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Cerner Corporation (NASDAQ:CERN)

Q2 2013 Earnings Call

July 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 R. Nill - Chief Operating Officer and Executive Vice President

Jeffrey A. Townsend - Chief of Staff and Executive Vice President

Analysts

Charles Rhyee - Cowen and Company, LLC, Research Division

David H. Windley - Jefferies LLC, Research Division

Robert P. Jones - Goldman Sachs Group Inc., Research Division

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

Sean W. Wieland - Piper Jaffray Companies, Research Division

David Francis

David Larsen - Leerink Swann LLC, Research Division

Michael Cherny - ISI Group Inc., Research Division

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Gavin Weiss - JP Morgan Chase & Co, Research Division

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Operator

Welcome to the Cerner Corporation's Second Quarter 2013 Conference Call. Today's date is July 25, 2013, 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 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 Cerner's Form 10-K, together with other reports that are furnished or to be 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 Investors section of cerner.com.

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

Marc G. Naughton

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

Now I will turn to our results. We delivered very strong results overall in Q2, with revenue being the one slight exception as it was at the low end of our guidance range, after again being impacted by reduced levels of lower margin technology resale.

Our total bookings revenue in Q2 was $935 million, which is up 33% over Q2 of '12 and is an all-time high for a second quarter. Bookings margin in Q2 was $817 million or 87% of total bookings. Our bookings performance drove a 23% increase in total backlog over Q2 of '12 to $8 billion. Contract revenue backlog of $7.24 billion is 25% higher than a year ago. Support revenue backlog totaled $757 million, up 6% year-over-year.

Revenue in the quarter was $708 million, which is up 11% over Q2 of '12 and at the low end of our guidance range. Recall that we had widened our guidance range for Q2 to allow for the potential of continued low levels of technology resale. This did occur, but revenue was within our widened guidance range. Similar to Q1, the lower technology sales have limited impact on earnings. We do expect technology resale to increase in the second half of the year from current levels. But as we discussed last quarter, this is one of the least visible components of our business, so we will continue to use a wider guidance range. The revenue composition for Q2 was $201 million in system sales, $165 million in support and maintenance, $322 million in services and $20 million in reimbursed travel.

System sales revenue reflects a 3% increase over Q2 of '12, with strong growth in software and subscriptions being largely offset by the decline in technology resale. The strength of the high margin components of system sales is evident in the growth of our system sales margin dollars, which were up 36% year-over-year.

Moving to services. Total services revenue was up 17% compared to Q2 of '12, with strong growth in both managed services and professional services and increasing contributions from ITWorks and Revenue Cycle.

Moving to gross margin. Our gross margin for Q2 was 82.2%, which is up from 81.3% in Q1 '13 and 76.9% in Q2 of '12. The large year-over-year increase in gross margin percent was driven by the lower mix of technology resale, strong software sales and strong services margins. The strength in these areas is also reflected in strong year-over-year gross margin dollar growth of 19%.

Looking at revenue by geographic segment. Domestic revenue increased 10% compared to Q2 of last year, even with the decline in technology resale. Global revenue growth was strong at 17%.

Looking at operating spending. Our second quarter operating expenses were $404 million before share-based compensation expense of $11 million. This is a year-over-year increase of 17%, which is below the growth of our gross margin dollars, reflecting ongoing operating efficiencies.

Sales and client service expenses increased 16% compared to Q2 of '12, driven by an increase in revenue-generating associates in our services business.

Our investment in software development was up 12% compared to Q2 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 continue to be reflected in increased gross spending and increased capitalized software throughout the second half of 2013.

G&A expense increased 37% compared to Q2 of '12, driven by increased personnel expense related to our strong growth and higher amortization expense related to recent acquisitions in acquired intangibles.

Moving to operating margins. Our operating margin in Q2 is 25.1% before share-based compensation expense and was up 240 basis points compared to Q2 of '12. This was driven by a combination of ongoing operating efficiencies, the lower level of low margin technology revenue and strength in high margin areas I have discussed. We expect margin expansion to remain above 100 basis points for the year.

Moving to net earnings and EPS. Our GAAP net earnings in Q2 were $112.9 million or $0.32 per diluted share. GAAP net earnings included share-based compensation expense, which had a net impact on earnings of $6.7 million or $0.02 per diluted share. Adjusted net earnings were $119.6 million, and adjusted EPS was $0.34, which is up 17% compared to Q2 of '12. The Q2 tax rate for adjusted net earnings was 34%, which is in line with our expected effective tax rate.

Now move to our balance sheet. We ended Q2 with $1.5 billion of total cash and investments, which is flat compared to Q1. Total cash and investments include $969.5 million of cash and short-term investments and $514 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 at $528 million, which is up $16 million from Q1. Our DSO in Q2 was 68 days, which is down from Q1 DSO of 69 days and 71 days in Q2 of '12.

Operating cash flow for the quarter was $177 million. Q2 capital expenditures were $86 million, and capitalized software was $44 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $47 million. Free cash flow was lower than recent levels due to higher CapEx, driven by investments in our cloud infrastructure, the build-out of our new campus and higher capitalized software. We expect capital expenditures to remain high in coming quarters, as we continue these important investments in our growth. Even at these levels of investment, we still expect to generate solid levels of free cash flow. We expect these investments to moderate by the second half of 2014 and for free cash flow to increase at that point.

