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Cerner (NASDAQ:CERN)

Q1 2013 Earnings Call

April 25, 2013 4:30 pm ET

Executives

Marc G. Naughton - Chief Financial Officer, Executive Vice President and Treasurer

Zane M. Burke - Executive Vice President of Client Organization

Michael C. Neal - Senior Vice President of West Region and Senior Vice President of Client Organization for Cerner Pacific

Neal L. Patterson - Co-Founder, Chairman, Chief Executive Officer and President

Analysts

Charles Rhyee - Cowen and Company, LLC, Research Division

Michael Cherny - ISI Group Inc., Research Division

Sean W. Wieland - Piper Jaffray Companies, Research Division

Lisa C. Gill - JP Morgan Chase & Co, Research Division

George Hill - Citigroup Inc, Research Division

Zachary William Sopcak - Morgan Stanley, Research Division

Richard C. Close - Avondale Partners, LLC, Research Division

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

David Larsen - Leerink Swann LLC, Research Division

Steven P. Halper - Lazard Capital Markets LLC, Research Division

Operator

Welcome to the Cerner Corporation's First Quarter 2013 Conference Call. Today's date is April 25, 2013 and this call is being recorded.

The company has asked me to remind you that various remarks made by 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 Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by the 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 the Cerner's Form 10-K together with the other reports that are furnished to or filed with the SEC.

A reconciliation of non-GAAP financial measures discussed in this earnings call can be found in the company's earnings release that was furnished to the SEC today and posted on the Investor section of the cerner.com.

At this time, I'd like to turn the call over to Marc Naughton, Chief Financial Officer of the Cerner Corporation.

Marc G. Naughton

Thank you, Kimberly. Good afternoon, everyone, and welcome to the call. I'll lead off today with a review of the numbers. Zane Burke, Executive Vice President of our Client Organization, will follow with sales highlights and marketplace trends. Mike Neal, Executive Vice President and Chief Operating Officer, will discuss operations and our works businesses; Neal Patterson, our Chairman, CEO and President, will be available during Q&A. Jeff Townsend, Executive Vice President and Chief of Staff is traveling today.

Now I will turn to our results. We delivered excellent results in the first quarter across all metrics except revenue, which was impacted by reduced levels of low margin technology resale that has little impact on our earnings, which were above expectations.

Our total bookings revenue in Q1 was $801.6 million, which is an all-time high for a first quarter. Bookings exceeded the midpoint of our guidance range by more than $60 million, and we're up 23% from Q1 of '12 when bookings grew 24%. Bookings and margin in Q1 was $717 million or 89% of total bookings. Our bookings performance drove a 21% increase in total backlog to $7.58 billion. Contract revenue backlog of $6.83 billion is 23% higher than the year-ago. Support revenue backlog totaled $748 million, up 6% year-over-year. Revenue in the quarter was $680 million, which is up 6% over Q1 of '12. The revenue composition for Q1 was $199 million in system sales, $161 million in support and maintenance, $306 million in services and $14 million in reimbursed travel.

System sales revenue reflects a 12% decline from Q1 of '12, which has grown 61% over the prior year, creating a very tough comparable. The decline this quarter was driven by a significant year-over-year decline in technology resale, which overshadowed growth in subscriptions and software. As you may recall, in Q1 of '12 we had approximately $40 million of upside driven by strong hardware sales and strong growth in device resale. In Q1 of '13, hardware was at more normal levels, while device resale declined. Since device resales are often driven by the third-party sales force, our visibility to that revenue is not as high as the rest of our business. In some quarters, that has provided an upside to revenue, but this quarter the lower device resale revenue was below our expectations, resulting in revenue below our guidance range.

The good news is that hardware and device resale are low margin businesses, which allowed us to still drive 8% growth in system sales margin dollars on the lower revenue number. As a reminder, we have looked to increase our technology resale business as part of a strategy to focus our clients, while making all of their technology purchases through Cerner. This allows us to address more opportunities and provides a platform to discuss device related solutions like CareAware or iBus. As we look across the rest of the year, our expectations for technology resale to start increasing from current levels.

Moving to services. Total services revenue was up 18% compared to Q1 of '12 with strong growth in managed services and professional services and increasing contributions from ITWorks and RevWorks. Support and maintenance revenue increased 10% over Q1 of '12.

Moving to gross margin. Our gross margin for Q1 was 81.3%, which is up from 78.3% in Q4 of '12 and 75.4% in Q1 of '12. The increasing gross margin percent was driven by the lower mix of technology resale and strong services margins.

Gross margin dollars increased 14% over Q1 of '12, which is more reflective of our underlying business growth than the revenue growth.

Looking at revenue by geographic segment. Domestic revenue increased 4% compared to Q1 of last year, and global revenue increased 19%. The lower domestic revenue growth is directly tied to lower technology resale. This is evidenced by the 12% growth in domestic gross margin dollars, which was driven by growth in the higher margin components of our business.

Looking at operating spending. Our first quarter operating expenses were $385 million before share-based compensation expense of $11 million. This is a year-over-year increase of 11%, which was below the growth of our gross margin dollars, reflecting ongoing operating efficiencies.

Sales and client service expenses increased 9% compared to Q1 of '12, driven by an increase in revenue-generating associates and our services businesses.

Our investment in software development was up 14% compared to Q1 of '12. As we have discussed, we have been hiring in our R&D organization, as well as utilizing consultants for targeted development work and we expect our R&D investments to continue growing. This will be reflected in increased gross spending and increased capitalized software throughout the rest of 2013. G&A expense increased 21% compared to Q1 of '12 driven by increased personnel expense related to our strong growth and higher amortization expense.

