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Cerner Corporation (NASDAQ:CERN)

Q2 2009 Earnings Call Transcript

July 29, 2009 4:30 pm ET

Executives

Marc Naughton – SVP and CFO

Michael Valentine – EVP, Client Organization

Trace Devanny – President

Jeffrey Townsend – EVP and Chief of Staff

Analysts

Richard Close – Jefferies

Charles Rhyee – Oppenheimer

Michael Cherny – Deutsche Bank

Glen Santangelo – Credit Suisse

Atif Rahim – JP Morgan

George Hill – Leerink Swann

Jamie Stockton – Morgan Keegan

Jeremy Lopez [ph] – William Blair & Company

Operator

Welcome to the Cerner Corporation’s second quarter 2009 conference call. Today's date is July 29, 2009, and this call is being recorded. 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 Security and 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 Cerner’s Form 10-K, together with other reports that are on file with the 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

Thank you, Stacy. Good afternoon everyone and welcome to the call. I will lead off today with a review of the numbers. Mike Valentine, Executive Vice President of our Worldwide Client Organization will follow me with sales and operational highlights and marketplace trends. Then Trace Devanny, our President, will discuss our global business and current thoughts on the stimulus opportunity. Trace will be followed by Jeff Townsend, Executive Vice President and Chief of Staff, who will provide some thoughts on meaningful use and innovation. Neal Patterson, our Chairman and CEO, is traveling today.

Now I will turn to our results. In what continued to be a challenging environment, we delivered solid results in the quarter. Bookings were above the midpoint of our target range for the quarter, with strong performance from our managed services offering. Our revenue was below our expectations, reflecting the continued impact of the challenging economy and some pausing by clients awaiting clarity on the stimulus requirements and healthcare reform.

Despite these challenges, our licensed software sales still improved significantly compared to Q1, which helped us drive earnings in our guided range. And our cash flow performance was again strong. Overall, we are pleased with our solid results given the macro environment, and remain encouraged by the significant opportunity associated with the stimulus.

Moving to bookings, our total bookings revenue in Q2 was $394 million, which was just above the midpoint of our guidance range. This is down 3% compared to last year and up 18% compared to Q1. This quarter’s bookings included continued strong managed services bookings and improved software bookings.

Moving to backlog, our total backlog increased 12% year-over-year and ended the quarter at $3.7 billion. Contract revenue backlog ended the quarter at $3.1 billion, which is 13% higher than a year ago. Support revenue backlog was $595 million, up 6% year-over-year.

Our revenue in the quarter was $403.8 million, which is flat compared to Q2 08, but up 3% sequentially, reflecting a slightly improved environment compared to Q1. Revenue this quarter is about $12 million below our guidance range, but the mix of our revenue improved compared to Q1 as the lower revenue was primarily related to lower technology resale instead of software. The revenue composition for Q2 was $114 million in System Sales, $124 million in Support and Maintenance, $158 million in Services, and $8 million in Reimbursed Travel.

System Sales revenue was down 5% compared to Q2 08, driven by a decline in technology resale, which continues to be pressured by the success of our managed services business. Compared to Q1 09, System Sales increased 14% driven by higher software sales.

Services revenue, which includes managed services and professional services, was down 2% compared to the year-ago quarter, with a decline in professional services partially offset by continued strong managed services growth. The decline in professional services is the result of lower billable headcount in the US, lower services revenue in the UK, and the overall challenging economic environment, which has led to some clients going slower on projects or deferring project starts. We expect our service revenue to improve as we begin to benefit from the stimulus as our work in the UK begins to ramp back up.

Looking at revenue by geographic segment, our domestic revenue increased by 6% to $337 million and our global revenue declined by 21% to $67 million. The decline in global revenue was driven by the previously discussed lower services revenue in the UK and lower technology resale. Global will also have tough comparables for the remainder of the year due to the large Middle East contract in Q3 of 08 and the UK catch up in Q4 08. So global revenue will likely be lower in 2009 than it was in 2008. Keep in mind that our global business grew from just $53 million in 2003 to almost $370 million last year. So the decline this year is a function of tough comparables created by this rapid growth and a challenging global economic environment; it is not representative of our strong global position and positive long-term global outlook.

I would make the point that our support and maintenance revenue increased 13% over Q2 08.

Moving to gross margin, gross margin for Q2 was 83.4%, which is up 120 basis points compared to Q2 08 and up 10 basis points compared to Q1 09. Our System Sales margin increased 70 basis points year-over-year and 420 basis points sequentially, reflecting the improved mix of software.

Looking at operating expenses and earnings, we have continued to prudently control expenses in this challenging economic environment. In Q2, our operating expenses were $267.2 million before options expense of $3.6. This is flat year-over-year after adjusting for the $8 million third-party supplier settlement in Q208.

Sales and client service expenses were down $3 million, or 2%, compared to Q208, reflecting lower professional services expense, partially offset by growth in managed services. Software Development expense was down $1 million, or 2%, compared to Q208, reflecting continued efforts to control our R&D expense.

G&A expense was up $5 million, or 17%. The primary drivers of the growth were a $1.6 million loss from foreign currency in the current quarter, compared to a $0.2 million gain in Q2 08, and higher year-over-year property taxes. You’ll also note a $7 million sequential increase in G&A, which is driven primarily by a FX gain in Q1 as compared to the FX loss in Q2.

Moving to operating margins. Our operating margin in Q2 was 17.3% before options expense, which is up 120 basis points compared to last year. We maintain a goal of exiting 2009 with operating margins near 20%.

Moving to earnings and EPS, our GAAP net earnings in Q2 were $43.7 million, or $0.52 per diluted share. GAAP net earnings include stock options expense, which had a net impact on earnings of $2.3 million, or $0.03 per share. Adjusted net earnings were $46 million and adjusted EPS was $0.55.

Our tax rate was 34%, which was in line with what we expected. Overall, we are pleased that we delivered solid earnings despite the lower than expected revenue. Good expense control coupled with increased contributions from more visible and recurring sources has enabled us to work through the challenging environment. We believe we have a very scalable infrastructure and that this will be reflected in very strong earnings power when stimulus driven demand ramps up.