Moving to capitalized software. The $44 million of capitalized software in Q2 represents 42% of the $103 million of total investments and development activities. Software amortization for the quarter was $23 million, resulting in net capitalization of $20 million or 20% of our total R&D investment. As I have indicated, we expect capitalized software to continue increasing in the second half of 2013, as we invest in key growth areas. Since much of the incremental development involves using third-party developers, we expect the growth in capitalization to be temporary. Similar to our overall CapEx outlook, we expect our capitalized software levels to flatten in 2014 and then decline in subsequent years.

Note that while we are increasing the dollar amount of software development cost capitalized, our total investment in R&D is growing by a higher amount, meaning that the net R&D expense on the income statement grew this quarter as it will throughout the rest of the year. We view this investment in development, combined with our share buyback and acquisitions, to be a good use of our capital.

Regarding our share buyback. In Q2, we've purchased $79 million worth of shares, bringing year-to-date repurchases to $142 million. We have purchased a total of 1.5 million shares pre-split, which is the equivalent of 3 million post-split so far this year. We have $28 million remaining from the $170 million that was authorized last December.

Now I'll go through Q3 and full year guidance. For Q3, we expect revenue between $740 million and $770 million, with the midpoint reflecting growth of 12% over Q3 of '12. This 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 and Q2, we are biased towards the lower end of this range.

We expect Q3 adjusted EPS before share-based compensation expense to be $0.35 to $0.36 per share, with the midpoint reflecting 8% growth -- 18% growth over Q3 '12 reported adjusted EPS.

For the full year, we expect adjusted EPS between $1.40 and $1.42, which is up from our prior guidance range of $1.39 to $1.42. The midpoint reflects 18% growth over our 2012 reported adjusted EPS and 21% growth when you adjust 2012 for our lower tax rate in Q2 and the gain on the investment sale we had in Q4.

Q3 guidance is based on total spending before share-based compensation expense of approximately $415 million to $425 million. Our estimate for the impact of share-based compensation expense is approximately $0.02 to $0.03 in Q3 and $0.08 to $0.09 for the full year.

Moving to bookings guidance. We expect bookings revenue in Q3 of $875 million to $925 million, with the midpoint reflecting 17% growth over Q3 of '12.

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 Q2 of $935 million is an all-time high for our second quarter and reflects 33% growth over Q2 2012. This increase was driven by strength across all our business models except for technology resale and included strong contributions from ITWorks and Revenue Cycle, which Mike will discuss.

Looking at other bookings metrics. We had 28 contracts over $5 million, including 14 over $10 million. The mix of long-term bookings was 34% in the quarter, which is slightly higher than historical levels due primarily to the strength in ITWorks and RevWorks.

Our new footprint activity was again very strong, with 30% of our bookings in the quarter coming from outside of our core Millennium install base, again, including wins against our primary competitor. In addition to ongoing competitiveness in the large hospital market, we also had strong results in the ambulatory space, where we had an all-time high level of bookings in Q2. This strength was driven by 6 competitive displacements of 3 different suppliers. Note that these ambulatory wins include both the clinical and Revenue Cycle, and our pipeline for both is very strong. We also had record results in smaller hospitals, with our CommunityWorks business adding several footprints during the quarter.

Another noteworthy area of strength this quarter was in the investor-owned market. Operationally, we brought the first 10 sites live for a large investor-owned client that just selected us in Q3 of last year for 19 sites. The ability to bring 10 hospitals live in just 10 months from contract execution is something I believe only Cerner can do, and its execution should position us well for future opportunities with this client. Our sales in the investor-owned market were also strong, with the highlight of being one of our largest clients selecting us to replace their existing hosting provider.

An area of emerging strength for Cerner that I'd like to highlight is the public sector. Like investor-owned, we think there are strategic and operational competencies that are important to compete in this space. Our proven scale, predictable results and budgets and ability to deliver value set us apart from others competing for this business. In Q2, we demonstrated our ability to compete in public sector business with success in opportunities ranging from behavioral health, to an Indian health services organization, to a very large state correctional health services organization that provides care to over 100,000 inmates. I believe our experience in this space positions us well for what we view is a growing public sector opportunity.

Our execution outside the U.S. was also good in Q2. Highlights include good activity in England, Canada, Australia and the Middle East and an expansion of our relationship with AMEOS Group in Germany.

Moving to general marketplace observations. We continue to see more separation between the 2 most successful companies and the rest, most of which continue to struggle with execution. This is evident in our ongoing success at winning new footprints, as well as activity in our pipeline.

Another industry observation is the operational and financial pressures on health care providers remains high. It is a challenge for them to keep up with Meaningful Use, health care reform, Value-Based Purchasing and other requirements, all while facing ongoing pressure on reimbursement. Our solutions and services are very well-aligned with helping our clients navigate these challenges, which is why we continue to have good results and a strong pipeline in what could otherwise be viewed as a challenging market.

In addition, providers are looking beyond their near-term challenges and increasing their focus on population health strategies to prepare for an expected industry shift to an at-risk model that incents ph] keeping people healthy. Our capabilities and population health, combined with the large investments we are making in new solutions and services, are creating competitive differentiation and positioning us for sustained growth beyond the current EMR and Meaningful Use era.

Finally, industry consolidation is continuing, with the biggest recent example being the announcement of Tenet purchasing Vanguard Health. This acquisition is another example where our large clients are being acquisitive to gain additional scale. As we have discussed, this is a positive trend for Cerner given our strong relationships with most of the largest health systems, which are also the most acquisitive.