Moving to operating margins. Our operating margin in Q1 was 24.7% before share-based compensation expense and was up 340 basis points compared to Q1 of '12. This was driven by a combination of ongoing operating efficiencies and the lower level of low-margin technology revenue. I would point out that even if revenue had been at the midpoint of our guidance range, without any additional margin, we still would've expanded operating margins by 250 basis points. We expect margin expansion to remain above 100 basis points for the year.

Moving to net earnings and EPS. Our GAAP net earnings in Q1 were $110 million or $0.62 per diluted share. GAAP net earnings included share-based compensation expense, which had a net impact on earnings of $7 million or $0.04 per diluted share. Adjusted net earnings were $117 million, and adjusted EPS was $0.66, which is up 22% compared to Q1 of '12.

The Q1 tax rate for adjusted net earnings was 32%, which is below our expected effective tax rate of approximately 34% due to a catch-up of the R&D tax credit, which was retroactively reinstated for 2012 in early 2013. Using a 34% tax rate reduces adjusted earnings per share by $0.02. For the remainder of 2013, we expect our effective tax rate to be approximately 34% plus or minus 50 basis points.

Now move to our balance sheet. We ended Q1 with $1.52 billion of total cash and investments, down from $1.55 billion in Q4. Total cash and investments include $1.01 billion of cash and short-term investments and $516 million of highly rated corporate and government bonds with maturities less than 2 years. Our total debt, including capital lease obligations, is $182 million.

Total receivables ended the quarter with $512 million, which is down $66 million from Q4. Contracts receivable, or the unbilled portion of receivables, were $30 million and represent 6% of total receivables. Cash collections were a record $784 million. Our DSO in Q1 was 69 days, which is down from Q4 DSO of 74 days and 76 days in Q1 of '12 and at the lowest level in the company's history.

Operating cash flow for the quarter was $214 million. Q1 capital expenditures were $49 million and capitalized software was $34 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $130 million.

Looking at the remainder of 2013, we expect quarterly capital expenditures to be in the $50 million to $60 million range as construction of additional space at our new Kansas City Kansas campus continues. At these levels, we still expect to generate good levels of free cash flow.

Moving to capitalized software. The $34 million of capitalized software in Q1 represents 37% of the $93 million of total investment in development activities. Software amortization for the quarter was $22 million, resulting in net capitalization of $12 million or 13% of our total R&D investment. As I indicated, we expect capitalized software to continue to increase in 2013, as we invest in areas Zane and Mike will discuss, that will position us for strong growth through the decade. Much of the growth in capitalized software is related to third-party developers we are using to accelerate development in certain areas. As a result, we expect the growth of capitalization to be temporary, as we plan to moderate these to third parties after 1 to 2 years.

Similar to this quarter, our net R&D expense will still be growing throughout the year even with increased capitalization, as we aren't just capitalizing that higher percent of existing spend. We view this approach, combined with our share buyback and small acquisitions, to be a good use of our capital.

Regarding our share buyback, we've purchased 722,000 shares for approximately $63 million during the quarter and now have $107 million remaining from the $170 million that was authorized in December.

Now we go through Q2 and full year guidance. For Q2, we expect revenue between $705 million and $735 million, with the midpoint reflecting growth of 13% over Q2 of '12. The slightly wider revenue guidance range accounts for a wider range of results in technology resale, and reflects expected ongoing strength in other areas.

For the full year, we continue to expect revenue between $2.95 billion and $3.05 billion, reflecting 13% growth at the midpoint. Given the lower technology sales in Q1, we are currently biased towards the midpoint of the range, but that could change as the year progresses.

We expect Q2 adjusted EPS before share based compensation expense to be $0.66 to $0.68 per share, with the midpoint reflecting 14% growth over Q2 of '12 reported adjusted EPS and 22% growth when you consider the $0.04 benefit we had from lower taxes in Q2 of '12.

For the full year, we expect adjusted EPS between $2.78 and $2.83, which is up from our prior guidance range of $2.75 to $2.82. The midpoint reflects 17% growth to our reported adjusted EPS and 20% growth when you adjust 2012 for a lower tax rate in Q2 and the gain on the investment sale we had in Q4.

Q2 guidance is based on total spending before share-based compensation expense of approximately $395 million to $405 million. Our estimate for impact the of share-based compensation expense is approximately $0.04 to $0.05 in Q2 and $0.17 to $0.18 for the full year.

Moving to bookings guidance. We expect bookings revenue in Q2 of $825 million to $875 million, with the midpoint reflecting 21% growth over Q2 of '12.

In closing, we are pleased with our results in Q1. With the exception of low margin technology revenue, all our key metrics were stronger than expected and we are well-positioned for a very good year.

With that, I'll turn the call over to Zane.

Zane M. Burke

Thanks, Marc. Good afternoon, everyone. Today, I'll provide sales highlights and discuss marketplace trends. Starting with our results. Our bookings revenue in Q1 of $802 million is an all-time high for our first quarter and reflects 23% growth over Q1 2012. This increase was driven by strong growth across most business models, which more than offset the decline in technology we saw Marc discuss.

Looking at other bookings metrics, we had 25 contracts over $5 million, including 16 over $10 million. The mix of long-term bookings was 32% in the quarter, which is in line with historical levels. We had continued success in expanding our Millennium footprint, with 27% of bookings in the quarter coming from outside our core Millennium install base. As I discussed at our Investor Day in March, our competitiveness is strong and we have a very good pipeline of new footprint opportunities. This competitiveness was evident again this quarter in another head-to-head win against our primary competitor, where our improvements and position experience and revenue cycle were favorably received and our capabilities and population health proved to be the deciding factor.

In addition to success at getting net new clients, we also continue to have success with existing clients expanding their Cerner footprint by selecting us to displace other suppliers in sites where they don't have Cerner. This is driven by a combination of our proven ability to deliver and lack of execution by other suppliers and the desire of our clients to standardize across their delivery networks and prepare for future models of healthcare.