Now I’ll move to our balance sheet. We ended Q2 with $384.1 million of cash and short-term investments and $99 million of Auction Rate Securities. Our total debt is $148 million. Total accounts receivable ended Q2 at $445 million, which is up $8 million from Q1. Contracts receivable, or the unbilled portion of receivables, were $141 million, which is down $20 million from Q1 and represents 32% of total receivables compared to 37% in Q1. Cash collections in Q2 were $436 million, with third-party financings of $21 million.

Note that our balance sheet still reflects billed and unbilled receivables related to the Fujitsu contract that represents over 10% of total receivables. While we still do not know the exact timing of when Fujitsu and the government will unwind their contract allowing us to finalize items with Fujitsu, we currently expect to fully collect these receivables. However, they will have a negative impact on DSO’s in the meantime.

Our DSO in Q2 was 100 days, which is down from 102 days in Q1 and up from 90 days a year ago. Similar to last quarter, the DSO was impacted by lower revenue, which is annualized in the DSO calculation. The shift this quarter to more of our total receivables being accounts receivable instead of contracts receivables should position us to keep bringing down DSO going forward as we have more billed receivables to collect.

Operating cash flow for the quarter was solid at $68 million. Q2 capital expenditures were $23 million, and capitalized software was $20 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $25 million, bringing our year-to-date free cash flow to $62 million and positioning us to meet our target of more than $100 million of free cash flow in 2009.

Moving to capitalized software, the $20.3 million of capitalized software in Q2 represents 29% of the $69.6 million of total spending on development activities. Software amortization for the quarter was $15.8 million, resulting in net capitalization of $4.5 million, or 6% of the total.

Compared to last quarter, capitalized software increased $2 million due to a slightly higher percent of project hours being eligible for capitalization, but this was more than offset by a nearly $3 million increase in amortization related to the GA of our latest Millennium release.

Now I’ll go through the guidance. We are maintaining our EPS guidance and bringing our revenue guidance down to reflect the lower year-to-date revenue and a more conservative approach for the rest of the year. While we remain bullish on the opportunity associated with the stimulus and expect our growth to accelerate in 2010, the current environment still warrants a more cautious view for the near-term.

Looking at Q3, we expect revenue in the $410 million to $430 million range. We recognize that the midpoint of this guidance range is flat compared to revenue in Q3 of 08, but keep in mind that Q3 08 was our best revenue growth quarter in 2008 and, as I said, we are remaining cautious on the top line for the near term.

We expect Q3 EPS before options expense to be $0.57 to $0.63 per share. The Q3 guidance is based on total spending before options expense of around $270 million, and our guidance assumes we have no material negative impact from foreign currency exchange.

Our estimate for options expense for Q3 09 and 2009 is approximately $0.03 and $0.12 to $0.13 cents per share, respectively. Moving to bookings guidance, we expect bookings revenue in Q3 of $380 million to $420 million, with the midpoint of that range reflecting a slight increase compared to Q3 of last year.

Looking at the full-year 2009, we maintain our guidance range for adjusted EPS before stock options expense of $2.40 to $2.50 per share. Our 2009 revenue guidance range is $1.7 billion to $1.75 billion, which is down from $1.75 billion to $1.80 billion, due primarily to the lower revenue levels in the first half of the year.

In closing, we are pleased with our results in Q2, including solid bookings in a tough environment; continued progress on our margin expansion initiatives; delivering earnings in our guidance range despite lower revenue; and strong free cash flow, reflecting the continued overall health of our business.

With that I will turn the call over to Mike.

Michael Valentine

Thanks, Marc. Hello everyone. Today I am going to share with you some observations on the marketplace and also review some operational and top line highlights.

Starting with the marketplace, in the current economic environment, many healthcare providers remain focused on maintaining strong cash balances to enhance their debt ratings and control their cost of capital, which impacts near-term capital spending. They continue to watch developments around the HITECH Act and the discussions around the definition of Meaningful Use. Uncertainty around how healthcare reform will impact them has also contributed to more conservative near-term spending.

As Marc indicated, this behavior has pressured our top-line performance, particularly system sales and professional services. These factors will likely continue to have some impact as we move through the year until there is more clarity around healthcare reform and Meaningful Use. However, healthcare IT is a cornerstone of healthcare reform both in the US and abroad, and we are very well positioned to benefit as the world economy improves and details around the stimulus and healthcare reform become clearer.

The front-end of this improved environment is reflected in our strengthening pipeline, RFP levels and second half of the year bookings projections, which we believe we can convert into much stronger top line performance in 2010.

Moving to our Q2 results. Given the challenging environment, we delivered solid results this quarter. Our bookings revenue in Q2 of $394 million was above the midpoint of our guidance range. And our deal mix included several large contracts, with 19 contracts over $5 million, 9 of which were over $10 million. 15% of our bookings came from outside of our Millennium installed base. Like last quarter, this is at the low-end of historical levels primarily due to less new deals getting completed in the current environment.

We continue to feel good about our competitiveness, and we have a good pipeline of new footprint opportunities. Notably, our new business RFPs are at multi-year highs, so we expect our new deal mix to increase in coming quarters.

Looking at the mix of bookings, in addition to the improved levels of software compared to Q1, we again had strong levels of managed services bookings. The continued success and strong reputation of our managed services business is also fueling demand for other services, such as Application Management Services, or AMS, and more recently, ITWorks. These types of services have the potential to contribute revenue and growth at levels similar to what we have delivered in our managed services business.

As I mentioned last quarter, we are engaged in discussions with clients about further extending our services through our ITWorks organization, which leverages our operational capabilities and infrastructure to take on additional IT functions for our clients. We are targeting clients who are committed to Cerner as their strategic HIT provider and looking to complete the journey in the most efficient manner. This represents a substantial revenue opportunity as we convert more of our clients’ current IT spend into Cerner revenue. This is also an opportunity to tighten our alignment with the clients, accelerate the expansion of our solution footprint, and replace competitors’ solutions. The discussions with our initially targeted clients for this initiative continue to go well, and we expect to have our first ITWorks deal completed by the end of the year.

Another area of strength in the quarter was our Lighthouse clinical process optimization services, which facilitates clients leveraging investments they have already made in digitizing their environments to drive more efficiency and optimize outcomes. This service has a proven record of creating a quick and measurable ROI. Our confidence in these solutions and the predictability of the results has grown to a point where we are beginning to align our payments with the client’s results, where we are essentially compensated based on documented savings achieved by our clients. We have seen solid performance in the first half of the year in this space and we expect it to continue to grow going forward.

