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Cerner (NASDAQ:CERN)

Q2 2010 Earnings Call

July 28, 2010 4:30 pm ET

Executives

Jeffrey Townsend - Chief of Staff and Executive Vice President

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

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

Michael Valentine - Chief Operating Officer and Executive Vice President

Analysts

Corey Tobin - William Blair & Company L.L.C.

Michael Cherny - Deutsche Bank AG

Atif Rahim - JP Morgan Chase & Co

George Hill - Leerink Swann LLC

Charles Rhyee - Oppenheimer & Co. Inc.

James Kumpel - Madison Williams and Company LLC

Jamie Stockton - Morgan Keegan & Company, Inc.

Steven Halper - Thomas Weisel Partners

Richard Close - Jefferies & Company, Inc.

Sean Wieland - Piper Jaffray Companies

Operator

Welcome to Cerner Corp. Second Quarter 2010 Conference Call. [Operator Instructions] The company has asked me to remind you that the 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'd like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corp.

Marc Naughton

Thank you, Jeremy. Good afternoon, everyone, and welcome to the call. I’ll lead off today with a review of the numbers. Mike Valentine, Executive Vice President and Chief Operating Officer, will follow me with sales and operational highlights and marketplace trends. Mike will be followed by Jeff Townsend, Executive Vice President and Chief of Staff, who will discuss strategic initiatives. Neal Patterson, our Chairman and CEO, will join us for Q&A.

Now I'll turn to our results. All key measures in Q2 were at or above expected levels. Our bookings were strong and exceeded a high end of our guidance range. Our income statement performance was very good, with revenue above the high end of our guidance range and continued strong margin expansion and earnings growth. We again had great cash flow performance with record levels of free cash flow reflective of high quality earnings.

Moving to the details, our total bookings revenue in Q2 was $468 million, which is 19% higher than Q2 '09 bookings. Bookings margin was $397 million or 85% of total bookings revenue, up from 84% in Q1.

As Michael will discuss, we are pleased to announce that we did sign our RevWorks client this quarter. In discussing our overall bookings, I do want to point out that due to the structure of this initial RevWorks contract, bookings will be recognized over time as the client achieves benefits. Thus the strong overall bookings performance this quarter did not include any current impact from the RevWorks contract.

Our total backlog increased 21% year-over-year to $4.48 billion. Contract growing a backlog of $3.85 billion is 24% higher than a year ago. Support revenue backlog totaled $637 million, up 7% year-over-year.

Our revenue in the quarter was $456 million, which is up 13% year-over-year. The revenue composition for Q2 was $136 million in system sales, $128 million in support and maintenance, $184 million in services, and $8 million in reimbursed travel.

System sales revenue reflects growth of 19% compared to Q2 '09, with strong software and sublicense software growth more than offsetting flat hardware revenue. Services revenue was up 16% compared to Q2 '09 with good growth in both managed services and professional services.

Support and maintenance revenue increased 4% over Q2 '09. As we indicated last quarter, we expect support and maintenance revenue growth to improve in the second half of the year based on enhanced software sales the past several quarters.

Looking at revenue by geographic segment, our domestic revenue increased by 13% to $381 million. Global revenue grew 12% to $75 million, reflecting another solid quarter following the challenging 2009.

Moving to gross margin. Our gross for Q2 was 82.8%, which is down 60 basis points year-over-year and 140 basis points sequentially. The gross margin decline was driven by lower system sales margins which were down 160 basis points year-over-year and 60 basis points sequentially. The lower system sales margins were related to lower margins on hardware, with licensed software margins remaining flat year-over-year and sequentially.

Looking at operating spending, our Q2 operating expenses were $285.6 million before share-based compensation expense of $5.8 million. This is up 7% compared to a year ago. Sales in client service expenses were up 10% compared to Q2 '09, driven primary by growth in managed services and professional services. Software development expense was up 3% compared to Q2 '09, reflecting continued control of this expense line.

G&A expense decreased 3% year-over-year. The decrease is primarily related to the year-over-year difference and the impact of foreign currency as we had an FX loss in the year-ago period compared to a small FX gain this quarter.

Moving to operating margins. Our operating margin in Q2 was 20.2% before share-based compensation expense. This is up 290 basis points compared to last year, and keeps us on track for our full year 2010 target of 20% operating margins.

Moving to earnings and EPS. Our GAAP net earnings in Q2 were $55.5 million or $0.65 per diluted share. GAAP net earnings include share-based compensation expense, which had a net impact on earnings of $3.7 million or $0.04 per share. Adjusted net earnings were $59.1 million, adjusted EPS was $0.69, which is up 29% compared to Q2 '09.

Our tax rate was 35.7% which is slightly higher than our projected level of around 35%. We expect to be closer to 35% for the rest of the year, assuming the R&D tax credit is extended.

Now I'll move to our balance sheet. We ended Q2 with $678 million of total cash and investments, which is up from $609 million in Q1. Total cash and investments include $633 million of cash in short-term investments and $45 million of highly rated corporate and government bonds with maturities over one year. Our total debt is $116 million.

Total accounts receivable ended the quarter at $442 million, which is up $19 million from Q1 but represents a lower percentage of total revenue. Contracts receivable, or the unbilled portion of receivables, were $130 million and represent 29% of total receivables compared to 30% in Q1.

Cash collections were $447 million, which is a record for a second quarter. Third-party financings were $7 million, representing 1% of total cash collected. Our DSO in Q2 was 88 days, which is down from 89 days in Q1 and 100 days in Q2 '09. The year-over-year decline was primarily related to the Q4 '09 reclass of Fujitsu receivables to other assets which we discussed on prior calls.