To give you a sense of how big this opportunity is, 7 of the top 10 health systems in the U.S. have a Cerner EMR footprint. And just within these clients, there are more than 300 sites that don't currently have a Cerner EMR footprint. This represents a substantial opportunity in the coming years.

The desire to standardized on Cerner is not limited to inpatient facilities or just clinical solutions. We also continue to see a trend to large IDN client switching to Cerner ambulatory solutions and expanding their use of Cerner revenue cycle solutions in both inpatient and outpatient venues. Clearly, the enhancements we have made to position and revenue cycle solutions are beginning to show up in our results. We're continuing to invest heavily in these areas, along with population health, which we believe will create substantial competitive differentiation in the market place.

Outside of the U.S., we had a good start to the year. In England we were selected by Lewisham Healthcare NHS Trust to implement a broad range of solutions and also had a good sales into our existing clients. In Canada, we substantially expanded our relationship with Vancouver Island Health Authority by creating an alliance to accelerate the deployment of our EMR throughout the island and across the continuum of care. In addition, Vancouver Island has become our second institute client with Tiger Institute being the first. Our primary focus will be jointly innovating in areas of population health and care for the elderly.

In the Middle East, we had strong results in Q1 and just received additional good news earlier this week from the Saudi Ministry of Health that we have been awarded the first pilot hospital for their national project. The pilot site is a recently constructed 500-bed hospital located in Riyadh. The scope of the national project includes 270 public hospitals across the Kingdom of Saudi Arabia. We've been working towards this opportunity for a long time and are very focused on delivering outstanding results at our pilot site to position ourselves for future opportunities in the national project.

Moving to the marketplace. We continue to see the following marketplace trends. Several suppliers are struggling with execution, which is creating more clear separation among the 2 most successful companies and then the rest. The significant volume of measures and mandates continue to pressure our clients with Meaningful Use, healthcare reform, ACOs, Value-Based Purchasing, quality reporting and changes in readmission reimbursement, representing the initial steps toward a transition away from fee-for-service to providers being responsible or health populations. As providers face these challenges, we are seeing them more focused on getting value out of their investments, which has led to more interest in share savings models and then our works businesses that allow them to impact our costs. Providers are also increasing their focus on population health strategies, as it become more clear the industry will shift to an at-risk model but in a sense of health, not just care.

Another area that is getting increased attention is revenue cycle. As the lines between clinical and revenue cycle blur, clinically driven revenue cycle has become a requirement. All new opportunities want integrated clinical and revenue cycle solutions and our existing base is transitioning to Cerner's revenue cycle at a more rapid pace.

Finally, industry consolidation is continuing, with health systems buying hospitals, physician practices and other venues to control more of the continuum of care, as they position themselves for the population health era. All these trends have been positive for Cerner and we expect them to continue. We have been extremely successful so far in the EMR era, and we believe that we are well-positioned to significantly expand our EMR footprint in the coming years. At that point, the healthcare industry will be wired, which is when our ability to use data to create optimal outcomes will differentiate us.

Before handing the call over to Mike, I'd like to make a few observations coming out of HIMMS, which took place in New Orleans last month. We had a great show with our booth demos and meeting rooms at or near capacity most of the week. We tracked over 2,000 interactions with clients and prospects. I was pleased with our ability to balance what we call the now and the next at HIMMS. We had a good balance and have been showing great progress on now topics, such as physician experience and revenue cycle. We're also showing the most comprehensive view of population health, which represents a key next topic. We found that while there are plenty of pretty screens and dashboards for population health at other booths across the floor, most of them had a narrow focus and lack access to real-time, rich content that is necessary to really make the tools useful.

We clearly have the most comprehensive approach to population health and we expect to make significant progress this year through our increased R&D investment and our expanded relationship with Advocate Health Care. As a reminder, the first phase of our partnership with Advocate was to work together to build effective models and algorithms that change the cost and quality of care and populations. We are now working with them to automate the workflow of population health management across their system, which is the largest accountable care organization in the U.S. This involves creating rules-based health management programs to facilitate optimal care and workflow across a network of doctors, hospitals, home health, nursing homes, pharmacies and other stakeholders. We believe this work will be a great foundation for solutions that can create significant value for our entire client base.

In summary, I'm very pleased with our results in Q1 and I believe we are very well positioned competitively and the investments we are making will only strengthen our position.

With that, I'll turn the call over to Mike.

Michael C. Neal

Thanks, Zane. Good afternoon, everyone. Today, I'm going to be discuss revenue cycle, ITWorks and our R&D focus areas. I'll start with revenue cycle. The highlight of the first quarter for revenue cycle was the expansion of our relationship with Adventist Health. As we announced in March, Adventist Health is transitioning responsibility for its revenue cycle management services to Cerner. As part of the agreement, members of the revenue cycle leadership team from Adventist have become Cerner associates.

The focus of the partnership will be decreasing variability and driving best practices to the standardization of revenue management technologies and business processes, as well as fostering discovery and innovation on Adventist Health's journey to population health.

Ultimately, this alignment allows for continuous innovation of software and revenue cycle management workflows to address both current and future reimbursement models. Their selection of RevWorks follows them choosing us last year to provide solutions and services for an integrated revenue cycle platform across their acute ambulatory and post acute venues.

An additional Q1 highlight for revenue cycle was another 1 of our large health system clients choosing Cerner RevWorks business-offered services for their ambulatory facilities. We will be responsible for business-offered services for nearly 800 physicians, making this our largest ambulatory revenue cycle client.

In summary, the tighter linkage between clinical outcomes and revenue cycle is leading more of our clients to evaluate our revenue cycle offerings in both acute and ambulatory venue. The recent endorsements from Adventist and other large clients is driving an increase in activity across our install base, as well as contributing to the success in new client opportunities.