The continued strength of Lighthouse, AMS and managed services and the creation of ITWorks are great examples of where our client relationship model is going. Our business models are becoming more directly aligned with the success of our clients, which is making us much more strategic to them and giving us larger growth opportunities.

The quarter also included continued momentum in some of our vertical markets. In our

CareAware suite of solutions, we had strong sales of MDBus device connectivity, which now has a device library of 375 with plans to be at 500 by the end of the year. MDBus sales have exceeded 100 facilities in just two years, which is illustrating the ability to accelerate into our whitespace with a vertical market focus. A primary reason for the strong momentum of MDBus is the compelling ROI. For example, since implementing the MDBus in May of 2008, one of our clients has improved nursing efficiency for device documentation time by 92% and has also improved biomed efficiency for device connectivity troubleshooting by 97%. This solution is essentially giving time back to caregivers and healthcare support staff to allow them to spend more time improving health outcomes.

We also had our first MDBus sale outside of the US this quarter. The global market is a substantial opportunity and we are increasing our efforts there, including the opening of Cerner Smart Room in our Dubai Vision Center.

Q2 also included several new RxStation footprints and good sales of our myStation interactive patient care solution. From an operational standpoint, the reliability and durability of the RxStation is being proven as RxStations in our initial clients have now processed more than 1 million transactions. The ROI benefits are also impressive. Since implementing the RxStation in September of 2008, one of our clients has achieved a reduction in medication charge errors, with lost charges going from 14% to less than 3%.

As I have mentioned, this focus on aligning sales, services, and development resources across certain vertical markets makes us a stronger, more agile competitor within those markets and can also accelerate our ability to fill whitespace in our existing base as well as more effectively pursue opportunities outside of our base.

One other area I’d like to highlight is our increasing presence and success in the small community hospital and critical access hospital space. There are about 1,300 critical access hospitals and about 2,000 small community hospitals. While we have substantial whitespace opportunities in our installed base of mostly larger hospitals and health systems, the smaller hospital market will also be an important element of our growth going forward.

We have made good progress at bringing solutions to these smaller venues at a competitive price by leveraging our hosting capabilities and implementation methodologies. For example, in early Q2 we brought a full suite of Cerner solutions live at a 15-bed critical access hospital, and they are already experienced benefits, including an increase of about 15% in monthly revenue due to improved charge capture. Q2 has also included new sales to a critical access hospital and a community hospital that will be implementing a full suite of clinical and revenue cycle solutions and technology, including Smart Rooms across the entire hospital. When the implementation is completed, we expect them to be able to apply for HIMSS Level 7 status.

Our momentum in this marketplace is very timely given the low penetration of HIT solutions and the stimulus dollars bringing many of them to the market for the very first time. With the potential for some existing providers to be challenged to bring their large installed bases to the definition of Meaningful Use, we view this as a significant opportunity.

In summary, I am pleased with our execution in Q2. We believe we continue to operate in somewhat of a bipolar business environment. Coming into the year we were seeing a general move towards reductions in operating and capital spend. Post stimulus announcement in February, we saw the market start to move in a positive direction, but that hasn’t yet fully offset the constrained spending environment.

Overall, I believe we have weathered this tighter environment very well and are in a great position going forward as healthcare reform and ‘meaningful use’ gain more clarity.

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

Trace Devanny

Thanks, Mike. Good afternoon everyone. Today I will discuss our international business and provide comments on the American Recovery and Reinvestment Act.

Beginning with our global business. As Marc discussed, our global top line growth was impacted by, not only tough comparables in 2008 generated by previous success, but also a very challenging global economy. Despite this difficult baseline, we have made steady progress in Q2.

I’ll start with England. Our forward progress in the National Health Service’s countrywide HIT initiative at the midpoint of the year has been solid. Choose and Book, our national e-scheduling solution, achieved a successful upgrade in June that allows General Practitioners to use SNOMED CT codes to find and refer patients. As functionality and usability have become more robust, activity levels have continued to grow with bookings more than 25% higher than the same period last year. A very good story.

Our work in the acute care space in London is also progressing, with both net new deployments and upgrade activities scheduled throughout the second half of the year. We also are moving forward with our partner BT in the South, as they have assumed work previously undertaken by Fujitsu. Most importantly, we continue to be the preferred supplier for NHS-leading Foundation Trusts as they contract for additional capability and capacity. The contract with Royal Berkshire Foundation Trust, signed in the quarter, being the most recent example. These activities are contributing to a building volume of work, which now includes active projects at over 20 trusts, representing more than 10% of all beds in England’s National Health Service.

As we look to the fall, our focus is on strong delivery. Our execution will be enhanced as we seek to use an implementation approach that is more consistent with our very successful and proven MethodM engagement model. This will have a positive impact for Trust clients like Kingston and Newcastle. Strong delivery, in turn, should leave both the National Program and Cerner well positioned for the future.

Other global highlights include good bookings contribution and successful execution on projects in Australia and the Middle East. We also had important go lives in France and Spain. We will have more to report on this front next quarter.

Overall, we remain very well positioned globally. Millennium represents the one scalable platform that supersedes global boundaries. Our proven technology provides a platform that will continue to position us as the worldwide HIT leader as the international markets begin to embrace their own healthcare reform initiatives. In summary, we are convinced that solid execution for the balance of the year should position us for strong top line growth next year.

I would now like to provide an update on the stimulus and how we expect it to impact our business. Relative to meaningful use, the retention of the CPOE requirement is good for our healthcare system, as CPOE is a foundational component to improving quality and patient safety.

As I detailed last quarter, our substantial presence in hospitals and physician practices across the US represents a significant opportunity, with nearly $8 billion of incentives available to hospitals and physicians with a Cerner relationship. It is difficult to quantify precisely how much of the incentive dollars will flow to Cerner and how much of it will be incremental to what would have already been spent. To that end, we are now doing a detailed mapping of the unpenetrated solutions or “whitespace” in our installed base, to the current meaningful use requirements. This exercise is validating that the magnitude of the opportunity inside our client base is substantial.