In summary, the environment remains favorable for Cerner. We have a large pipeline of new footprint opportunities with only 1 primary competitor. Our solutions and services are well-aligned with what health care providers need both today and in the future, and industry trends are creating additional opportunities for Cerner.

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

Michael R. Nill

Thanks, Zane. Good afternoon, everyone. Today, I'm going to discuss Revenue Cycle and ITWorks and provide a midyear update on our corporate imperatives.

I'll start with Revenue Cycle. In Q2, we had very strong Revenue Cycle results that included another RevWorks client. The client we signed this quarter is a pediatric hospital that offers over 40 pediatric specialties and subspecialties and has had Cerner Solutions since 1991. This partnership marks a milestone for us, as it is our first pediatric hospital to choose RevWorks.

Like many of our long-term clients, the RevWorks alignment was viewed as a natural next step to continue driving value out of their investments. They're looking to strategically align with RevWorks in consideration of future regulatory requirements, financial predictability and desire for innovation and best practice Revenue Cycle operations. This selection, coupled with very large clients endorsing our Revenue Cycle solutions and services in recent quarters, reflects ongoing momentum in our Revenue Cycle business. This activity also represents early returns on the significant investments we have been making in our Revenue Cycle capabilities. Our pipeline for Revenue Cycle solutions and full RevWorks services is very strong, as the tighter [ph] link between clinical outcomes and Revenue Cycle continues to drive more clients to our integrated offering.

Q2 also included success within our ITWorks offering, as we signed a contract that represents a major expansion in relationship with a client that began using Cerner Solutions in 1989. This is our largest ITWorks client to date and is another example of how very long-term relationships can continue to expand in meaningful ways. The client has 3 hospitals with a total of more than 700 beds. Like our other ITWorks clients, their desire to strategically align with Cerner was based on a desire to keep up with current and future regulatory requirements, plans for continued growth and a desire for innovation in health and care.

As Zane discussed, our clients face ongoing pressures to address multiple industry requirements while also controlling costs. Our works offering provides a way for them to address these requirements, drive better performance and control those costs.

Now I'd like to provide a midyear update on our corporate imperatives in areas of R&D investment. As you know, our imperatives in R&D investments are focused on physician experience, population health and Revenue Cycle. Investment in these areas are strengthening our competitiveness while also setting us up for the next wave of growth.

I'll start with physician experience. We made very good progress in 2013 in enhancing our physician solutions for both inpatient and ambulatory settings. A major part of this effort has been PowerChart Touch, which is now generally available in the Apple store for use on the iPad. PowerChart Touch's fast, easy and smart solutions have been very well-received in the marketplace, and in May, PowerChart Touch received an award for Best Clinical Health Care Experience Application at the International User Experience Awards. This award, along with the record results Zane discussed, is good validation of our work. Going forward, we remain focused on building out applications with various specialties and creating seamless workflows across all devices.

Moving to population health. Progress this year includes advancing our Cloud platform and data analytics capabilities that are foundational to population health efforts. Also, our expanded partnership with Advocate Health Care is a tremendous step forward and is an exciting opportunity for us. Advocate is a thought leader regarding population health, so it means a great deal that they chose Cerner to partner to help develop the technology to manage the health and care of populations for which they have gone at risk.

We've also made good strides with Revenue Cycle. The primary indicator of this progress is a demand for our solutions and services, which has picked up substantially in recent quarters. Our work has improved our competitiveness, as having Revenue Cycle solutions tightly integrated into the clinical process is important to ensure proper reimbursement in the new value-based payment models. Going forward, we will continue to invest heavily in Revenue Cycle capabilities, including key differentiators like revenue analytics and care management.

In summary, while most of our competitors are bogged down with Meaningful Use and other regulatory requirements, we are investing heavily to position us for more market share gains and for long-term growth. We're seeing clients choose Cerner for the value we show today and for the fact that we have a vision that will sustain them in the future. We believe we are the only company in the industry making the investments in technologies, architectures and solutions that will meet the needs of our clients over the long haul. We are future-proofing our clients, and it's good for our business as well as theirs.

With that, I'd like to turn the call over to Jeff.

Jeffrey A. Townsend

Thanks, Mike. Today, I'm going to talk about the Primary Health network and provide an update on the work we are doing with Advocate Health Care.

I'll start with the Primary Health network, which is a pilot program we launched last month that connects incentives and aligns consumers and providers to facilitate improved health. The PHN involves the health retailer, a high-performance physician network and innovative employers. The key component of the network is the use of select retail locations to serve as access points for wellness screenings with a nurse. At these screenings, individuals will learn important elements about their health, receive tailored recommendations for becoming healthier and select a primary care physician that aligns with their health needs and preferences. Our Cerner wellness solutions and Healthe Intent platform provide the underlying technology for the program's wellness, condition management, education, performance analysis and reporting components.

We are pleased that the retail partner for this pilot is Walmart, which gives us the potential to have a significant impact on the health and wellness of communities, as 70% of America visits one of their stores every other week. Kansas City-based Hallmark Cards is the first of multiple employer participants for the pilot. Hallmark's employees and their spouses now have convenient ways to discover their health status and connect with highly engaged physicians in the community who have been specifically selected for them based on their individual preferences. With the Primary Health network, we are aiming to create an entirely new health care experience by engaging individuals with a team dedicated to their wellness and helping them create a medical home. Ultimately, this should lead to a community that delivers measurable, high-quality, evidence-based health services at a reasonable cost by aligning incentives with improved outcomes.