Moving to ITWorks. Q1 did not include an ITWorks deal, but we are seeing the level of interest in ITWorks increase as our clients face ongoing pressures to address multiple industry requirements while also controlling costs. As a result, our pipeline is very strong, and we expect significant contributions from ITWorks in Q2 and for the year.

Now I'd like to focus -- now I'd like to discuss our areas of focus on R&D and our approach to accelerating innovation. Last quarter, I went -- when I went through our imperatives, which are focused on physician experience, population health and revenue cycle, or as we define it, PPR, as you would expect, a major portion of our R&D efforts are focused on these areas. We've already made significant progress in each of these areas, and we believe the window of opportunity during which we can leapfrog the competition in physician experience and revenue cycle and further our leadership position in population health. These investments are what will set up the next wave of growth, and we are going to invest heavily now while most competitors are bogged down with Meaningful Use and other regulatory requirements.

To go fast, we're supplementing our direct hiring of engineers with utilization of third parties in targeted areas. We're embedding these third-party resources into existing development teams so we can go faster without relinquishing control or losing efficiencies. In addition to the benefit of going faster, we believe this approach will allow us to moderate the spending after 1 or 2 years of elevated investment.

Before handing the call over for questions, I'd also like to make a few comments on interoperability and the CommonWell Health Alliance. As Jeff announced on our last call, we have been increasingly vocal around our support for interoperability and the importance that this will have on realizing the benefits of a digital health economy.

For example, Cerner's contributed over 50,000 lines of open-source code along with personnel and money toward the development of the Direct Project, which is a standard-based method for electronic sharing of encrypted health information. But a giant historical barrier to full and fluid interoperability has been the lack of a systematic method of identifying individuals. Without accurate identity management, large-scale interchange of records can actually lead to mismatched data and new sources of error. If we don't do something, the return on a significant investment in EMRs will be diminished. It would be like building a telecom network, but not having phone numbers.

The CommonWell Health Alliance, which was announced in March by Cerner and other founding members is aimed at addressing this problem. CommonWell is an open, nonprofit consortium, founded on the idea that patients and their care providers should be able to access their health information regardless of where care occurs. A central piece of CommonWell is an agreement to use a standards-based, cloud-based identity management service to help ensure accurate patient identification and to manage consent and keep track of the location of records.

CommonWell membership is open to all, and we are actively recruiting other healthcare IT companies and expect several more to join soon. We look forward to validating the concept through the pilot this year. This is the right thing for healthcare, and it needs to happen if we ever want to achieve the level of care coordination we envisioned in the future.

With that, I'll turn the call back over to the operator for Q&A. Kimberly?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from the line of Charles Rhyee from Cowen and Company.

Charles Rhyee - Cowen and Company, LLC, Research Division

Marc, just had a quick question on -- really on the bookings. Obviously, a good strong quarter on international. Can you give us a sense in the bookings mix, what -- maybe how international bookings are looking relative to domestic? Looks like on the revenue side we're seeing good international growth, is that the same that we're seeing also in the bookings?

Marc G. Naughton

Yes, this is Marc. I think clearly from the bookings side, some of the deals we talked about with Vancouver Health Authority, Vancouver Island Health source and some other opportunities we had globally, there was a very strong quarter for global. So I think that's spelt good from a bounce back. We've talked on these calls about areas of the globe that do have strong economies and are in an acquisition stage. So I think that's positive. Clearly, the Saudi pilot announcement that we've been chosen to as the first selected supplier there to move forward is a very big deal in the Global Market. So I think we're starting to see some good contributions from global. Obviously, we're also seeing good strength in the U.S. But I think it's pretty reflective of the revenue growth from the global side that we're starting to see that bounce back.

Charles Rhyee - Cowen and Company, LLC, Research Division

Okay. And then maybe just as a follow-up question on the tech resale, obviously, you kind of missed your expectation, but is it one of those things where maybe the deal didn't close in the quarter because of the -- the vendors themselves not getting it done. Does that mean that we just -- shifting these are maybe pushed out a little bit? Or not necessarily that the deal is dead?

Marc G. Naughton

Well, I think on the tech resale side it's usually not the result of 1 single big deal that's out there that doesn't get done. It's a series of smaller transactions. These transactions oftentimes are driven by the third-party sales force. So we don't get a lot of visibility to it. In some cases, we don't -- we may even be competing in some cases, which seems unusual, but that is how it works. So we even get less visibility there. I don't think that there's any pent-up deal that's going to fall in a different quarter. I think from our standpoint, we've always had a little bit of lumpiness in the tech resale. We looked in Q1 of '12, we delivered $40 million over revenue expectations in Q1. Q2 kind of Q3 and 4 were a little bit more in a tighter range. And I think we're using those as our best estimate of what we're projecting for Q1. I think the variety of things relative to timing of deals, rollout of new platforms by some of those suppliers, there's a bunch of things that can impact that. But there wasn't any single big deal that's going to come back in later. I think on my comments, I indicated that we do kind of think that this is a low point and then it will start ramping up, gradually, through the rest of the year. But we don't see -- Q2 won't have a catch-up, if you will, relative to what the '12 levels were. And once again, this is low margin stuff. To be able to kind of be that $10 million below our guidance range, $25 million off the midpoint and not impact our earnings at all was -- gives you an indication of -- that this is more of a strategic sale, part of our goal of having those clients buy everything we can from us, so that we can identify needs, be able to sell some of our device connectivity software into these clients rather than something that we're all looking to make a lot of money on.

Operator

The next question comes from the line of Mike Cherny from ISI Group.