We also believe that the opportunity outside of our client base is significant. There are a large number of healthcare providers who have either not bought systems or have continued to use legacy systems from suppliers who have not yet delivered a more modern platform. As importantly, we believe that some HIT suppliers may struggle achieving meaningful use compliance using their current technology. The opportunity for stimulus incentives, as well as the risk of facing penalties, has the attention of these providers, and we think the next few years will present a big opportunity to expand our presence in the U.S.

In addition, as Mike already mentioned, we have become increasingly well positioned in the small community hospital and critical access hospital market, which has a lower penetration than information systems. We like our chances there as well.

In the physician practice market, we are well positioned with our fast, low-cost, speed-to-value ASP model. We continue to have success getting our large health system clients to sponsor PowerWorks as their preferred EMR, which strategically pushes our solution out into their physician provider communities.

In Q2, we signed 7 additional health system sponsors, bringing the total to more than 30. In front of the stimulus, we are also stepping up our direct sales efforts and executing on other strategies that will extend our reach with physicians. Regarding interoperability, we have a history of proven innovation with interoperability capabilities like the Cerner Hub. The Hub connects healthcare providers within a community and is an important differentiator given the emerging interoperability requirements mandated by the stimulus.

And finally, we are having discussions with many of our clients and state governments about creating regional networks to facilitate broader interoperability, allowing for such things as health record banks, as well as population and disease management programs. This differentiates our clients in their region as well as providing a new business opportunity for Cerner.

In summary, we continue to view the stimulus as a substantial opportunity, and we believe we are very well positioned to take advantage of it.

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

Jeffrey Townsend

Thanks, Trace. I am going to provide some updates on meaningful use and also discuss a recent rollout of one of our Blue Sky, cloud computing services.

Last quarter, I made a few points about meaningful use and the journey our clients are on. I indicated that while the end criteria may be very technical in definition and will include requirements for interoperability, there are some simpler visible experiences to determine

meaningful use, such as No Pen being used to place orders, and No Clipboard in the waiting room for your medical history.

In HCIT talk, this would be CPOE, Medication Reconciliation, and interoperability to support Personal Health Records. I also indicated that there needs to be a two axis component to the measurement; the first being the functional capability, and the second being adoption, measured as use of the system.

And these targets should be closely linked to the objectives of the broader healthcare reform agenda to ensure that longer range strategies around chronic disease management and preventative care are “built-in”. Since our last call, there has been a lot of activity around meaningful use, with the HIT Policy Committee providing their initial and then slightly revised recommendations.

Our overall reaction to the progress and direction to date is positive. They have maintained important elements, such as CPOE, which is a fundamental building block to patient safety, while also factoring in required adoption metrics to ensure that benefits are being driven from the investment. In addition, they have announced the preliminary measurement criteria and approach, which is focused on the impact of HCIT in the context of outcomes. The most significant part of the proposal to date is the direction that this will be an incremental, moving bar over time. It is not a one-time event.

The role that HCIT will play is now embedded into the dialog of policy, quality and efficiency. While there are still several steps to the definitions being final and hundreds of public comments for the Committee to consider, it is clear that HCIT will become a mainstream policy mechanism for measurement and improvement that plays a vital role in the systemic reform of healthcare delivery for years to come.

At the end of last year, we shared progress on our cloud computing efforts, code named “Blue Sky”. As we ramp deployment of this platform in preparation for Cerner’s Healthcare Conference in October, I wanted to provide an update on a recent rollout of one of these services, which is called uCern.

uCern is a contextual collaboration and social networking platform that we have been using internally since last fall. It has changed the dynamic of how we work, making Cerner a more nimble, knowledge organization. Over the summer, we have begun to roll this offering out to client organizations, extending the reach of our customer network to the edges, where our solutions and services meet healthcare delivery, allowing not just clients but end users to engage.

To share one example, recall that last year we announced CodeWorks, which has now morphed into uDevelop. This is a space to support a unique audience of developers, both Cerner associates and external developers, that will innovate at the fringes of healthcare delivery, likely hands-on at the point of care. It is the ecosystem to support innovation that will be distributed through our online solutions store, where many of our Cloud services will be offered. Ultimately, we believe this will become a viable environment where millions of customers will generate demands for more contextual experiences across a variety of technical platforms.

To frame the impact of this shift, we have been an organization that is tuned towards business-to-business interactions, in a traditional 1.0 model. For the most part, the core of our business runs on several hundred large relationships, across a few thousand individuals. The real consumers that establish the success of our brand are those that rely on our solutions and services as part of their day-to-day role in healthcare. This isn’t the 30,000 plus IT professionals; it’s the 2.5 million healthcare professionals that engage with our solutions as part of their daily routine.

A key element of the uCern client deployment is to link the Millennium user community to this platform, creating a more direct feedback channel for innovation at the edge of healthcare, bringing together communities and experts in context. This is only one click away from an even bigger audience, patients. The number jumps to 60 million to 70 million plus interactions across our client base annually, again in the context of healthcare and the specific interests and needs of the patient. The last click is the family relationships that surround the patient.

We envision a day when Cerner has more than 120 million relationships, self organizing all with a contextual identity, consuming Blue Sky services to navigate and address their healthcare needs. A lot of boundaries are going to be moved in the next decade as healthcare is digitized. We are encouraged by the thoughtfulness of meaningful use to date and the sustained focus on HCIT as a positive mechanism. We’re at the beginning of several fundamental shifts that will create the next decade of value creation, adding clients to uCern is one of the strategic building blocks to support this next wave.

With that, I’ll turn the call over to the operator for the Q&A.

Question-and-Answer Session

Operator

(Operator instructions) The first question comes from the line of Richard Close with Jefferies. Please proceed.

Richard Close – Jefferies

Hi, just curious with respect to the change in the revenue guidance, Marc if you could just elaborate, what was the biggest change that you guys made to I guess the components of the revenue?

Marc Naughton

Well, relative to Q2 in our mix, we're probably $12 million or so below our guidance level. I break that down to be about $8 million to $9 million of tech resale relative to what we had previously seen and what we were expecting and about $5 million of services, and even in that vein, travel was probably $1 million less than what have historically seen on a reimbursed travel basis.

