymond James

When you look at professional services, trying to understand your comments, is there a timing period or point in which you cycle easy comps and you expect professional services to grow or I’m just trying to think without getting specific 2009 guidance is this something you would definitely start to expect to rebound in 2009? The flatness now when do you expect that to step up?

Marc Naughton

The logic would be that some of these contracts we are signing as we are having a strong finish to the year there will be professional services related to those. We do expect the U.K. to start ramping back up during 2009. So all of the indicators would indicate that we should start seeing positive growth in our services business both globally and as we have seen recently growth in our domestic as well.

I’ll turn it over to Neal for some closing comments.

Neal Patterson

I was looking for somewhere to add some commentary in the Q&A but the team here was doing a great job. Just a couple reflective comments here at the end. Actually this reminded me a little bit of 10 years ago as Y2K was approaching and everybody was quite nervous and wasn’t sure whether the world was going to come to an end or not, or at least all computers stopped working. That didn’t happen and we didn’t think it would happen.

I think we are all a little nervous with these kind of times around us. I think it has been said and I will re-state it. People don’t choose to be sick. You choose whether to buy the new car or new refrigerator but healthcare there is not a lot of choice to is. So if we are in for a recession or we are in a recession it will probably impact healthcare but it is not going to impact it the way it does other industries. Our clients, their choice of another CT Scan or whether they are going to automate their whole clinical practice and kind of prepare for the future, we come out on top of that when our clients prioritize their use of their capital.

The credit markets, we watch that very closely and it grabbed the attention of some management teams we work with daily. I personally feel with my clients and they all got pretty innovative pretty fast and they really didn’t lose their focus on what their major projects were and it grabbed their attention so that wasn’t always the best thing but it didn’t change what we are doing with them.

There is more uncertainty in these times than there has been but we have the greatest scale, the best scale of any company in this industry. Our global footprint is a positive here. There is always something happening somewhere that is both positive and negative somewhere in the world so having the diversification at the footprint level and our global reach is certainly a positive here.

Our business model has changed a lot over these last 10 years and almost all of those changes are better. They provide for us the, and over this last 10 years we have delivered frankly very good, predictable, consistent results so when we say it is going to happen we have a very good track record of it happening. We always are going to put the caveat at the end these are forward-looking statements.

So we have moved a lot, the company in the last 10 years and frankly the next 10 years nobody is going to stop in this day in time to think through what is going to happen in the next 10 years but how information technology and how integral it becomes in healthcare delivery and the levers and opportunities to really make fundamental changes to healthcare those levers are going to create a lot of opportunity for us going forward.

We have a very good team here at Cerner. We have proven we can not only manage a company as we grow it but we have also proven we can continue innovating and creating new opportunities for us around IT and we are going to continue to do that.

With that I’ll close. Thanks for your attention. We’ll talk to you in 90 days.


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