The PHN also can address access and capacity issues, drive referrals to primary care and create more revenue opportunities for those that shift to manage contracts or add-on services create value against total cost. We are already working on plans to expand the PHN to additional markets, and I will provide updates on our initial pilot and expansion plans on future calls.

As you know, we are also investing heavily in systems to help our providers manage the health of populations. While our investments are very broad, a focused area of investment is tied to our work with Advocate Health Care and the Advocate physician partners, as this work will lead to solutions being used at scale beginning next year.

As a quick background, recall that we began an initial collaboration with Advocate in April 2012 to create new data-driven predictive models designed to improve patient health outcomes and safety. One of the first outcomes of this partnership was the joint development of a predictive agent for readmissions that has demonstrated significant improvement and predictive power as compared to the majority of the existing models. A study highlighting this success was recently published in the Online Journal of Public Health Informatics.

Our relationship expanded this year to further advance clinical integration and population health management capabilities across the continuum of care for the 500,000 lives for which they have gone at risk. We are enabling them to identify who in their population meets criteria across 16 specific registries and 60 performance improvement scorecards, with parameters Advocate has created. As members needing care are identified, we will facilitate personalized interventions, enrollment and care management programs and ongoing monitoring to allow Advocate to keep people healthy. This work with Advocate is going at a fast pace and is very complex.

An example of the complexity is that we are aggregating normalizing data from 52 different data sources, including multiple EMRs, private and public payers, third-party billing and registration systems and physician specialty scorecards. This requires the ability to take both structured and unstructured data and run it through our Big Data engine using medical language processing, not just the more commonly used Natural Language Processing or NLP. This allows us to enhance the data and map it to a normalized standard to have a highly structured longitudinal record that enables all the real-time analytics I've discussed.

The level of interest by our clients in what we are doing with Advocate in the population health overall is very high. This was demonstrated last week when we hosted our first Population Health Summit, which drew 144 client attendees. Clients were able to network and learn from each other on other topics of population health management, readmission prevention, health information exchange, member engagement, patient-centered medical homes, continuum of care, analytics and quality measures. The summit validated the level of client interest and the direction we are going with our population health solutions.

In summary, I believe our approach to population health is differentiated in the marketplace. We believe many companies positioning themselves as suppliers of population health solutions underestimate the complexity, and none of them are addressing the population health opportunity with the comprehensive architectural approach that sets us apart.

Before turning the call over for questions, I'd like to highlight an announcement that was made yesterday by the CommonWell Health Alliance, that CPSIA and Sunquest Information Systems have joined as the newest members. They joined Allscripts, athenahealth, Cerner, Greenway Medical Technologies, McKesson and service provider RelayHealth in a collaborative effort focused on achieving interoperability and data liquidity on a national infrastructure. As we have stated, achieving data liquidity is a critical foundation for delivering better coordinated, more effective care, and we believe the addition of CPSI and Sunquest strengthen these efforts.

In addition to adding members, CommonWell also made significant progress recently at establishing a governance structure, developing services and planning for an upcoming pilot program.

With that, let's open up the line for questions.

Question-and-Answer Session

Operator

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

Charles Rhyee - Cowen and Company, LLC, Research Division

Marc, you're obviously taking advantage of being a consolidator in the market -- your customers are being the consolidator in the market. And you mentioned Tenet briefly here. Can you kind of -- I know this is a contract that you kind of took over the entire thing a couple of years ago. Can you maybe give us a sense on where you are actually with that client? And if I'm not mistaken, I think you already serve some of the Vanguard system. Can you kind of talk about the mix there for you? And sort of -- if that kind of transition's all over, when would you kind of think about discussions with Tenet about that?

Zane M. Burke

Charles, this is Zane. Just a couple of comments. We are still engaged in the middle of the rollout, a very successful rollout at the Tenet engagement they rolled out to a number of other facilities. They're in the 30s in terms of their facility counts that rolled Cerner out. So that's an active engagement that's still ongoing, and there's a lot of work to do there. Obviously, the Vanguard transaction hasn't been completed by Tenet, and we haven't had excessive dialogue about what that means for us. But that's a positive sign on that. There are about 8 of the 20 -- I believe 28 facilities of Vanguard are Cerner facilities today.

Charles Rhyee - Cowen and Company, LLC, Research Division

Okay. Great. And then maybe one follow-up. I mean, you were talking about the opportunities you have within your expanding relationship within your -- in your base here. But thinking more broadly, as the hospitals are getting impacted by sequestration and stuff, a couple of days ago, one of the IT service providers, which I think also implements some Cerner and Epic as well, kind of talked about sequestration having some delays on some systems development. It doesn't seem like it's really having an impact on you, but maybe you can kind of help us understand where some of the differences might be, what some of these service providers are seeing versus, I mean, what you're seeing.

Marc G. Naughton

This is Marc. The only one that I'm aware of that talked about the lack of the market, I think other reporting indicated that anybody they were laying off, they'd be happy to hire. So I think that was a very targeted view of the market. We continue to hire kids off campus and experienced people to -- for our implementation teams. Our business is as active as it has ever been. Our backlog in those projects is the biggest it's ever been. So we're certainly not seeing any lack of demand for those services due to anything that the government is putting out there. In fact, the more things the government puts out there, the more we see an interest in systems, given their ability to reduce cost while meeting all these new requirements.