Operating cash flow for the quarter was an all-time high at $110.2 million. Q2 capital expenditures were $23.9 million and capitalized software was $20.7 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was also an all-time high at $65.6 million. It is worth noting that free cash flow for the quarter again represents more than 100% of net earnings and reflects continued strengthening of our earnings quality.

Also note that our year-to-date capital spending of $56 million is below our planned level for this point in the year. We do expect capital spending to be higher in the second half of the year, but we are still positioned to keep full-year capital expenditures at the low end or below our initial guidance of $130 million to $150 million.

Moving to capitalized software. The $20.7 million of capitalized software in Q2 represents 29% of the $72.3 million of total spend on development activities. Software amortization for the quarter was $16.4 million, resulting in net capitalization of $4.3 million or 6% of the total. Based on our current release schedule, we still expect amortization to increase by about $1 million per quarter for the rest of the year, which would put it at about $18.5 million by Q4.

Now I'll go through the guidance. Looking at Q3 revenue, we expect revenue in the $455 million to $470 million range, with the midpoint of this range representing 13% growth over Q3 '09. For the year, we expect revenue between $1.83 billion and $1.875 billion, up from a range of $1.8 billion to $1.875 billion and reflecting 11% growth at the midpoint.

We expect Q3 adjusted EPS before share-based compensation expense to be $0.71 to $0.76 per share, with the midpoint reflecting 20% growth. For the year, we expect adjusted EPS of $2.85 to $2.92, which is up from the prior range of $2.80 to $2.90, and reflects about 20% growth over 2009.

Q3 guidance is based on total spending before stock compensation expense of approximately $285 million to $290 million. Our estimate for stock compensation expense is approximately $0.04 to $0.05 for Q3 and $0.17 to $0.18 for the year.

Moving to bookings guidance. We expect bookings revenue in Q3 of $450 million to $480 million, with the midpoint of this range reflecting 10% growth over last year.

In closing, we are pleased with our results in Q2 with all key metrics at or above our expected ranges. Specifically we are pleased with our strong bookings and revenue growth, continued strong margin expansion and growth in earnings, and record levels of free cash flow generation.

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

Michael Valentine

Thanks, Marc. Hello, everyone. Today, I'm going to provide observations on the marketplace, some operational updates and results highlights.

I'll start with observations on the U.S. marketplace. Overall, the market continues to improve compared to the conditions we saw for most of 2009. The impact of the lingering economic downturn is less severe in part due to stimulus activity. In regards to the stimulus, we believe the recent release of the final Meaningful Use rules is a positive for the industry and for Cerner. In our opinion and based on feedback from many clients, the final rules appropriately provide flexibility and address most of the concerns of those who provided feedback on the interim rules. And they do this without compromising the end goal of driving tangible benefits to the widespread adoption of HIT. The adjustment should allow for more practical rollout of the program and make the incentives more broadly attainable.

For Cerner, stimulus activity has contributed to strong results so far this year and we expect momentum to build as we move throughout the year and into the next several years. In our view, this will clearly be a multi-year journey with each stage of the stimulus requirements building on the prior stage. Cerner is very well positioned to grow as we work with our large existing client base to get them to Meaningful Use. And for clients that are already at or near Meaningful Use, the stimulus dollars could provide capital to purchase solutions and services that will bring them beyond Meaningful Use.

As demonstrated this quarter by our strong bookings outside of our install base, the stimulus is also creating new footprint opportunities as hospitals that don't have an EMR are now engaging and others are looking to switch suppliers for a safer path to Meaningful Use.

Looking at the competitive landscape, we feel very good about Cerner’s positions due to depth and breadth of our solution, readiness to meet Meaningful Use, and proven services capabilities. In contrast, many of our competitors have solution gaps, multiple versions of solutions with unclear migration paths, scarce services resource and/or they are involved in M&A activity. This is creating confusion and disruption in their install bases and is leading to opportunities for Cerner. Our pipeline already reflects specific prospects that we refer to as rebounds, where we have the opportunity to gain a client that chose a different supplier many years ago, but has chosen to reenter the market to make a new platform decision now.

In summary, we continue to believe the next few years will be a major opportunity to grow the breadth and depth of our market share. Beyond the stimulus opportunity, healthcare providers will also be dealing with health reform in coming years. As I discussed last quarter, this will change many things in the healthcare landscape and will create opportunities for Cerner. Creating coverage for the uninsured will bring second-order effects such as increased volumes that will create capacity constraints and changes to reimbursement models that may make it challenging to provide care profitably. The legislation also creates more compliance and reporting challenges for our clients in the areas of paper quality and waste fraud and abuse measures. These challenges create strong incentives for our providers to maximize efficiency and represent another long-term positive for HIT.

Another part of the changing landscape will be the evolution of reimbursement and care delivery models designed to align incentives between the payer and providers and between the physicians and the community and major acute-care hospitals. Accountable care organizations, or ACOs, represent one potential model which would involve contracting entities representing the physician, hospital and possibly others across the continuum of care for major high cost or high prevalence medical conditions. These new models will likely create both challenges and opportunities for our clients, and as Jeff will discuss a little bit later, they clearly will create opportunities for Cerner to play an expanded role in driving higher quality, better coordinated and more efficient care.

Now I will provide results, highlights and observations. Our bookings revenue in Q2 of $468 million represents a 19% year-over-year growth and includes 16 contracts over $5 million, including 10 over $10 million, which is a record for our Q2. Our bookings from new footprints were strong with 34% of bookings coming from outside of our core Millennium install base. This includes success against all major competitors and represents a very diverse group of new clients. The new footprints included a children's hospital, several mid- to large-sized hospitals, several critical access and community hospitals taking advantage of our community works ASP [application service provider] offering, a county provision health department and a large multi-facility health system. This volume and diversity of our new footprints reflects the strength across all segments of the market.