Going forward, we’ve adjusted our revenue based on the fact that our expectation today is that demand [ph] from stimulus is going to be dependent more clarity around meaningful use or clarity around healthcare reform, and therefore probably will be more towards the end of the year in traditionally our largest quarter, which is Q4.

Richard Close – Jefferies

Okay, a question I guess for Mike would be, you mentioned a couple of times hospitals trying to save cash or hoarding cash to help out on their debt ratings, I think the Housing and Urban Development loosened some of the rules on profits in terms of their debt levels and their operating margins needed in order to get some additional debt. Have you heard from your clients about any positive changes on that front and whether things are improving for them, and so the new business that you're seeing at a multi-year high, is it likely to some of that loosening and benefit the second half of your year?

Michael Valentine

Okay, I will answer Part A. I haven't really heard much of that buzz in the marketplace, and quite honestly that would affect more so, I believe the installed base, the clients that are continuing journeys versus the ones that are starting. But I think we continue to see pretty conservative behavior on both sides of the – on both camps installed and some of the new footprints.

Your second part of the question, I think the biggest thing that is going to inspire the new footprints are the people who have to put in new infrastructure to meet the requirements of stimulus and meaningful use, that is going to be largely driven by the actual definition of meaningful use and how high of a bar it actually ends up at, and also the reform wild card as that plays out through the summer and maybe the rest of the year. So those are two larger things on the radar that they are watching in my new opinion as they are making the decisions.

Marc Naughton

Richard from my perspective on the CFO side, most of them are still dependent upon rating agencies rating their debt and a lot of that. One of the primary characteristics is cash on hand. So I think even with (inaudible) with the change you mentioned there is still a little bit of hesitancy until more clarity occurs for them to cut loose those funds. The good news is they clearly have. For the most part in our client base, the cash is there, they are just deferring some of that spending until they get a little bit more clarity is what they need to spend it all.

Richard Close – Jefferies

All right. Thank you.

Operator

Your next question comes from the line of Charles Rhyee with Oppenheimer. Please proceed.

Charles Rhyee – Oppenheimer

Hi, thanks for taking the question. A couple of questions just maybe for Marc here, you know the bookings obviously came to a good number here relative to the first quarter for the high end of your range. Can you just help us think about what is in the bookings here given that we're sort of diverging, I guess between bookings and revenues? Is it that there is a greater mix of managed services in there, and so we should be expecting that kind of recognition over a longer period or maybe give us some help thinking about that?

Marc Naughton

Yes, we did – traditionally we have probably seen somewhere between 20% and 25% of our bookings in managed services. In this quarter, that number was a little bit higher than that in less than – between 25% and 30%. So there was an impact of managed services, which as you indicate would roll out longer. Compared to Q1 though, we were very pleased with our software number. We sold – we almost doubled our software bookings for the quarter relative to Q1. So the mix and that being pretty attractive, the element that didn’t appear in the mix was technology resale. And that is a quick yes, those rise into the income statement doesn't apply a lot to earnings, and so that is kind of one of the reasons that we are able to deliver our earnings goal, while being short on the revenue line.

I would make one more comment on the revenue shortfall just to make sure that we are clear. In the US, we actually had 6% growth in our revenue. The majority of our shortfall related to year-over-year differences in our global business, including tech resale and including primarily UK services reduction as those projects still are kind of getting ready to restart. We would expect that number right now for the NHS program is probably around $13 million to $15 million of revenue a quarter. We would expect it to grow back up to the kind of $22 million to $25 million a quarter as both these programs ramp up and as our activity selling the standalone trust is more successful.

Charles Rhyee – Oppenheimer

You know, speaking of the UK, we are hearing that you know especially in the southern cluster, you know, there are some other vendors winning some engagements there, prior that would have been pretty much all Fujitsu, and then you were the vendor for Fujitsu. Can you give us a sense on how the landscape is changing in terms of the opportunities there, and then can you remind us how much you had booked in previous periods for Fujitsu-related bookings are how we are accounting for that in the backlog currently?

Trace Devanny

This is Trace. I will take a quick shot at the bookings environment in England. We have one, as I think we have identified in the call, at least a large percentage of those transactions that are outside the program, which is an indication of I think the strength of our message as well as the strength of our solution set, where I think you have seen some vendors and some suppliers being successful in the south has simply been legacy systems being upgraded.

So no net new change of footprint but rather just taking what they have been using for years and improving or just extending that relationship. So we like our position in England. We think we have the most robust set of solutions, and I think the activity around clinical systems outside the program have been focused in our direction. We think that will only continue with the good performance around execution between now and the end of the year.

Marc Naughton

Yes, relative to the backlog and relative to the Fujitsu contract, Charles if you remember we may add a relatively major adjustment to our backlog to take that out, when that contract was determined not to go forward. So there is nothing left in the backlog relative to that. Anything new that is driven from that is through individual sales to trusts or through continuing to work with BT within the program would show off as additional bookings.

Charles Rhyee – Oppenheimer

Okay, great. Thanks for the clarity.

Marc Naughton

Sure.

Operator

Your next question comes from the line of Michael Cherny with Deutsche Bank. Please proceed.

Michael Cherny – Deutsche Bank

Hi guys. So I'm just looking for the (inaudible) that you guys sent out, and obviously you guys had a really strong quarter in terms of the large new deals that were won with 19 above $5 million, and 9 above $10 million. Could you talk about some of the characteristics you saw in those deals, what caused the buying patterns? What people are looking to add in that perspective and kind of is there any trends that kind of crossed over multiple of those deals?

Michael Valentine

Yes, this is Mike. Characterizing the deals, I mentioned in the script earlier, we had 85% of our business come through our client base. So you can characterize a lot of what happened in the US as filling out the road maps and aligning towards the CernerWorks, the hosted solution. I would describe the environment as largely paying very strong attention to the current initial draft of meaningful use, and we got several clients move down the path towards that definition, even though it is not finalized it represented either alignment with or slight new launches and variations to what their previous road maps would have been and they are filling that out.