Operator

Your next question comes from the line of Dave Windley from Jefferies.

David H. Windley - Jefferies LLC, Research Division

I wanted to ask a couple of questions around population health. So your Advocate partnership, I believe, is moving very rapidly toward the system completion on that by the end of this year. So I'm curious about, one, the commercialization opportunity of that system or something akin to it. And would those 144 who attended your summit be the likely targets for that? And then on the cost side of things, would we see R&D tail off after that's complete?

Marc G. Naughton

Yes. Jeff, I'll let you maybe answer some of the Advocate questions. From a financial side, we clearly are focusing on getting a lot done in a short period of time relative to population health. It's part of our overall investment and IP that you're seeing hitting us on the capital side. That's not just limited to population health. Obviously, doing physicians and Revenue Cycle, which is a huge market potential for us going forward, are all things that we're working on. But those -- that really big push to get those projects out do tail off as we hit kind of the middle of 2014. So as we talked about in my script, the CapEx should reduce as we hit in 2014. But Jeff, do you have any comments relative to the summit and Advocate?

Jeffrey A. Townsend

Yes. On Advocate, the way we somewhat broadly look at it is, they're 1 or 2 eras ahead or cycles ahead of most of the marketplace. So the solution said that they're taking forward, and as I outlined with dozens of data sources and 16 registries, the rest of -- if I'm summarizing the attendees to that conference, all have initiatives at various stages, whether they are shared savings programs, they are attempting member engagement or they're just building data warehouses. So the advantage of Advocate is the ability for them to see what does it look like when you put this entire stack together and begin to coordinate comprehensively, versus at a component-based level. So we see them -- those other organizations as they continue to change their reimbursement contracts and take on more risk or launch broader ACO initiatives. We'll then fall in line and somewhat replicate or copy that Advocate roadmap.

David H. Windley - Jefferies LLC, Research Division

If I could ask one follow-up, Marc. On your new building build-out, when those are complete and you're moving people into those buildings, should we anticipate a spike in operating costs or the combination of operating costs and depreciation in the income statement? And when would that hit if we should?

Marc G. Naughton

Yes. We are building -- the first building of the 2 building complex campus is complete, and people are moving in there as we speak. The cost of moving is very low, because it's all basically taking people from Kansas City facilities and moving them just to a new facility. So for the most part, the expense isn't very high. And many times, it's the cost of the couple of cardboard boxes for them to put in their trunk to take over the new building, not that we're low-cost movers, but that is an approach that many of them take. So you won't see any big costs -- when the buildings are complete, they'll start depreciating, but that will be over a 50-year life. So...

Operator

Your next question comes from the line of Rob Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

I had a high-level question. If you look at a lot of the hospital and med tech manufacturers, it seems like hospitals might have cut back on CapEx broadly. Is that something you guys have noticed in the marketplace? And if so, are hospitals being more cautious around IT spending as well in your view? Or has it been more restricted to things linked closer to utilization?

Zane M. Burke

Rob, this is Zane. What we have seen is, certainly, people are being judicious about how they invest dollars, but that they use health care IT as one of the ways that they're actually going to drive costs out of their businesses. And so they're using that as a lever for that. They've also looked at, I think, a number of the activities around ITWorks and RevWorks that Mike talked about with you, where they're utilizing some of those services to help create more predictable cost models and actually drive better efficiencies and use their funds in other ways. So it's created quite a bit of opportunity for us.

Marc G. Naughton

Yes, this is Marc. Just the CFOs I talk with, many of them talk about from an MRI, from that type of CapEx standpoint that there was a race where I had to have the latest, greatest, most efficient. Now nobody's -- people aren't investing quite as much in that infrastructure. They work just fine. So many people aren't really investing -- needing to invest to keep up with the competitive environment relative to some of that hardware. So we can certainly see a differentiation, at least when I talk to people, about what's on their CapEx list, things that are going to help them take 20% out of their operating costs as opposed to, "I'm trying to get the next new thing so that I can attract radiologists or stand alone."

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Makes sense. And then if I could just follow up. It seems like you guys have had some success in the public sector. Can you maybe just discuss the trends in that market specifically amongst those clients? And how are you thinking about the size of that overall opportunity?

Zane M. Burke

The trends have been -- there's actually funds there. We're seeing it, everything from, "how do we manage the health status of the population?" to -- everything up to the incarcerated folks. And so the gamut of public health is quite large, and there seems to be quite a bit of funding and even in decreasing public budgets that are out there. So we see it as a fairly significant opportunity, and we're the only ones in the industry that provide the continuum of care across all those different marketplaces where we can actually go hunt for dollars in those different markets.

Operator

Your next question comes from the line of Steve Halper, Lazard Capital Markets.

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

Relative to the lower sales on tech resale, can you identify what areas within tech resale were below your plan? And as a follow-up, this is not the first time we've seen this. How, as a management team, can you sort of get a better handle on that component, even though it'll recognize in the bottom line impact as nominal?