We also had contributions from a wide range of solutions beyond just core EMR and CPOE. This is reflected in good performance by many of our agile business units, or AVUs, where we align sales, services and development resources to focus on specific vertical market opportunities. This approach contributed to good Q2 bookings from areas like device connectivity, Rx station dispensing units, critical care, women's health, lab, clinical process optimization and imaging.

In the physician practice space, we had another good quarter. The momentum we are building in this market is in part due to the improvements we have made in our user interface and workflow over the past several years, which have made our offering much more attractive to the end-user. We are also seeing more hospitals and health systems influencing physician practice decisions, which is clearly a trend that favors Cerner’s integrated offering. We believe this trend will accelerate in the coming years with the evolution of the new care delivery and reimbursement models, such as ACOs, which will blur the lines between different venues of care and make having a common system across all venues more important.

Also, I think the pending acquisition of Eclipsys by Allscripts is an example of industry suppliers trying to create a broader offering to be more competitive as well as align with the direction the provider market is heading. We believe this activity validates our view of where the market is going and illustrates the importance of having the solution breadth and common platform that we’ve had for many years.

Another noteworthy solution category for Q2 was revenue cycle. Operationally, we brought seven client sites live with our patient accounting solution during the quarter, and continue to receive very positive feedback. In addition, 10 more clients purchased revenue cycle solutions and we signed our first RevWorks client. As I've discussed previously, we have made great progress with our patient accounting solution, and this progress has allowed us to advance conversations with clients about our broader Cerner RevWorks offering, which goes beyond patient accounting and provides solutions and operational services to help healthcare organizations with their end-to-end revenue cycle functions.

Despite the clinical focus of stimulus requirements, it is clear that the revenue cycle systems will need to be updated in coming years to be more clinically driven so they are capable of supporting required clinical reporting, bundled payments, pay-for-quality and a transition from ICD-9 to ICD-10. Navigating this transition along with organizations looking to cover a greater continuum of care through ACO’s will add a great deal of complexity to the revenue cycle, which we believe creates a great opportunity for our RevWorks offering.

Similar to our ITWorks, we think RevWorks represents a significant growth opportunity for Cerner. In both cases, we are increasing our alignment with our clients by becoming directly involved in their operation. Whether it is IT operations or revenue cycle operations, Cerner becomes more strategic to our clients, and we are able to create incentives that define success with shared objectives. And both services drive additional revenue to Cerner without increasing our clients' existing spend. They are just directing existing spend to Cerner and letting us use our scale and capabilities to drive efficiencies.

Now I'll provide a brief update on the CareFusion agreement we announced last quarter. As a reminder, Cerner and CareFusion will be offering enhanced medication management capabilities to existing and new clients of both companies. As part of the agreement, Cerner will serve as a channel for this CareFusion Pyxis dispensing technologies into our strategic Millennium client base. This agreement is valuable to Cerner because it extends our device source strategy to a leading global supplier of medical devices and validates Cerner clinical workflow vision were the EHR serves as a single source of truth. It also creates an opportunity to significantly increase adoption of our iBus device connectivity solutions.

For CareFusion, the agreement allows them to offer a complete closed-loop medication system with fluid EHR integration, and it also gives them a strong distribution channel. This partnership also creates a better option for providers by creating a solution for integrated and automated workflows that is prebuilt and simple to purchase and implement.

Currently, we are still in the transition period and are setting up operational processes. This is going very well and we expect to be fully operational very soon. We also continue to make good progress on plans to integrate additional CareFusion devices, which was part of the intent of the original agreement. From a financial standpoint, we still expect the impact to be immaterial this year during the initial stages of the agreement, but have a larger impact in 2011 and beyond.

Moving to our global business. As announced earlier this month, Trace Devanny, our President, who was going to relocate in England to focus on our global business, left the company to pursue another business opportunity. We wish him the best and thank him for the substantial impact he had during his 16 years at Cerner, particularly his role in expanding our global business. Trace's responsibilities have been transitioned to our current leadership team. And as we announced last week, we will continue to expand our teams and make further investments in the global markets, which we see as a key driver of future growth.

On the business side, we had a solid quarter globally with 12% revenue growth and good contributions to our bookings from several regions. We are pleased with this performance, particularly given the state of the global economy. In England, activity is ramping up following the restructuring of our agreement with BT last quarter. The restructuring has created much more clarity and allows for a greater emphasis on Cerner's more flexible implementation approach that has contributed to the improved satisfaction with our most recent go-lives. We now have a more strategic platform in both implementations and training and a more direct relationship with the trusts. While speculation about the direction of the NHS program continues, we believe the need for information technology will continue to play a central role in modernizing the NHS. Cerner's proven delivery capabilities and commitment to the marketplace position us to expand our work with the NHS Trust as we continue to deliver demonstrable value and benefits.

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

Jeffrey Townsend

Thanks, Mike. Today, I'm going to build on some comments Mike made about opportunities for Cerner created by the shifts that are occurring in the healthcare landscape. I'll try to share a glimpse of what we're predicting as the next wave of opportunity as healthcare becomes more digital.