Michael Cherny - ISI Group Inc., Research Division

So I just want to dig in a little bit to the comment I believe Zane made about the trend you're continuing to see in terms of the large IDNs and converting over on the ambulatory side to more Cerner Solutions. I know that for a long time ambulatory is a place that you'd spend a lot of dollars investing in and really improving the functionality there. Now as we think about going forward, particularly with regards to Stages 2 and 3 Meaningful Use, is this more a push where you guys are educating these clients you may not have known about the success of your ambulatory product or more of a pull on their part in terms of they're trying to figure if the vendors that they have and obviously we that there are a lot of ambulatory vendors that have allowed their users to attach their Meaningful Use Stage 1, but they're realizing that for Stages 2 and 3, they may need something just a little bit better?

Zane M. Burke

I think it's a -- this is Zane. I think it's a little bit of both. It's a combination of one, that clients are seeing how strong our ambulatory offering is and it's actually a lead with solution for us today. And it's extremely competitive, and it's actually the best out there on a stand-alone basis, and that's becoming much more well known. But there's also the factors that you just referenced, which are some suppliers are having challenges as we look forward to some of the, not just Meaningful Use elements, but just the changes in what's going to happen in health care models. And there are people that are preparing for those changes and those larger IDNs are getting ready for the changes in Healthcare Reform much beyond just the Meaningful Use elements. So it's all those elements. We did see very strong growth again in ambulatory in the first quarter.

Michael Cherny - ISI Group Inc., Research Division

Great. And then just one quick housekeeping question. I know you mentioned the Saudi Arabia deal. I assume that's going to be part of that 2Q bookings that you mentioned?

Zane M. Burke

Yes, that's in Q2.

Operator

The next question comes from the line of Sean Wieland from Piper Jaffray.

Sean W. Wieland - Piper Jaffray Companies, Research Division

So a lot of the providers have been talking about tough utilization trends. And I wanted to know if you have any thoughts on that and primarily any impact that you're seeing in your pipeline, as I read through there?

Zane M. Burke

This is Zane. We've seen some organizations with some utilization detriments and some of that -- and what's going on in their existing markets. But we have not seen that have an impact on value behavior. If anything, it gets them to think about what are all the other areas where I need to be really good in terms of ambulatory side, in terms of the other continuum of care spaces, which actually really helps Cerner versus our primary competitor.

Sean W. Wieland - Piper Jaffray Companies, Research Division

All right. That's helpful. And then second thing is, tech resale used to be just hardware, now it's a more diversified business. Is there any particular areas within tech resale that were showing weakness?

Marc G. Naughton

Relative to this quarter, I think there was a -- certainly a -- some of the low margin hardware elements and then some of the device resale elements. Those are the 2 areas that were below what we would have provided relative to our guidance. Those are the 2 components. When you break down the lines and you go down to the hardware detail, there are elements of hardware that we get some pretty decent margins on. So you almost have to separate hardware to 2 different components of kind of low margin and then medium margin I guess would be what I would use for lack of a better phrase. So in this case, it was a lower margin, the lower margin hardware and the device resale, which tends to be low margin that impacted us.

Sean W. Wieland - Piper Jaffray Companies, Research Division

Okay. And specifically, what kind of hardware is the low margin hardware?

Marc G. Naughton

It will vary a lot. It's just some of the basic computer stuff that -- obviously the price points on that are continuing to decline. It's not necessarily the more complex devices that we sell. But once again, a lot of this resale is going through their client base, their sales force, and we're writing the deals on our paper. But the profit we get from that is very small, it's really just part of the strategy of being the one-stop shop to get -- to be able to act as that for our clients. And just to give you a little bit -- for a little more color, once again, that number has varied significantly just from Q1 of last year to Q1 of this year. We think, at this point, we'll be more conservative on guiding that as we're going forward and we have guided to expect that to kind of increase slightly as we go forward. And we think that's the safe way to do it.

Operator

The next question comes from the line of Lisa Gill from JPMorgan.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

I just had a couple of questions. Zane, I was just wondering, I know you said that 27% of the bookings were outside of your core base. But can you just give us an indication as to what you're seeing as far as greenfield versus replacement opportunities in that -- outside your base?

Zane M. Burke

Sure, Lisa. So most every -- most of our -- in acute-care setting, they were replacing some competitor. They have some form of automation, and so there's very few organizations I can think of that don't have automation. So these are replacement era elements. You may have some in the ambulatory space, pure greenfield, where the physician has adopted an EMR. So in that marketplace, you're still seeing a mix of greenfield and a mix of the replacement opportunities. And then in the acute-care setting, you're replacing somebody else's solution.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And is there one competitor that you're primarily replacing in the marketplace right now? And I think to an earlier question, there's north of 400 little EMR companies that are out there. Is that really where this next opportunity is, that they're not going to be able to meet Meaningful Use 2 and 3 and that's where you see the replacement? Or is it something else?

Zane M. Burke

And Lisa, when you refer to the 400, I'm assuming you're referring to the ambulatory setting.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Yes, the ambulatory setting.

Zane M. Burke

Okay. So I'll phrase it towards that. It's all competitors. We've replaced, literally, all the large top 10 competitors in the last 12 months. So when we go through that, all the top 10 we have come through and had a replacement for.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Okay. Great. And then, I guess my last question would just be on Saudi Arabia and the opportunity and timing there. I mean you talked about there's a new pilot program that will be in bookings next quarter, but is there a way to quantify how big that market potential is?

Zane M. Burke

Well we -- in my comments, we talked about the 270 hospitals. We would anticipate there will be additional pilots by other competitors in that space. And so it's likely to assume that those additional -- that who succeeds in the pilot phase will get the lion's share of those other 270 hospitals that are available.

Marc G. Naughton

I would clarify, the pilot is just for the one hospital. So from a bookings standpoint, it is not going to be a significant contributor to our Q2 bookings guidance.

Operator

The next question comes from the line of George Hill from Citigroup.