Marc G. Naughton

Yes, this is Marc. Those are third-party resale items. They're not our items. Obviously, we have a very small inventory of things that we actually put out there such as Rx station cabinets, but -- and the [indiscernible] space has been probably the biggest impact for us. In 2012, we had a lot of sales. Those tend to be cyclical when you come out with a new model, then the cycle kind of flattens until the next new model comes out and then it picks back up. So that's impacted the total tech resale probably as much as anything. As a management team, we work as hard as we can, but when it is a third-party sales force that's doing the work, and because of potential competition in certain areas, they don't want to share their information relative to what their pipeline looks like and their timing. We really have to kind of fly blind a little bit on that. So we do our best relative to creating a guidance range that can take the low and the high. This quarter, we came in kind of at the low end of what we expected. We think that's going to slightly increase the rest of the year. And, obviously, we wouldn't want to create any expectations that we're higher than that because of the lack of visibility. So I think as a management team, we're doing everything we can to get a better view of it. We're continuing to roll out other opportunities in the hardware space, the device space, expanding our portfolio so that we can get more diversity, which will help us be able to predict a little bit more accurately. And Steve, as we've talked about for a long time, certainly, at the top line impacts, but given how that the revenue doesn't flow down to a great extent down to the earnings line, it's really just not something that we're overly concerned about. I think it's good revenue to get, it's part of our strategy of getting everything the client wants to buy coming through us, which we think will expand our opportunities as we move forward into these new areas. But from a business standpoint, I think we're doing exactly what we need to do and what we can do. And you just -- guys will just have to bear with us a little bit given some of the variance.

Operator

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

Sean W. Wieland - Piper Jaffray Companies, Research Division

So I look at your Q3 guidance and it implies revenues are going to have a pretty big ramp. Can you just talk about what is going to be driving that revenue growth in the fourth quarter and also the sustainability of that growth into next year?

Marc G. Naughton

Relative to the -- on the Q4 elements? Relative to the year, what the Q3 guidance is going to be?

Sean W. Wieland - Piper Jaffray Companies, Research Division

Yes.

Marc G. Naughton

Obviously, Q4 is, overall, our strongest quarter. I mean, that's the quarter that we always do well in. There's a lot of pent-up demand. We see a lot of opportunities in the marketplace that are going to be coming into our bookings that are going to create revenue opportunities. A lot of things are in our backlog that are going to continue to contribute to it. So I don't know if there's anything unique other than the success that usually comes with the fourth quarter driving that, which usually entails strong software and other things that are quick turnaround items, plus things that are building up in the backlog that will roll out. But there's nothing unique that I identify.

Sean W. Wieland - Piper Jaffray Companies, Research Division

Okay. And then a follow-up. Can you talk about -- I like the investments in the Cloud infrastructure. Is your population health management platform being employed in a multi-tenant environment? And what do you think about the multi-tenant environment for kind of the core Millennium? Do you see a time where you'll be deploying your inpatient solutions via the Cloud?

Michael R. Nill

This is Mike. Regarding population health, yes, the Cloud, I mean, basically, by its -- by design is a multi-tenant environment that provides us with the scalability that we need to support countries for this type of application. So regarding whether this will make its way into our existing solutions in the inpatient environment. If we start with PowerChart Touch. PowerChart Touch is being implemented in a Cloud-type architecture, and we're doing that to deliver the response time and speed that's required for those type of tablet applications. I think, over time, what we will find is we're not going to do a wholesale move of all of our current clinical applications into the Cloud. I think there will be some opportunities to provide some functions on an as-needed basis, but that will be a gradual evolution over time.

Marc G. Naughton

Sean, this is Marc. Just to -- not to step on Mike's toes here, but just to go back to your revenue question. Do keep in mind that when we are -- that based on the hardware we're seeing from a revenue perspective in Q4, that we've kind of indicated the low end of our annual guidance is more likely. And I think if you factor that in, you're not going to see a huge ramp in Q4 relative to what the revenue would look like. The difference in potential for that to be bigger would be if hardware recovered stronger. But we don't know that, that's something we're seeing on our radar today. So hopefully, that helps clarify it. Sorry.

Operator

Your next question comes from the line of Dave Francis with JAAG Research.

David Francis

A couple of quick questions. First, Marc, on the systems sales margin, understanding that with the lack of hardware revenue pass-through there, that the margin is naturally going to be higher. It was exceptionally high this quarter. And I guess I'm wondering, what should we be looking for in terms of where does that level top out and what should we be expecting from a software margin perspective going forward for the company as you guys continue to push the envelope on that?

Marc G. Naughton

Well, relative to systems sales gross margin at 82.2%, it's up less than 100 basis points over Q1. So I think given the current state of our hardware sales, we're kind of looking that, that's probably the range that our gross margins are going to be in. So I don't know that there's -- that, that's historically high. Well, I have to go back and see how high that is. But certainly, it's strong, it's going to reflect lower hardware and it's going to reflect the continuing strong software that we've been seeing. So based on those -- the diversity of those margins that are contributing to gross margin, we think kind of what we see in the first 2 quarters should be what we continue to see for the year.

David Francis

Okay. And a quick follow-up. Relative to the activity that you've seen among the buyers and what your works service lines offer them relative to more efficient use of capital and what have you, are you expecting to see any kind of acceleration in terms of deals signed there? Or should we continue to be looking for just 1 or 2 bigger deals per quarter here over the next several quarters?

Marc G. Naughton

This is Marc. I think if you're going to say 1 or 2 deals a quarter would be an acceleration, we kind of have indicated that when we thought we kind of hit a good stride, we'd be doing 1 a quarter. We're getting pretty close to that. Is there an opportunity to expand on that? I think there is. Zane, what are your thoughts?