As Mike indicated, stimulus is driving a multi-year opportunity for Cerner's providers’ top technology to meet the meaningful use requirements. In our view, stimulus is just part of the shifting landscape and there are substantial opportunities beyond stimulus. While Stage 1 of Meaningful Use is now locked down, there are currently three stages or requirements that's tied to the payment opportunities, and many of our clients are using this opportunity to both work ahead and prepare for the next round of investments and their roadmaps as the stimulus dollars begin to arrive.

As we’ve shared before, our prediction is that the policy mechanism established by stimulus will continue as a more permanent expectation, continue to add measurements and minimum capabilities, which will be tied to reimbursement. I share just one example of the second-order effects. Device integration is targeted in one of the latter stages, but also provides significant benefits to the organization, making their EMR efforts more effective by capturing and interoperating between the device and the EMR. When we launched DeviceWorks, stimulus didn't exist. It was just the next logical wave.

While the legislation around stimulus and health reform are separate, the two are clearly connected. The digital environment that will be created by stimulus will link into the clinical reporting and quality requirements included in health reform. We believe there will be a new wave of demand for Cerner solutions and services to facilitate better coordination of care and new payment models in an environment that will require a systemic shift in healthcare delivery organizations. As we introduced some time ago, more and more of this opportunity will expand beyond the four walls of a single organization and move coordination of care along with managing health status of communities to the cloud.

Cerner's deep strategic relationships with large health systems is a big advantage in the shifting landscape as it will be the large systems that drive the early innovation and consolidation of care venues to create new delivery models such as accountable care organizations.

As outlined in the reform legislation, early pilots are being awarded to validate the concepts of shifting the accountability of care coordination and bundled services to providers. We are already working with several clients on their strategies to lead the way in become new age health systems, and I expect that you'll continue to hear ACO is the focus of provider strategies in the near term.

To highlight one area where coordinating information across the fragmented delivery system is gaining traction, our Cerner network in health information exchange offerings facilitate better clinical integration and coordination of care in the connected healthcare landscape. We have had early success with our clients in building out HIEs and Cerner network services that are providing great value, and the interest is accelerating as evidenced by eight new Cerner network clients signing in Q2.

Currently, the total traffic on the Cerner network is nearly 30 million transactions a quarter compared to less than five million transactions a year ago, which gives you a sense of how much our HIE and Cerner network activity has increased.

Making the assumption that more information is digitized and connected to cross the community creates a new challenge for healthcare delivery: How to sort through it all. Today, the common practice is to diagnose and treat within the four walls, using information collected and managed during the visit. At best, personal history is provided by the clipboard.

Going forward, the entire continuum of medical history will be available around the person, and the expectation to manage chronic conditions and quickly know the entire history of the patient will put significant time pressure and reimbursement risk on the delivery system. While more and more systems will be connected, the challenges of unstructured data and varying nomenclatures will highlight the second-order effect of the digital infrastructure. Some of you may recall seeing the early stages of semantic search during our Investor Day in March. Assume that your lifetime record is potentially hundreds if not thousands of discrete results, vital signs, documents and images spanning years, providers and likely geographies. Underpinning this capability is the sophisticated natural language processing engine which understands clinical concepts and maps this information to ontologies and nomenclatures, each with the ability to be tagged to concepts and categories, each of which are ultimately indexed for search. It leverages knowledge of the clinical meanings of words, as well as the context in which they occur to create algorithms that identify and rank the most important information contextually.

We are now experiencing results of early pilot activity and plan to launch this at our healthcare conference in October to prepare our clients for the next wave of solutions. The disruptive element of this stack of technologies is the base ability to improve value of the information originating in a non-structured form, providing the potential to skip over a multi-year journey to evolve standards and implement capabilities within each organization’s EMR. By providing this as a set of cloud services, it makes this consumable, not only within our client base, but across the evolving HIT digital platform.

There will be many applications for this capability beyond just finding things. Given the entire record is mapped and indexed, the ability to just overnight to a note-quality reporting metric would be deployed through a clinical agent versus an upgrade to the EMR. We have experienced similar success with this style of deployment approach as our H1N1 efforts from last year have been reapplied to support the CDC in monitoring health concerns in the Gulf Coast region. The applications in both revenue cycle and emerging ACO reimbursement will require much more rapid response to regulatory requirements. The applicability to disrupt the current approach to medical research and remove the fragmentation of information is significant as well.

In summary, there continue to be several significant opportunities to capitalize on the second-order effects of both stimulus and reform, as more of the healthcare delivery system is digitized and connected in the coming years.

With that, I would like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Michael Cherny from Deutsche Bank.

Michael Cherny - Deutsche Bank AG

So just quickly, I know there’s going to be a lot of questions on the stimulus. I want to jump into one quick on the revenue cycle business. Obviously you guys are starting to get some traction here. You saw some nice orders and go-lives in the quarter. Can you talk about the type of clients that are buying revenue cycle solutions? Are they clients that don’t have anything currently in-house, are these replacement solutions, are these existing Millennium clients that are kind of building up their offering? I just want to get a sense of kind of who is the early adopters of revenue cycle solutions.

Michael Valentine

Yes, this is Mike. For this quarter, most of the business that we described, the new footprints, were net new footprints to Cerner. So it was essentially clients making a full revenue cycle and clinical decision together as part of their selection of Cerner as a new footprint. What you see historically is it's about a 30%/70% mix. So about 30% is back into the base and about 70% is net new footprints. The revenue works client that we announced, or the footprint that we announced, was back into our base.

Michael Cherny - Deutsche Bank AG

And then you obviously -- it’s exciting to see the first RevWorks client. Could you talk about some of your pipeline expectations on near-term basis or any more color to see -- thinking about how quickly that could ramp up?