George Hill - Citigroup Inc, Research Division

Zane, I kind of want to start off with post HIMMS. We're all talking about population health management, Cerner's history in selling new clients has kind of been to lead with the vision. What I'm wondering if you can talk about is like talk about the degree to which you guys are marketing Synapse and Healthe Intent, how much clients are buying in as they see Cerner's vision of the future? How it impacts the sales process and kind of how it impacts the pipeline?

Zane M. Burke

Well it's absolutely the key differentiator. So we are leading with population health as our strategy, both from a core EMR solution, as well as the Healthe Intent platform itself. And so a lot of the organizations that are making decisions today, in fact most all of them, are making the decisions today because they need to get to a platform, which takes them to a better place over time, and that better place over time is how they prepare for those future healthcare reforms. So it's absolutely front and center a part of our marketing strategy and how we lead with and talk about those elements. And we can deliver today a number of things along the population health strategy today, so everything from our HIE to our member portals to what we do from a performance improvement perspective for those clients. So we can not only talk about the vision, but we can actually go execute today on a number of items, which get them on a journey towards population health.

George Hill - Citigroup Inc, Research Division

Okay. And you talked about another win this quarter versus your key competitor. Can you say whether or not population health was a component of that?

Zane M. Burke

Absolutely was, front and center, a part of that.

George Hill - Citigroup Inc, Research Division

Okay. And then Marc, just a -- I guess, a bean counting question for you. Just on the tech resale side, do you feel like that is a one-quarter event that we've seen here? Or is that indicative of the trend of Cerner selling more web-based solutions, selling more hosted solutions? So I guess is this a one-off, or is this a secular thing that we should be keeping our eyes peeled for?

Marc G. Naughton

No, I think if you look at the history, we have a lot of hardware we sold. As we did more hosting, we sold less hardware and we kind of -- we got into device reselling as a way to kind of bring that back up, because we like that revenue stream and the strategy of being the one-stop shop. I think at this point, relative to the quarter, I think it's more just the marketplace and what was getting done out from the people that we're reselling, I think it can be a variety of things, both the market is still active. So I think it's more the technology and maybe some of our suppliers that we work with are rolling out new platforms that can lead to a pause in the buyers buying the next new thing. I think we're getting hit with that as much as anything else. So I think in that case, we kind of are level setting and resetting to the Q1 level, though using that as a place where we expect to grow from. So I don't think it's -- that that's all gone away. I think there's a cyclical nature to this stuff that we probably haven't seen enough history to know about. And I think now that we're seeing that history, we're level setting our expectations. So okay, Q1 lower level, we expect it to grow as we continue on through the rest of the year and we'll give you some -- give you updates, obviously, each quarter, as to where we stand on that.

Zane M. Burke

And George, this is Zane. I think you've seen some variability on the upside for this as well. So some of the over attainment on the upside that didn't necessary fall to the bottom line as well in terms -- because of the low margins in prior quarters. I think you see they reverse here. So there is some variability in that.

Operator

The next question comes from the line of Ricky Goldwasser from Morgan Stanley.

Zachary William Sopcak - Morgan Stanley, Research Division

This is Zach Sopchak in for Ricky. I wanted to ask first just about the trend of the hospital consolidation, what you've talked about in the past and mentioned there was accelerating here. And I was just curious, when you think about consolidation of hospitals, what kind of that maybe using a Cerner system, how should we think about a lag between when a Cerner hospital purchases another hospital and when you might actually see that business come through?

Zane M. Burke

This is Zane, Zach. It's a -- each situation is going to be unique and relative to that client strategy on how they -- whether they've developed a standard for their organization or whether they're contemplating using multiple platforms moving forward and where they are in the maturation of themselves that are the pure IDN in creating scale around that. Those that have developed standardization and have that as part of their core methodology and logic, I think you can expect that to drive growth in a 12- to 18-month window from when the acquisition closes, and you're seeing that in some of our activities to date. Those that have yet to mature in that space and really create a standard across their enterprise, I think that will be a longer-term benefit for us.

Zachary William Sopcak - Morgan Stanley, Research Division

And then just 1 follow-up on that, too. You also talked about 7 of the top 10 systems are on Cerner, but there are 300 site opportunity, at least 300, that aren't at it. What drives that differential? Is it just legacy, acquisitions that haven't had a chance yet? Or is there some technical reasons why they may not have switched yet?

Zane M. Burke

It's mostly -- it's a legacy element and a -- and some parts of those are strategies where at one point in time they may have had a 2-supplier strategy going in. Maybe Cerner on the high end and someone else on the lower end. And then what they've learned over time is that Cerner, when you create a standard and use the scale of what we do and what they do, we can scale to -- across all of their enterprises. And so we've seen that play out in several scenarios, and that's part of where we see that. We also see some other elements where it's a prove your model. So prove that this works and -- so create some larger pilots and then be successful on those larger pilots and then we anticipate rolling out throughout the enterprise that way. So there's a couple of different flavors there.

Operator

The next question comes from the line of Richard Close from Avondale Partners.

Richard C. Close - Avondale Partners, LLC, Research Division

On the 800 docs revenue cycle ambulatory, can you talk a little bit how that gets booked? Is it just like 1 year worth of collections you estimate and that goes into bookings? Just talk a little bit about that and how we should think about that going forward, if you expand the revenue cycle for ambulatory?

Zane M. Burke

Richard, this is Zane again. It's very similar to what we do on the -- in a full RevWorks model here. So in this particular case, it's a full outsourcing deal for a several year period. And so it's reflective of that several year revenue cycle take over that particular business office. So given the size and nature of this organization, they had a pretty significant business office on the ambulatory side that we're taking over.

Richard C. Close - Avondale Partners, LLC, Research Division

And were they using your ambulatory product?

Zane M. Burke

They were using our -- in this case, they were using our EMR solution. This also includes the selection of our revenue cycle solution on the ambulatory side.