Zane M. Burke

We feel like there's great opportunity there, and I think you've hit it, Marc. I think we see continued demand for those type of services in our base, and I think there's an opportunity for some of that to accelerate.

Marc G. Naughton

Yes. I think the key is that as systems look to handle their costs and reduce their costs, our works businesses absolutely are in tune with that approach, because we're going to help them manage and actually probably reduce their overall spending on a like-for-like basis from what they're doing. So in that environment, we are getting more and more people looking at us for an option to help them drive the cost cuts that they need to remain competitive.

Operator

Your next question comes from David Larsen, Leerink Swann.

David Larsen - Leerink Swann LLC, Research Division

Zane, can you talk briefly about these investments that have been made into the physician user experience? And can you talk about PowerWorks, how that product has evolved? And just in general terms, of the 45,000 docs that are currently your clients, are they all in PowerWorks or some of them on PowerChart? And then can you also just talk about Ascension Health and their decision to go with athena?

Zane M. Burke

David, you had a number of questions, so I'll see if I can answer those. If I miss one, please help me come back to it. But Cerner ambulatory, which is what we refer to our solution, we are leading with an integrated Cerner -- integrated solution. And so many of the wins over the last 24 months and this growth that we've had has been in our integrated environment. We continue to market and sell the PowerWorks environment, which is typically done for affiliated physicians, which is also the Cerner Millennium solution just in a hosted model. We've had great success actually in the Business Office Services and Revenue Cycle side, with our Business Office Services and our Millennium solution in the Revenue Cycle particular space. We've actually crossed the 50,000 physician mark for docs overall that are using some form of Cerner ambulatory solutions in that setting. As it relates to one of the competitors in this space and our client, obviously, Ascension is a significant client of Cerner's. It's very committed to the inpatient solution. My understanding is that particular arrangement is more of a hunting license within that organization and reflects that overall. So I like our competitive position against that particular competitor over the long term. And actually, one of our displacements was actually related to that environment and a number of competitive wins versus that particular supplier.

David Larsen - Leerink Swann LLC, Research Division

Okay. That's very helpful. And then has there been recent new releases or new versions of PowerWorks that came out in 2013? And can you talk about maybe the functionality in those new versions relative to previous versions?

Zane M. Burke

So the functionality within Cerner Ambulatory and PowerChart, overall, we've had a number of enhancements in that regard over the last 24 months, 24 to 36 months, and is an absolute lead with -- for Cerner today and is really one of the best, is was actually the #1 black book ambulatory EHR out there. And so the enhancements that we've made to the solution overall from an ambulatory perspective have been extremely well-received by our clients, as well as the early returns around PowerChart Touch in the ambulatory environment, which is, that's the first venue which that application will hit as well.

Operator

Your next question comes from the line of Michael Cherny, ISI Group.

Michael Cherny - ISI Group Inc., Research Division

So just digging in a little bit, you mentioned how long-term bookings number for the quarter was a little bit above the elevated level. I think you said 34% relative to where it's been previously. As you think about that as a percent of total bookings, particularly into the population health management push, which seems to be a little -- a combination of service and technology, maybe more service-oriented, how do you expect that trend to move over time? Are we more likely to see it closer to that mid-30s level? Or is that 25% to 30% range you've historically talked about the more likely level?

Marc G. Naughton

Yes. I mean, Michael, it's -- my crystal ball is not clear enough to know even exactly what the population health business model is going to be as it rolls out in its various venues to be able to kind of know how long-term those might be and where they're going to fall. So clearly, if it's a PMPM for an extended period of time, then that would be a longer-term booking. I think, certainly, in the near and medium term, that the 30% or so bookings being long-term reflects our overall growth in bookings and the fact that works businesses are really starting to gain momentum and starting to get some traction. So we'll certainly -- if that moves much off of the 30%, we'll talk to you about what we're seeing is moving that, if it's moving up or down. As the works businesses start clicking, if I get to the suggested 2 works deals a quarter and if I'm doing ITWorks and RevWorks, it could impact it. But we have such strong demand for all of our other existing solutions and our services and things that don't go into long-term and a lot of the new business that we're getting and we're signing up. Most of that is a short-term or at least not in our long-term bookings. So I think that the likelihood is that we'll stay in that same range for a while. And if we're going to see a movement out of that, we'll try to give you a heads up as to that. But in the near term, I don't see -- we'll get a nice balance for both elements of the portfolio or growing at a similar rate.

Operator

Your next question comes from the line of Greg Bolan, Sterne Agee.

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

I wanted to ask kind of a quarterly ritual question, Marc, on uses of cash. Any update there as it relates to what you guys are thinking about?

Marc G. Naughton

Yes, Greg. I mean, today, obviously, we reported -- I'm talking about cash flow, how we had spend a lot of the cash flow and coming up with about $47 million of free cash flow. So we are certainly investing that cash flow that we're driving in the quarter in some of our infrastructure, obviously, from a building perspective, the infrastructure on the CapEx side relative to our population health and other initiatives and, certainly, on the stock buyback and on the R&D investments. So I think kind of on a quarterly basis, we've all got a big focus on investing back in the business. The $1.5 billion number we kind of hit, we've been at for a couple of quarters. So we're really investing the cash we've earned since then back in the business. We think that's the best path. We still are going to keep an eye on that $1.5 billion, keep an eye on the marketplace. We're always interested in things that can add to our portfolio without impacting our single architecture strategy. And a lot of the acquisitions you've seen us do in the last 1 or 2 years have been things, such as behavioral health, that has actually put us into some of these government markets that you can't even submit an RFP if you don't have that specific requirement. So I think we're going to continue looking at that, and we're comfortable with where we're at with cash now. We'll continue to look at stock buyback. Obviously, we have a little bit left to finish up our current one. But right now, I think we like what we're doing with our cash, and we're going to look at continuing to keep that $1.5 billion in our pocket for -- as we see opportunities develop.