Neal Patterson

The pipeline has been growing. Our expectation is we really wanted to ramp it similar to what we've achieved in the ITWorks front. So we signed three clients last year in ITWorks, and we want to see a similar growth pattern from RevWorks. And what we're seeing so far in the pipeline, we think we can achieve that.

Operator

Our next question comes from Charles Rhyee with Oppenheimer.

Charles Rhyee - Oppenheimer & Co. Inc.

A couple questions here. First, just let’s talk about the stimulus here. Mike, you gave some color around what you're seeing. Can you give us a sense on -- do you see any shifting or as you approach a client, when you look at your base, to the extent that those are ready for Stage 1, have you been pulling other clients further behind forward in the queue? In other words, trying to get as many people ready for Stage 1. I guess that's the first question. And then are you also seeing if people are already done with Stage 1 spending, have you -- I know you made some mention about it. Are you seeing a big devotion of budget now to sort of expected requirements for Stage 2 and 3?

Michael Valentine

Yes. The first question, let me clarify it that I'm understanding it. You're asking are we, Cerner, prioritizing the implementations for the clients to achieve Stage 1 of Meaningful Use?

Charles Rhyee - Oppenheimer & Co. Inc.

Yes.

Michael Valentine

No, we’re not. We’re working on -- we treat the backlog of consulting business as a single entity. We're not prioritizing within that. We have the capacity to deal with that. We've actually ramped up our consulting capacity by 159 people in the first half of the year. We expect to do about the same if not a little bit more in the back half of this year. So we're not throttling or phasing our clients in any manner.

Charles Rhyee - Oppenheimer & Co. Inc.

Is that something you're kind of seeing maybe with some of your competitors at all?

Marc Naughton

Yes, this is Marc. We can't speak to how our competitors are going to get to Stage 1. We sign a contract and we start that project right away. And if that project is for a client who’s already at Stage 2, then we're going to go proceed. Because a lot of these clients that have been on the journey are actually spending their next set of dollars to go further down the path and we don’t -- there's no way we're going to slow them down by any actions in our side.

Michael Valentine

The answer to your second question, relative -- are people continuing their journey, and the answer is yes. I think what you see is the folks that are close to Stage 1 Meaningful Use there, their roadmaps are considering the attributes that were defined in Stage 2 and Stage 3 and, as Jeff mentioned in his comments, from the top down, there are requirements that are going to be driving from -- just to address the aspects of health reform. So I think that what we're seeing is their roadmaps are continuing into a multi-year journey and everyone is starting from a different point. But it's not exclusive focus on the Meaningful Use attributes, which is a trait that we would say that we’re seeing. And that they may not always buy the entire journey at once. And so what we see in terms of our pipeline for services, we see a big pipeline that has a multi-year tail to it. So we're not seeing all upfront purchases for that journey, but they are defining that journey.

Charles Rhyee - Oppenheimer & Co. Inc.

And a question for Marc. If I look at sort of the bookings and the system sales revenue, and given your last quarter's contract backlog, I would have estimated the contract backlog for the current quarter to be higher than where it is. Is that a function -- I know there has been some talk in the market of a client that you lost to one of your competitors. Is that maybe what we're seeing in there, or maybe you can speak to that? As you lose clients, is that -- how does that treat in the backlog?

Marc Naughton

Relative to the backlog, the backlog represents contracts that have been signed, that have a future stream of revenue, and that revenue continues to come in. Obviously, this contract backlog is for -- a backlog for any client that’s been out there for a while. To the extent that they have bought new stuff, there’d be some things in the backlog. To the extent they haven't bought anything recently, there would be very little in the backlog. But to specifically address your question, clients -- very, very few times a client would make a decision to go away from Cerner. That's a multi-year process by which they are going to switch, if they actually end up making the switch. So from our standpoint, there's really usually no impact on backlog. And I would think that the -- we can go through the math with you after the call, but I think the math should work out fairly consistent that the contract bookings, if you do the math, should -- there are no adjustments to backlog inherent in the roll forward calculation that we do this quarter.

Charles Rhyee - Oppenheimer & Co. Inc.

One more last question. Obviously, there's news that the decentralization of the NHS is being proposed, putting really more of the decision making in the hands of the general practitioners to sort of purchase healthcare services on behalf of the patients. How do you think this is going to affect the way the Trust then purchase a technology, or do you think it might not have any real impact?

Michael Valentine

This is Mike. I think if it goes to independent buying decision basis, we will address that marketplace in an identical fashion to what we do here in the U.S. We’ve already started to build out that capacity. We've created essentially a vision center in our facilities over there to help tell the story of the journey. So we would address it just like we do the U.S. marketplace in addition to fulfilling our requirements around the program.

Operator

Our next question comes from Corey Tobin from William Blair.

Corey Tobin - William Blair & Company L.L.C.

Two quick ones, if I could. Marc, on this RevWorks contract. Can you just give us more details, please, as to how this contract’s different from either a -- I guess primarily from an accounting standpoint versus the other contracts that are in backlog? That's the first question. And then I'll follow up with the second one after that.

Marc Naughton

Primarily it's a services contract, so it's not a whole lot different from what the other ones are. The only difference is relative to margins that you might recognize. There are some performance requirements that we’re going to be conservative and probably not recognize that portion of the revenue. So it’ll be a little bit kind of like the U.K. for a while where it’s revenue equals expense. Because it's basically at that point, under that concept, a zero-margin contract, we haven't taken any bookings into account relative to our backlog or our bookings and announced numbers. So as we get more experience, sign more of these contracts, that likely changes, but we try to be conservative when we’re getting into one of these new areas.

Corey Tobin - William Blair & Company L.L.C.