As Marc mentioned, that really hit all of our lines of business. You saw, we had a good software quarter, we had a good hosting quarter, the mix of some of the other services, and content was solid. So I think it hit all of the businesses that were largely tied to people finishing out road maps. What we didn't see, which is a little bit of a surprise to us was quicker movement of new footprints, making decisions and moving forward. We think that is going to happen. We indicated that in the comments that you will see that going forward. But it was a little bit of a surprise that you didn't see that hit to me that we didn't see that hit in Q2, but I expect that it will hit more so, more frequently in terms of mix in Q2 – Q3 and Q4 as we finish out the year.

Michael Cherny – Deutsche Bank

Great and then just one more for Marc. You guys have obviously generated over the last year and a half I think some pretty impressive free cash flow. As that continues to build on the balance sheet, do you have any thoughts about what they used to cash flow (inaudible) or they will be through M&A or continued internal investments?

Marc Naughton

Well, I think we – Mike as we look at that number I think the key for us is we are always on the lookout for interesting technology that can be folded into the volume platform. We're going to continue the self develop I think on investment in R&D through a lot of our efforts that it is kind of flattening at a level that is stronger than anybody else in the industry is spending, $275 million a year. But I don't know that we need to invest a lot more in that space, because I think we're doing it pretty effectively.

So I think you'll see it. Keep an eye on this as we progress. Certainly stimulus provides an opportunity for a lot of companies especially enterprise wide companies like us. It can also provide a challenge for some other companies. So we would like to have a good sized warchest that we have available to take advantage of opportunities that may come along.

Michael Cherny – Deutsche Bank

Great, thanks guys.

Operator

Your next question comes from the line of Glen Santangelo with Credit Suisse. Please proceed.

Glen Santangelo – Credit Suisse

Hi, I just wanted to follow up quickly on that last question with respect to the meaningful use definition. Now that we have had a couple of cuts at the definition, and it sounds like you spent a fair amount of time with your clients. Do you feel like from their perspective they have an adequate roadmap in terms of kind of where we're heading. And to just a kind of follow on with the comments you just made, you were a little bit surprised that you didn't see them act in the second quarter. I'm guessing you are suggesting you are going to start to see them act in the third quarter? Did I hear that correctly?

Trace Devanny

Yes, I think the comments Mike made was that new clients outside of our existing base.

Glen Santangelo – Credit Suisse

Okay.

Trace Devanny

That we thought were going to be coming to market, driven to the market by the need to get compliance with meaningful use. They sent out RFPs, but they are not hurrying their processes as much as we thought it would be.

Glen Santangelo – Credit Suisse

And Marc, and what about within your existing client base?

Marc Naughton

And what we saw from our comments earlier, we see them absolutely mobilizing, and we did the a third, a third, a third descriptor of the base before which a third of them are using this as a reason to stay the course, a third are using this as a reason to take action to take action to accelerate, and a third are waiting to see what the future holds in terms of the final definition of meaningful use.

So that is how I describe our existing client base, and as we have talked about before, we took the opportunity with the announcement of the fact that there was going to be a meaningful use definition to go out can touch everyone of our CEOs of the top 20 clients, top 200 clients across the country. And as part of that exercise, we set a pretty high bar in terms of this is where we would like to see the definition of meaningful use fall. It turns out as Jeff Townsend commented earlier, the definition of meaningful use the initial drafts are pretty close to where we were proposing and projecting they would end up. We are just going to get there in a stair step fashion over the course of the next four or five years.

So by building the road maps with those clients early on and then adjusting them as the first drops of meaningful use come out, it has created a dialogue with that client base around where they potentially need to get to, and how they need to fill in the gaps, and in many cases down to the point of talking about individual projects and in some cases already moving on those projects. And you saw that come through in our bookings mix in Q2.

Glen Santangelo – Credit Suisse

And so when I look out to the bookings in Q3, you are kind of expecting flattish bookings next quarter, does that assume you are making relatively conservative assumptions about any incremental stimulus related bookings we may see? And then just to follow on to Charles’ question earlier before, are you seeing –do you expect to see continued changes in the mix of your bookings?

Trace Devanny

Yes, I think relative to what we are seeing in being conservative, I think as you know every quarter we go through a forecast and we lay out and share with investors of what we think our best view of the opportunities that we expect to sign in the next 90 days are going to add up to from a bookings perspective. I think clearly our clients are focused on that, our installed base has road maps that get them to meaningful use.

The capital requirements to do that are kind of offsetting some of the need for speed and that is why in Q3 we think people may be waiting to get a little bit more clarification. It appears pretty solid that CPOE is going to be the answer, but at this point I think people with their road maps know when they have to get started to get there, and know they have a little bit of leeways through the end of this year to start those projects. And I think that is probably one reason that we are not expecting a huge Q3 relative to stimulus driven business, and once again seeing a lot of the new business being more in the RFP stage as opposed to coming to market immediately. Mike, add on.

Michael Valentine

Yes, only thing I would add to that is Glen the things that we have witnessed that the new business is going to make up a bigger percentage going forward. That is in our projections. We expect that to happen like any business we have seen historically, it isn’t as predictable as the business that we do in our client base in terms of timing.

But I would fully expect that the mix is going to increase in the new business, because we see the things in our pipeline that are projected that have actually gone all the way through board approval phases. I would expect those to land and that would represent a higher mix in our bookings in the back half of the year.

Glen Santangelo – Credit Suisse

Then just one last question, I will jump off, Marc it kind of sounds like based on the guidance you provided in Q3, you are expecting a pretty sizeable up-tick in Q4. I mean why then should we expect this, as this is kind of what we're talking about an up-tick in bookings?

Marc Naughton

Yes, I think Q4 is seasonally the largest quarter we have. It represents the end of the year for these people. Our sense is that stimulus will be fairly well defined by that. By the end of the year it has to be defined. So I think that's a reasonable expectation and people haven't spent a lot of comfortable dollars. They're going to be coming up against the end of their year and a lot of these entities have some level of, you know, use it or lose it type of spending. So while they have held back in the first part of the year, we think we could see our normal seasonal approach where we have a very strong quarter in Q4 from the bookings revenue and a cash flow standpoint.

Glen Santangelo – Credit Suisse

Great, thank you.

Operator

Your next question comes from the line of Atif Rahim with JP Morgan. Please proceed.

Atif Rahim – JP Morgan

Hi thanks. I have some questions for Mike. You have mentioned in your comments that the client activity you are seeing was at multi-year highs. Perhaps do you – you know, elaborate on that and say when was the last time you saw this level of activity?