Gregory T. Bolan - Sterne Agee & Leach Inc., Research Division

Fair enough. And just kind of thinking about -- and I apologize if I missed it, if you made any comments on this, Marc. But just regard -- with regards to the pipeline and the magnitude of it, just kind of recalling sometime around this time last year, just how you felt about the pipeline going into the back half, specifically into the fourth quarter. Just wanted to see if maybe you could characterize, maybe qualify, if you would, where you are versus, say, historically just in terms of all-time high or close to it. Or how are you thinking -- or what does it look like at this point?

Zane M. Burke

This is Zane. We just completed our forecasting process where we actually go through and talk about the next 4 core pieces, and I can't say that it was an all-time high. And so we did see -- we have seen significant growth in the pipeline across all segments inclusive of our global segments and domestic as well.

Marc G. Naughton

This is Marc. The marketplace is as strong as we've seen it. The things that we're rolling out, the new businesses, RevWorks, ITWorks, are just exactly what certainly our clients are looking for. And I think we talked about some of the other competitors, clients starting to come back to the market. This forecast meeting we just had, '14 looks like the time when we're going to start seeing those come in more than a onesie-twosie fashion. So we like the market that we see certainly for the rest of the year and actually into the visibility we had in kind of the early part of '14.

Operator

Your next question comes from the line of Gavin Weiss with JPMorgan.

Gavin Weiss - JP Morgan Chase & Co, Research Division

You mentioned the CommonWell announcement of a few new members there. What steps have been taken in this group today? And where do you see the real implications of this going forward?

Jeffrey A. Townsend

This is Jeff. As far as the group goes kind of since our HIMSS announcement, I'd say there's been 3 paths that the broad group has been working on together. One is to co-form the real entity, the governing principles around that entity and how it evolves over time. The second path would be on the pure technology itself. And so taking the library of existing standards that are out there and attempting to accelerate those that make sense to achieve that objective around that ID and to get that into the market more quickly, so how do you introduce new standard without it becoming almost another wave of Meaningful Use where the suppliers have to go do a lot of work back in their EMR and that delays adoption? So I think you'll see -- as we introduce the pilots, that will be probably one of the areas I'm probably most excited about and the work that's been done to date. The third category is to actually go pick those target markets that have in a community enough of a sampling of all the participants. And as I briefly said in my comments, I think we're down to 3 to 5 communities that we've honed in on to go bring this up in the near term. So my expectation is, over the next few months, you'll begin to actually see demonstrations of the solution and a more open platform that allows others to go adopt it more quickly.

Operator

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

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

I guess just real quick. Zane, you said that you guys have had a record quarter for ambulatory deals, all-time record, I think. Just -- it seems like you've had a couple of great years from an ambulatory standpoint. Can you talk about -- and maybe this is a question for Mike, I don't know. From an implementation standpoint, have you really hit the inflection point as far as getting those docs live? Or is that something that is still in front of us?

Zane M. Burke

This is Zane. Many of those are still in front of us. So we did have a number of physicians go live in the last -- in the first 6 months of the year. So I think we're -- we went live with about -- over 4,000 physicians since the beginning of the year, but we've added significant in excess of that. So we have opened a number of those to go live in front of us.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Okay. And then maybe this one's for Mike. But the works deals, I would imagine that all of the effort that is going to go into ICD-10 is probably causing hospitals some stress on top of Meaningful Use. I was just curious if -- among the various topics that are driving the IT or the RevWorks deals, if ICD-10 is toward the top of the list. Or could that potentially accelerate some near-term opportunities from a works standpoint?

Zane M. Burke

This is Zane. Again, just in terms of the market opportunity for that, there is opportunity around ICD-10 services, but it's not the primary driver of either RevWorks or the ITWorks elements. The RevWorks side, many of them are preparing -- they're really thinking about, yes, ICD-10 is part of their first hurdle they have to get over, but they're really preparing for multiple hurdles as it relates to changes and what's going to occur in the reimbursement elements of this and in terms of really getting an updated Revenue Cycle solutions and processes around that. And the ITWorks piece is really much more around fixed predictable costs at a time when they have kind of an insatiable appetite for IT solutions and services.

Marc G. Naughton

Well, this is Marc. I wanted to thank everybody for being on the call today. We're very pleased with the results, and certainly, the activity that we see in the market going forward really is at an all-time high, as we've indicated. We are very focused on investing in our platform. And you're going to continue to see us use cash to do that for a targeted period of time that will end in 2014, where you'll see us go back to kind of traditional free cash flow levels that are near 100% of our net earnings. So I think we are doing the appropriate thing investing at it -- investing in it at a time when the market is there and when we think we know what the market is asking for. So we feel great about the business, and we look forward to having a chance to talk with you all later. Thank you very much.

Operator

This concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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