So just evolve and they’ll find the out years, and when you do start to take revenue on it, it becomes very profitable?

Marc Naughton

In terms -- the margin that we are deferring certainly as we earn it will be profitable, and there will be some impact relative to -- have some type of a small level catch-up. But once again, these initial contracts, we’re really want to get in the business, so there's not a high level of margin that’s going to come from some of the first one or two of these.

Corey Tobin - William Blair & Company L.L.C.

And then switching gears for a second, just hitting on the Cerner network, which was highlighted in the prepared remarks, a couple of questions on that. How many hospitals are submitting data into this today -- and I apologize if you already gave that number, but can you give us a feel for how many hospitals are submitting, how may ambulatory physician offices are submitting, or lab facilities or whatever it might be? And what's the revenue model around this product for Cerner?

Marc Naughton

This is Marc. We don't have any numbers to share with you yet about the total. It's obviously tentative in the initial stages. So it's growing as -- when we get to a point where it makes sense to start sharing numbers with you, we will do that. And the business model can vary. The basic business model we're looking at from these networks relies heavily on taking the transactions that are already running through those organizations to other -- through other suppliers who take kind of a toll charge, running those through Cerner and us taking the toll charge to fund the network, and that's how we make money on these.

Operator

Our next question comes from Atif Rahim from JPMorgan.

Atif Rahim - JP Morgan Chase & Co

In the past you've talked about a third of your customers potentially waiting on the sidelines until the final MU rule is out. Now that, that's behind us, what kind of conversations are you having with these guys, and any tangible metrics you can give us on what percentage of those you think will sign maybe by the end of the year or so?

Marc Naughton

This is Marc. You always ask very good, detailed questions and to answers we can’t really provide detailed data for. But, Mike, you want to give us just a sense of clarifying what we said, what we mean when we say a third of our clients are not necessarily on the journey yet?

Michael Valentine

Yes. I would just say that now that the final ruling is out, it's very actionable. And the people who have an intent to achieve Meaningful Use are moving forward. We've already -- in most of those cases in our install base we've certainly built out what that roadmap and journey and those project plans would look like. And by and large, our client base is moving down that path. There are rare exceptions that they're not. As I mentioned earlier, that Meaningful Use is really manifesting itself, and not in really in the terms of a bubble as you would describe. It really looks more like a shift in spend, an increase shift in total spend around HIT that has a multi-year look to it. So it's not really a bubble in the way we're viewing it and the way it’s showing up in our pipelines. And we talked about this a little bit on the last call. This time last year to this time this year, we've seen about a 20% or more increase -- 20% or plus percent increase in our total pipeline. And that's a multi-year view. So I think it really is manifesting itself in an increased ongoing spend versus a bubble per se.

Atif Rahim - JP Morgan Chase & Co

Maybe I could take a stab at that in a different way. So if you look at the deals that are in the $5 million plus or $10 million plus range, how many of those are clients who are just on their way to maybe Stage 1 criteria, meeting the Stage 1 criteria versus someone you think who might meet schedule and are going beyond that? Is there any way to segment that perhaps?

Michael Valentine

The easiest way to answer that is to actually tie it at the -- the percentage of our business’s core that came from our base was about 66%. And every one of those would tell you that they're working on Meaningful Use, and no one has achieved 100% of Meaningful Use for 100% of their eligible professionals and at the hospital level. So there are attributes of that, that may apply to Stage 2 when that gets defined. But there -- I would say 66% of it came back to the base and they're all working on components of Meaningful Use.

Operator

Our next question comes from George Hill from Leerink Swann.

George Hill - Leerink Swann LLC

Mike, you alluded earlier to a business combination by a couple of your competitors and I thought maybe you could revisit and give us an update on Cerner's ambulatory strategy and how aggressively are you guys thinking about the practice market, either is there a way to pursuing it on its own or pursuing it as an extension of the hospital strategy?

Michael Valentine

Well, we're pursuing both angles. What we've seen thus far this year, the first half of the year has produced as many net new providers to Cerner as all of 2009. So we're off to good start. I would say it was a little bit -- we didn't meet our internal expectations in this quarter. We had two large transactions that were through a client, an existing health system, that didn't get completed in the quarter, but we expect to happen in the next quarter. And our expectations for the back half of the year are continued growth. So it's on. We see ramped-up activity in RFPs and demonstrations and proposals and we expect that activity to produce results through the back half of the year. And it will be both independent buying and through our existing client base. So our competitiveness has definitely increased, improved, in specifically around the physician, and it's making a difference. We're seeing that in our win rate of these individual physician solutions and we're seeing it in our win rate overall for complete EMR purchases. Our win rate has never been -- it’s as high as it's ever been in head-to-head competition in the marketplace.

George Hill - Leerink Swann LLC

It's good that you guys continue to see new facilities like new children's and new multi-hospital systems come to you guys. I guess, can you provide us a little color when you go to a -- when Cerner puts a new footprint in a new children's hospital or a new multi-facility situation, in what type of technology situation are these organizations coming to you, and what are they starting down the path with Cerner with? Are they starting with kind of the core six products, are they starting with just like a lab or a pharmacy functionality? Just kind of -- trying to get a sense for a before, what they buy and where they're going.

Michael Valentine

They are largely going after Meaningful Use in its definition of Stage 1. So all of the footprints that I talked about adding in this quarter are starting journeys to get to Stage 1, Meaningful Use. Their existing profile is always mixed. We actually had two what I would describe as rebounds, so folks that made decisions in the last several years and are reentering -- reenter the marketplace and pick Cerner. So we see a greater volume of those rebounds in our pipeline going forward, which is good news. But most of them are -- they come from some level of automation, they don't have confidence in their current platform and they're in the marketplace to start the journey to Stage 1.