Richard C. Close - Avondale Partners, LLC, Research Division

Okay. And a quick question for Marc. On the G&A, the growth, I guess, 20% year-over-year, if I'm looking at that. Was there anything onetime in there? Or can you talk a little bit about the G&A expense in the quarter and then going forward the remainder of the year?

Marc G. Naughton

Yes. Nothing unique in it, just we're getting to be a bigger company. We've got some higher level of personnel that are coded as administrative in nature. And then obviously, some of the amortization from the acquisitions we've done is going to be driving that number. But it'll be consistent going forward. It's not going to -- it's not a onetime hit that will come back out.

Richard C. Close - Avondale Partners, LLC, Research Division

So modeling, look at about 7% of total revenue, that's a good ballpark? Am I looking at that right?

Marc G. Naughton

Yes, without looking at the numbers right in front of me, I think if that's consistent kind of with what this quarter was, then that would be an appropriate level.

Operator

The next question comes from the line of Sandy Draper.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

My question, Marc, is on the R&D side and your comments around in a couple of years, or a year to 2 years, tailing off on some of the using the outside people. I know that means your cap rate goes down. Would that mean your absolute software dollar cost would actually drop? Or you're just thinking moderated growth once you start to build -- to leave those -- let those go off?

Marc G. Naughton

Yes, Sandy. I think if you kind of do the math, you're going to have a period that we've talked about where we're going to be spending more money to get to our -- to go down our innovation roadmap at a quicker pace. That is going to create, obviously, capitalized software, and that software will start to amortize kind of in that next 12 to 18 to 24 month period. So as we start reducing the dollar cost of those people that are working on those projects and being capitalized, you'll start to see the amortization kick in as those projects go GA. Obviously, the goal is to get those projects to go GA faster and so that will start kicking in. So overall, the expense side, the net expense will grow and continue to grow, but when you do look at the gross dollars and then go through the cap and then the amortization, that growth is going to be kicked off a lot -- the amortization hitting us will be driving that growth more than the savings that we're going to realize because those people aren't here anymore. So there'll be a tail to them and their work, as we capitalize and amortize it. So it will be kind of a continual growth in that spend.

Alexander Y. Draper - Raymond James & Associates, Inc., Research Division

Okay. That's helpful. And second question is maybe for Zane and maybe as well, Marc. When I talked to hospital executives across the board, whether it's CIOs, CFOs, CEOs, I would characterize it probably that it's the highest anxiety level I've heard in the close to 20 years I've been dealing with healthcare. Some of the things that Zane, Marc, commented on earlier sounds like it's a positive. Is it actually accelerating anything in terms of sales process? Or are there times where people are getting that "I'm so confused that I know I need to do something, I'm slowing down?" I'm just wondering is there any pace of change in the sales process because of this really high level of anxiety?

Zane M. Burke

This is Zane. It's actually creating, in many cases, buying behavior. And I think it's part of what Mike was referencing in some of his comments around the pipeline for things like ITWorks. Because they recognize there is so much work that needs to be done to get them ready for this new world. So I agree with you, Sandy, on the anxiety component. There's so much work that needs to be done, and they have -- they're facing cost pressures, et cetera. So how do they go about doing all that work? How do they get to where they need to be in terms of having access to all the information across the continuum of care given their current structures, given their current spend on that? And what we offer in terms of ITWorks perspective is the ability to come in and scale, to move them much more quickly than they would ever be able to move themselves and get to the other place in a way that has got a much more predictable cost model to it. So it's providing a level of assurance in terms of both cost and quality and we can deliver a lot more in terms of solutions. So it's a perfect example of where that anxiety is creating buying behavior. And so we're seeing things like the ITWorks come together much more quickly than they have in the past, and I would say that's going to be also true around the revenue cycle side that I think we'll see some accelerated elements around the RevWorks, around that.

Operator

The next question comes from the line of Jamie Stockton from Wells Fargo.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Maybe just 2 quick ones. Zane, the 300 hospitals that you say are within those large health systems that are partially using Cerner today, my assumption is that a lot of those hospitals are meeting Meaningful Use with some other systems. So I'd be curious to get your view on kind of how those hospitals are going to transition off of those other systems now that they're having to continually meet these usage thresholds. Are the hospitals thinking "hey we're going to move aggressively before we try to go to Stage 2" in many instances? Or are they thinking "let's get through this period where we're getting the incentive payments and then start to make the transition for these legacy systems"?

Zane M. Burke

I think it's a blend on that. So there are a few where we are -- you have to obviously stage it out, right, so they'll say "we're going to get to Stage 1 on our current supplier and then the plan is to get to Stage 2 on Cerner". We have some that are now saying "we'll get to Stage 2 on our current supplier, knowing what those rules look like and their level of comfort. But we need to do Stage 3 on Cerner." So we begin to plan for that and as particularly, these -- many of these are, like all of them, are very large entities where it takes multiple years to roll it out and so oftentimes, you're having a -- you have a plan that is reflective of the complexity of those organizations, and so you've got to go target the ones that are most at risk in terms of -- the sites that are most at risk, get those in the model, knowing that you're going to have your rollout in those scenarios. Does that make sense?

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Sure. And then maybe just a quick follow-up, Marc, the sales and client service expense was down sequentially, I think it's been maybe 4 years since that's happened given how much your works businesses have been ramping. Can you talk about whether like there is new seasonality again that's going to be impacting that? Or was there anything unusual that caused that to be high in the fourth quarter or abnormally low this quarter?

Marc G. Naughton

Yes. I don't -- I think when you look at -- it's probably a combination of more things like depreciation, lower bad debt, hitting some of that stuff. There's nothing in the business, we're pretty much have continued to grow that workforce on the services side and continue to have the demand for their services. So there's nothing in the model that would -- and nothing I see that would say that there's a pause that's going on in the sales and client services component of that. So there's nothing in the business that would -- other than just those non-cash items that would impact it.