Michael Valentine

My comment was around the count of RFPs that we're seeing come in the door. The view I was looking at was a three-year view. I don't know what it was like before that. We can probably get to that database. We are seeing more activity both in our traditional markets as well as the comments that we had around getting into some of these smaller markets that I would describe as $100 million or 100 beds or smaller health systems, hospitals. We are seeing, you know, activity on that front given our ability to start delivering some solutions in that space. So all in total, we are seeing more activity than we've seen in the last two or three years from a new footprint, new RP standpoint.

Atif Rahim – JP Morgan

Okay, and then on the software sales that you said were pretty strong this quarter, what type of products are clients buying and Marc had mentioned they were up significantly from 1Q, but could you provide us what the year trend was like?

Michael Valentine

I'll comment on the first part of the question, I'll let Marc look up the second part. The first part of the question is literally they're filling out the roadmaps, they're continuing the journey. So when I described our clients in, you know, either getting into meaningful use or continuing their roadmaps. It is largely finishing the clinical automation. So kind of the ordering and documentation within the environment, and in many cases, you know, some of the specialty areas as well, ancillaries within the health system. So it is a mixture. The other thing that we mentioned in the script is the advancement of the medical device connectivity engine or MDBus. We are seeing good continued traction in that space as well, which is also part of the definition for meaningful use as it rolls out in 2013 in the current draft.

Marc Naughton

And Atif if you compare that – if you kind of look at the mix between Q2 08 and Q2 09, they are actually fairly similar with Q2 09 having lower tech resale mix relative to Q2 08 and a little bit lower probably on the managed services side, but making that up on some of the other elements including professional services. So year-over-year the bookings are relatively flat. So there isn’t a whole lot of change and between the elements they are not significant ones that I noted other than tech resale being lower this quarter.

Atif Rahim – JP Morgan

On an absolute basis would you say software is up year-over-year or down?

Marc Naughton

On an absolute basis, software will be up.

Atif Rahim – JP Morgan

Okay, all right. Thanks very much.

Operator

Your next question comes from the line of George Hill with Leerink Swann. Please proceed.

George Hill – Leerink Swann

Hi guys. Thanks for the question. Question for Mike, I am wondering if you can characterize the conversations, I am just kind of following up on Atif’s question within the current installed base. What I'm trying to get a sense of is where is the average Cerner customer now from the perspective of clinical functionality versus where we expect them to be with respect to meaningfully using 2011 and 2013, and what is the incremental in sell or up sell that is required by the customer to meet meaningfully use, and I guess the answer to the question, I'm really trying to get is you're going to see hospitals that need to spend $2 million to get to meaningful use, hospitals that need to spend 6 and hospitals that need to spend 10, and I'm trying to wrap my hands around that. I apologize for the meandering question?

Michael Valentine

No, it is actually a fair question. We are doing a lot of work on that front to find out exactly what those numbers really are. Part of it is a little bit of guesswork at this point, since meaningful use is still technically in draft format. I would say that the things that are going to have the biggest impact for us, i.e., what do our clients need to go do to get some meaningful use. If getting to higher levels of automation. So it is getting into CPOE, if you're not already there.

That is going to drive all of our business models. So the numbers you threw out, you know, I would be looking for higher numbers because I want to fill out everyone of our business models. I want us to host their technology. I want to be a large part of the implementation. I want to make sure that we are doing it in an optimal way. So we are rolling in lighthouse services. So to us it is a pretty complex algorithm, because not only do we want to get them technically to meaningful use, we want to be a big part of that being a big winning solution for them and for us.

So we are dissecting it on a case-by-case basis. One of the fundamentals that we have been forced to do is look at clients not as buying decisions. So as an example an entity may have nine facilities but they really buy as a single facility. However, each one of those is going to get measured for meaningful use at a facility level. So we have to actually go down and break it down to understand the level of automation and the roadmap for meaningful use at every one of those facilities. So that in itself is creating an opportunity and it is going to accelerate in many cases their journeys.

There's some pure whitespace. I think we all commented on throughout the script that I think it is going to create a sense of urgency around interoperability, when it gets further defined. I think it is going to represent real opportunity for us as Trace mentioned in his comments, the device connectivity. So we really wanted to first to talk about the definition of the problem in the context of connecting devices and yet you see it come out in a couple of different layers of definition for meaningful use. So we think that's all goodness both in our installed base, and really the opportunity for us outside of our installed base. So –

George Hill – Leerink Swann

And I guess one quick follow-up. Considering that you are expecting to see an increase in new business come on through the bookings, with respect to the RFPs and the RFIs you're seeing right now, maybe give us an update on the competitive environment and how you expect displace and I guess you know, why we should have increased confidence that you guys can continue to win your share of the business going forward?

Michael Valentine

The RFPs are coming out and they are going to mere – there are going to want a roadmap to meaningful use as quickly as humanely possible and that's usually defined by the rate of change that they will accept within their environment and it is not necessarily throttled by our ability to deliver. So the thing we have going for us to get to part B of your question is the predictability of implementation, predictability of cost and certainty both as professed by ourselves as well as independent third parties around being able to deliver the right capabilities to get you not only to the current definition of meaningful use, but to keep up with it as it continues to stair step over the years.

So that's going to be our differentiator in the marketplace. We are going to go, you know, we will compete with every new footprint with all the, you know, expected candidates that you see out there. Our win rate, our competitiveness has improved over the last 18 months. I think there's a lot of things that we are going to – that have an impact on that, but we only think it is going to continue as we continue to make pretty large investments in our solutions and R&D to continue to expand the definition of our solutions.

George Hill – Leerink Swann

Okay, thank you.

Operator

Your next question comes from the line of Jamie Stockton with Morgan Keegan. Please proceed.

Jamie Stockton – Morgan Keegan

Hi guys. Thanks for taking my question. Mike in the critical access facility market and the community hospital market, are those facilities purchasing anything that's materially different than what some of the larger facilities are purchasing today or looking at?