George Hill - Leerink Swann LLC

And, Marc, just briefly, Corey's question asked another way. The RevWorks initiative recognizing the margin expansion that the company has achieved, what is the margin drag on the RevWorks initiative, I guess over the near term, what’s it expected to look like?

Marc Naughton

It’ll be very small, given that we’ll have some level -- some small level of revenue equal expense. You won't notice it in the margins.

Operator

Our next question comes from Richard Close from Jefferies.

Richard Close - Jefferies & Company, Inc.

Yes, just to be clear, Mike, with respect to the 10 revenue cycle clients added in the quarter, can you clarify how many of those are new footprints, or did you say all of them are new footprints?

Michael Valentine

This quarter, all of them were new footprints.

Richard Close - Jefferies & Company, Inc.

When you look at your pipeline -- I think you mentioned the $10 million deals at record levels. When you break down your pipeline, do you see a similar level of $10 million contracts going out over the next year or so, or continuing to grow off of the current level?

Michael Valentine

Yes, I think as we continue to offer solutions that represent broader capturing of a client's existing spend, that the mix is going to continue to grow. I think you’ve seen, if you followed the shift over the last 12 to 18 months, we're securing more and more larger transactions that are making up our mix. So I would expect that trend to continue as we expand our ITWorks capabilities, our RevWorks capabilities and as these new footprints enter the marketplace and sign up for at least Stage 1 in Meaningful Use. And then we've also -- we always have big swing opportunities that will represent large transactions, and we're going to continue to take big swings.

Richard Close - Jefferies & Company, Inc.

And then just a final question real quick here. On the new decisions or new footprints, obviously a nice rebound first quarter to second quarter. Do you see the level that you achieved in the second quarter, that carrying through over the remainder of 2010?

Michael Valentine

Yes, I do.

Operator

Our next question comes from Steven Halper from Stifel, Nicolaus.

Steven Halper - Thomas Weisel Partners

Could you just give us an update on the activity in the small hospital market? About a year ago you sort of outlined that as a strategic objective for you in terms of displacing some existing competitors there. Just wanted to know how the -- what the product offering, how the product offering has come along and maybe some signs of success in that market.

Michael Valentine

This is Mike. We started reengineering our Millennium solution to allow for essentially a multi-tenant capability similar to what we have in our PowerWorks offering for physicians. We completed that work and the final stage of that work will be completed this summer. So from a solution perspective, we feel very good. From a market perspective, we now have a little more than 15 footprints in that business model. So that business model didn't exist about a year ago. And our pipeline is very solid. There is a lot of activity, the reimbursement inclusion of critical access hospitals will make a difference. So I have high expectations for this group and I think they're executing well, off to a good start, and the back half of the year should show some good things as well. They’re not -- as you've seen, they're not large transactions. It’s a different competitive landscape, mostly obviously in the lower end. We see Meditech a lot, we see CPSI. We see them all. But I think we're getting better at competing, our win rates there are high when we engage, and we're going to have -- we have plans to broaden out the capacity of our sales force. So I think so far it's been a good investment. We've seen some success and we're going to continue to make investments in that area.

Steven Halper - Thomas Weisel Partners

So just to clarify, the sales function is within that small group, correct?

Michael Valentine

Right. We don't allow it to be a distraction for our core sales force, so we delineate the marketplace generally at the 75-bed and below level.

Steven Halper - Thomas Weisel Partners

Would you disclose how many sales people you have in that group at this point?

Michael Valentine

No.

Operator

Our next question comes from Sean Wieland [Piper Jaffray Companies].

Sean Wieland - Piper Jaffray Companies

Last quarter you talked about a certain percent of your clients that were on track to pursuing Stage 1. And so given the changes to Stage 1 under the stimulus, what's your updated view of that percentage? And if you have an update view on the bookings opportunity within the base, that would be helpful.

Michael Valentine

I think the percentage is about the same, so that the Meaningful Use -- and I'm speaking from a do they have the capabilities of achieving Meaningful Use and are they on the right roadmap. They still have to attain Meaningful Use by utilizing the system. So given that those parameters have been lowered, there's a higher probability that they'll attain it, but our figure right now is 75%, ballpark, will receive 100% of the funding. We're going to go revisit that statistic because of the shifting in the timeframe to allow for the two year, the two-year window to slide with the health system or the provider. So I would expect that to go up as people kind of reinvigorate their journey.

And we haven’t -- on the bookings question, we haven't provided guidance around the bookings associated with that client base.

Marc Naughton

This is Marc. The high level numbers we’ve talked about relative to the stimulus opportunity, we haven't updated those obviously, with the change of Meaningful Use. As we do more work on it, see it change significantly, we can do that. But I don't think it's going to make a huge difference overall in those large numbers.

Sean Wieland - Piper Jaffray Companies

And if I could ask a follow-up question on the RevWorks strategy, could you -- it seems like you're really hitting the gas here in revenue cycle management, and could you articulate as to why? Is that because of macro issues that are going on in the marketplace, is it because of competitive pressure, is it because of the incremental growth opportunity? Why the big push into revenue cycle management?