Operator

The next question comes from the line of David Larsen from Leerink Swann.

David Larsen - Leerink Swann LLC, Research Division

Zane, I think you mentioned that you won a large site going head-to-head with one of your main competitors due to population health. Can you just give an example of what drove that decision or specific functionality within your population health system? Is it like the ability to look at pods by physician? Is it nutrition? And then, it sounds like you're hiring a lot of developers to build more software within population health. Can you just sort of give a little more granularity on that, please?

Zane M. Burke

Well, I'll give you some granularity around the individual opportunity and then see if Mike has some comments he'd like to make around the engineers on that and what they're doing. Around this particular opportunity, what they saw is that we were the first and only organization that came with a plan for the entire enterprise, and so a layer that's above all systems that are out there, whether they're Cerner or non-Cerner Solutions. In addition to that, they also were very intrigued by what we're doing from a value perspective and how we think about the different cost improvement initiatives that we could do in the interim time period, as well in our Lighthouse solutions. And so the 2 key elements was really that we weren't just an EMR organization, that we were working towards a bigger objective, and that bigger objective, the solution that we're proposing is different than what is out there from anyone else where there are a bunch of little niche piece parts and ours is actually an architecture for an entire enterprise and an entire system along that line, and that's what was very attractive to that organization. Mike?

Michael C. Neal

Yes, I think Zane covered it fairly well. This is Mike. I think the fundamental difference is, our approach is not a singular closed environment. We recognize that it's going to be a heterogeneous environment. And we need to build an architecture that allows us to aggregate data across a variety of sources and provide answers across the full continuum of care. I think they recognized that Cerner had not only a vision but a development plan to produce that and our competition did not.

Operator

The next question comes from the line of Steve Halper with Lazard Capital Markets.

Steven P. Halper - Lazard Capital Markets LLC, Research Division

Just a quick housekeeping question. Marc, you indicated what you thought the quarterly CapEx would be for the remainder of the year, $50 million to $60 million a quarter. Can you sort of give the same absolute dollar number in terms of cap software recognizing that the percentage of the total is going to be higher than it normally is, but what dollar amounts are you looking at?

Marc G. Naughton

Well, I think, as we go through the year, Steve, that you're going to see CapEx relative to software will probably increase as we're kind of spending some more money in that space. So that will go up a little bit. I think if you're kind of trying to get the view of the cash flow and the free cash flow, I think for 2013 that we'd expect, with all the investment we're making, both on our new Kansas campus, capitalized software, other CapEx, that we be at or slightly above kind of what we did in 2012. So the 425 we delivered there. I think that's -- be our expectations, to be slightly above that for the year, keeping all the CapEx elements in mind. And that obviously refers to us spending on the Kansas campus, it's relatively high. That spending continues kind of through early '14, but then drops off once we complete that campus, so we would expect to kind of return to more recent levels of free cash flow generation relative to net income at that point. But I think that for '13, because of the investment, we'd probably look to be at last year's level or slightly higher than last year's level.

Steven P. Halper - Lazard Capital Markets LLC, Research Division

Right. But your expectation is that you're done with the campus on -- in the first quarter of 2014 and so your '14 free cash flow should be that much higher as that sort of winds down and you go back into more of a maintenance mode on the CapEx side?

Marc G. Naughton

Yes. We move into that -- the second building and final building on that campus in Q1 of '14. So there'll be probably some payments that come after that. But for the most part, that will be done certainly either first quarter or first half of the year.

Steven P. Halper - Lazard Capital Markets LLC, Research Division

And when should the -- this elevated level of capitalized software start to ease as well?

Marc G. Naughton

As we said, the effort we're using related to the consultant component is kind of a 12 to 24 months. So we would expect it to continue into '14, but probably see that dropping down dramatically as we go into '15.

Neal L. Patterson

Okay. So, this is Neal. I'm going to do the close here. Marc wanted to do the close and talk more about tech resale, but I thought that was probably -- he's probably done enough here.

So just kind of zooming out here. We wake up every morning kind of at the intersection of healthcare and information technology. Probably the 2 most dynamic sectors in our society. And it's an exciting place to be. We built a fairly broad-based global kind of business platform and a broad set of business models to basically provide a set of solutions and services to healthcare.

Our clients, particularly in the U.S., but for the most part worldwide, have -- there is a lot of anxiety out there. There is an unquestioned attack on their revenues. Most of them feel huge pressures on reducing their kind of unit cost and the cost of their cost structures, and they're getting a tremendous amount of mandates on quality and most of the mandates have basically penalties, economic penalties if they don't meet them.

So there's just an awful lot of dynamics out there. It's going to be a very exciting kind of deck into this decade and there's going to be a lot of change. So we're going to be bold about how we approach it. We have -- I'm pretty sure we have the largest IT development organization in the world. And as you can tell from our numbers and from our comments, we're accelerating the growth of that. It's an example of our boldness.

We are on the physician side of the physician experience. We're basically attempting to leapfrog how physicians use technology. Quite bold. You can see in our works models a fair amount of boldness kind of how we are defining what we think our clients will need currently and in the future. And we grow organizations that are world-class to go -- to provide that service.

So -- and you can see from the CommonWell Alliance that we use our leadership position in the industry for the greater good, but also to basically highlight where basically we have bad actors around subjects such as interoperability.

So we're going to continue to be bold. We think there is an awful lot of opportunity. We think we're pretty -- we have a high-quality organization, and we think we have a lot of opportunity the rest of this decade. So thanks for your time and look forward to our next visit.

Operator

Thank you for joining today's conference. This concludes the presentation. You can now disconnect your lines. Good day.

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Source: Cerner Management Discusses Q1 2013 Results - Earnings Call Transcript
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