Michael Valentine

From a – if you looked at it technically the answer would be no. If you looked at it from a solution level the answer is absolutely yes. Essentially what we have done is taken the PowerWorks implementation and delivery model. So PowerWorks is our ambulatory EMR solution capability. We have taken that same approach to the critical access market where we have paired down the functionality and the capabilities of the Millennium system, and we have created a multi-tenant environment, so that we can really host and manage multiple facilities in a single instance of our software, which allows us to get to both from an implementation standpoint and from a cost and infrastructure standpoint, to a price point that they can afford and live with longer-term in terms of complexity and cost. So that's really what's gotten us into that marketplace, the learnings that we had out of our PowerWorks delivery model. We have applied that to this new market as well as, you know, ambulatory surgical centers and a few other markets that we are going after.

Jamie Stockton – Morgan Keegan

Okay, and a quick question for Trace. I think that you mentioned that you were looking at expanding your direct sales effort when it came to physician practices and what they were doing in electronic health record area. Does that mean that you are hiring for direct salespeople?

Trace Devanny

Yes, I mean we are in fact doing that and we have a very concerted effort at regional level to expand our visibility and our sales touches to the physician community marketplace. All of this was a backdrop of interoperability. We think it is an important strategy, and we think it is one we are well positioned to make a big dent.

Jamie Stockton – Morgan Keegan

Great, and are you guys working with any value-added resellers today or if you are, could you give me an idea of the number.

Michael Valentine

We have had conversations with some different parties on that front. We haven't formally declared relationships on that front, but it is something that we are evaluating.

Jamie Stockton – Morgan Keegan

Okay, and my last question is really a broader one. You know, as you guys look at the definition of meaningful use or the criteria that have been laid out today, you know, for a hospital or a physician practice is there anything that you would not be able to provide internally?

Michael Valentine

No.

Jamie Stockton – Morgan Keegan

So, you know as you think about, you know, software getting certified for meaningful use, which looks like it is going to start to happen late this year, it looks like there is going to be a comprehensive certification and that some vendors will get certain modules certified as being able to meet part of the criteria for (inaudible). So do you feel like you'd be able to get that comprehensive certification? Do you feel like most of your competitors are also in that position?

Michael Valentine

We can't really comment on where our competitors are one way or the other, but we are very confident of our ability to get our solutions certified as we have met all the certifications required to date by the certifying agency. So it is not going to be an issue for us.

Jamie Stockton – Morgan Keegan

All right, I appreciate it.

Michael Valentine

I will only take one more call, one more question.

Operator

Your next question comes from the line of Corey Tobin with William Blair & Company. Please proceed.

Jeremy Lopez – William Blair & Company

Hi thanks for taking my question. It is Jerry [ph] for Corey actually. Marc I just wanted to circle back to the guidance and as you look at kind of Q3 and possibly Q4, you know, recognizing that you know more projects are probably slipping today than a year ago and in your past. I'm wondering are you expecting, you know, higher proportion of those sales than in the past to come from backlog or are you more dependent on the turns business in the back half of the year?

Marc Naughton

You know, relative to those services business, we think if the mix probably stays pretty similar. I think a lot of the business in the backlog that has been deferred to the extent. It is likely the business is going to first come out and come in to the income statement, but that being said, we are also seeing clients who want to sign up for additional services and get started probably right away with something that is not in the backlog.

We see that kind of in the mix or services bookings anyway that between contract and just kind of those what we would call enhancement of that quarter bookings that’s usually a fair balance between those two, and I don't think we see anything different going forward in that. We have a fairly high-level visibility in that. As I indicated here the mix we have there was primarily global focused, because it is a little harder on the visibility, even if it is in the backlog, the timing of getting some of the global clients to do their share of the work. But I think that's something we will work through relative to our visibility and ideally fit it into our guidance at this point.

Jeremy Lopez – William Blair & Company

Okay, fair enough. And just one follow-up if I could, a bit of a bigger picture question, and you know, the emphasis you guys have a huge footprint, but you also alluded to a potential replacement opportunity and wondering if you guys can provide any thoughts on the number of sites that you feel might be candidates for replacement as a result of the stimulus package, and it sounds like your go-to-market strategy is more of this, you know, the model you've just discussed with respect to critical access in community hospitals. I'm wondering if that is how you plan to go-to-market to get some of those opportunities.

Marc Naughton

Plus, I think we'll go to market across the spectrum from people that have selected a supplier, but don't believe that they are going to be able to deliver effectively at a meaningful use level. We continue to do some internal reviews, and it is a pretty big number. There are some major competitors that have installed base more than a1000 clients that we think represent a very good opportunity for us to (inaudible). So that's what we should – we will see those across the people who haven’t made a decision will tend to be more at the community hospital and that size of hospital, and certainly we will complete hard for that new business, but we do think people will be making other decisions as it gets closer to the measurement dates.

Jeremy Lopez – William Blair & Company

Have you seen serious pipeline activity with respect to those opportunities already or is that something you're kind of anticipating will ramp into next year?

Michael Valentine

This is Mike. We've seen activity on that front. So I will just elaborate on Marc’s comments. I don't want to give you the wrong impression. We have a fairly sizable sales force, and we are assigned to every account out there, whether they are a Cerner footprint or not, whether they made a decision in the last five years or not.

So we have lots of things to offer the market, not just people who are looking to make a decision for the first time in a while. So even in a competitive footprint, we want to proliferate some of our solutions that can peacefully coexist in that environment and start to build a more, you know, a stronger Cerner relationship with those clients. So we are after them all.

Jeremy Lopez – William Blair & Company

And with respect to the current pipeline, are you seeing it already or is this something that you should expect to ramp up?

Michael Valentine

Well, if you follow the third-party reviews, they'll point to some deficiencies. We are aware of those deficiencies as well, and we have had – made sure we put ourselves in position to have conversations with the known health systems that have solutions that have proposed deficiencies. So, yes, the answer we are out there talking to them, and they are receptive to the conversation because they are fully aware of their situation and they understand where the bar is moving and meaningful use definition.

Marc Naughton

And we do think that that pipeline probably ramps up as meaningful use gets clarified, and the options under their current supplier are clearly defined.

Michael Valentine

Right.

Jeremy Lopez – William Blair & Company

Thanks very much.

Marc Naughton

Thank you, guys. Thank you everyone for attending the call. We look forward to talking with you in the future.

Operator

We thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect and have a great day.

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Source: Cerner Corporation Q2 2009 Earnings Call Transcript
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