Michael Valentine

Yes, this is Mike. I would say there’s a couple dimensions to it. First, the marketplace that we're going through relative to some of these new footprints, they're willing to make a decision that is an integrated clinical revenue cycle decision. So we went through a period of time where people were largely making clinical only decisions and they were separating out the revenue cycle, and now what -- and it's likely that they're attributing it to some of the aspects of health reform, tying reimbursement to clinical outcomes, et cetera. So we're seeing more activity on the new footprint front in the revenue cycle business. I think our solutions have improved substantially. Our delivery capability has improved substantially. We have organized the teams in a way that has created a high level of focus, and they're hitting the marketplace with that focus. And I think it's making a difference. So I think the market's ready for it, I think we'll see more of it, and our solutions are getting better and better by the quarter.

Operator

Our next question comes from Jamie Stockton from Morgan Keegan.

Jamie Stockton - Morgan Keegan & Company, Inc.

I guess, Mike, when you think about net new customers that are coming to you on the hospital side as a result of the government program, would you say that the majority of those decisions are still ahead of us?

Marc Naughton

The question is do we think there are more clients, more hospitals and health systems out there that are not current clients that are going to make decisions. Yes, we think there is a lot more to be made than have already been made. I think Mike’s point that he made earlier was it's not a bubble, though, it's not something you're going to see in the next six to nine months. We actually see a consistent growth of our pipeline spread over a multi-year period, which I think is -- for us is a much healthier growth opportunity. But yes, there's a lot more business ahead of us than what we've seen to date.

Jamie Stockton - Morgan Keegan & Company, Inc.

And then maybe as somewhat of a follow-up on that, Marc or Mike, the pricing environment. Could you just give us some color on how pricing has been holding up?

Michael Valentine

I think it's held up fairly well. There are some situations that get incredibly competitive, and there are situations where we like to limit the up-front scope of work. And quite honestly, we have some offerings that allow for additional revenue generation on the client's behalf for cost savings and we try to align incentives around those in revenue sharing- or gain sharing-like opportunities to preserve the overall margin of the relationship between us and our clients. So there are some that are pretty competitive. They get there, but by and large, I think that the valuation of the journey itself has remained intact.

Marc Naughton

Jamie, this is Marc Naughton. I just look at kind of discounts-off lists as a measure, as I’ve talked about before, and we track those graphs every quarter and they are consistent with what they've been in the last six to eight quarters. So as Mike said, in certain circumstances, pricing is competitive, but overall our pricing has held pretty steady.

Operator

Our last question comes from James Kumpel from Madison Williams.

James Kumpel - Madison Williams and Company LLC

A lot of headlines recently have shown that Epic is winning an awful lot of big academic medical centers from a competitor. But you guys seem to have momentum amongst publicly traded hospital systems. Can you maybe distinguish between the needs and demands of that customer base versus those of the academic medical centers?

Michael Valentine

Yes. I would say that the for-profit space puts a high valuation on predictability and implementation, the ability to have a partner with scale that holds itself accountable for all aspects of the delivery, including services, technology, software solution and has the scale to do that across what tend to be larger organizations that have a geographic spread. So I think the alignment in that space is good. I think the fact that we're improving on the revenue cycle and we're winning in that space makes a big difference. And I would just point out that we -- our strategy has not been to announce individual wins historically. So we added 15 new footprints this quarter. In more than half of those we competed against the firm that you mentioned that gets mentioned a lot on the HIT blogs, and that's good. We’re like the strong silent type. We're going to continue to compete with them. We think there are areas that we excel and we're making really good progress in the area of physician usability. And so we think our competitiveness against them and all other competitors has never been stronger. So we feel good.

Jamie Stockton - Morgan Keegan & Company, Inc.

And just to follow up, Marc, can you highlight what you've done differently on the cash management side to drive up free cash flow, and do you think you can continue to run free cash flow above and beyond the net income level?

Marc Naughton

I think key, as we mentioned, is CapEx has been a little bit lower than we would have projected for the year. Some of that is just some timing on projects a little bit. Some of it is innovations we're making relative to platforms and hosting, which is the main capital expenditure we have. The introduction of Linux into that environment is helping us relative to our costs. So I don't know that it's something that is getting communicated. The last half of the year that number probably goes up a little bit, but we still see us throwing out significant amounts of cash, and we would expect CapEx still to be at the low end or below the low end of our $130 million to $150 million guidance.

I'd like to turn the call over to Neal Patterson for any closing comments he might have.

Neal Patterson

Thanks, Marc. Thanks to all of you all for staying on here with us and the very good questions. Just a couple comments. If you look at the quarter, I think that this was a very good quarter. Frankly, we're in a very good environment. There's no question the stimulus had -- kind of changed a not as good environment to a very good environment. That’s got a fairly long tail to it, so that takes through the -- basically, when you add the stages together and the length of the stages, that takes it through the really middle part of this decade. The things you didn't really ask about are the bigger questions around health reform. How do we fundamentally take the health system in this country -- and every other country has asked the same question, and how does -- what is the health system we’re going to leave our kids. Those are big, profound questions. The fact that we're digitizing healthcare in this era is going to create a whole bunch of opportunities, in our opinion. So the one question they actually had told me that if it comes, I get, was the United Healthcare's acquisition in the HIT space and frankly, I think if you asked them -- I didn’t, they didn't call us and share with us their thoughts, but there’s platform that is going to be created once the digitization happens and there's an opportunity for a platform and I think other people see that. There's not a lot of people see that, but we've shared with you our ideas about that quite a bit, and in there is just we believe a lot of opportunities for the last half of the decade. So I think you saw the results of a good environment. I think you saw the results of a pretty good business plan and pretty good set of business strategies, and I think you saw a very good execution on this quarter. So with that, I'll let you go back to your day jobs. Thank you very much. Good luck. See you -- talk to you next quarter.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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Source: Cerner Q2 2010 Earnings Call Transcript
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