Investors in Cerner (NASDAQ:CERN) were pleased with the company's relatively sizable acquisition of the Health Service unit from German-based Siemens (OTCPK:SIEGY). As a result of the deal, Cerner will also form a strategic partnership with Seimens to accelerate growth going forward.
While I very much like the deal based on absolute and relative valuation multiples, as well as the strategic considerations, Cerner's valuation has gone up way too much over the past few years. This creates no appeal to me as a prospective investor.
Acquisition of Siemens' Health Service Unit
Cerner announced the acquisition of the health information technology business from Siemens in a $1.3 billion all-cash deal.
The deal is very much strategic, as Cerner aims to combine R&D investments, its knowledge base and complementary client base. As a result, the future scale in terms of resources and knowledge should speed up the pace of innovation.
Part of the deal involves a new strategic alliance between Cerner and Siemens to bring solutions to the market based on Cerner's expertise in IT leadership and Siemens' focus on medical devices and imaging.
Under the terms of the transaction, Cerner anticipates the deal will close in the first quarter of 2015. The transaction has already been approved by the board of directors of both companies.
The Organizational Implications
Cerner CEO and Co-founder Neal Patterson likes the deal to acquire Siemens' Health Services very much because it creates additional scale, knowledge and R&D capabilities to aid the company in its progress going forwards.
The combined operations employ some 20,000 workers in 30 countries. Siemens' Health Service business provides healthcare information and technology solutions for health and care coordination.
The alliance with Siemens itself, which is in essence a separate transaction, is also aimed at innovation in advanced diagnostic and therapeutic technologies. Both Cerner and Siemens will contribute some $50 million to form the strategic alliance, integrating health IT with medical technologies. Under the terms of the strategic formation, both companies will cooperate for at least three years, focusing on enhancing workflows and improving clinical outcomes in the wider fields of IT and health.
Financial Implications Of The Deal
The deal seems very appealing in my eyes. Cerner has posted trailing annual revenues of a little below $3.3 billion. Yet the combination is anticipated to post $4.5 billion in annual revenues and $650 million in R&D investments. This implies that the contribution from the healthcare business will add some $1.2 billion in sales, valuing the transaction at around 1.1 times sales.
The deal will add some $0.15 per share in non-GAAP earnings as soon as the year of 2015, being accretive to 2016s' earnings by some $0.25 per share. This could imply that adjusted earnings could improve close to $90 million per annum in 2016. After accounting for lost interest income on cash balances, this could result in incremental earnings of about $100 million. Based on a $1.3 billion price tag, this values incremental earnings at 13 times earnings, a very appealing multiple versus Cerner's own operations, which command much steeper valuation multiples.
Total pre-tax synergies resulting from cost savings and cross-selling opportunities are projected to be above $175 million by 2017. This is very substantial as 7-8 years of pre-tax synergies alone make up for the valuation multiple for the unit. At the same time, Cerner stresses that this outlook was conservative and mainly consisted out of low hanging fruit opportunities to take out costs.
A Look At The Recent Performance And Valuation
At the end of July, Cerner posted its second quarter results. The company posted net sales of nearly $852 million, a 20% increase compared to the year before. Reported net earnings improved by little over 14% to just above $129 million.
The company ended the quarter with nearly $1 billion in cash and short-term investments, while having a lot of other long-term investment assets as well. This comfortable net cash position, given that the company has just $155 million in total debt, allows Cerner to rather easily finance the deal with cash from existing means.
With some 350 million shares outstanding and shares trading at $55 per share, equity in the business is valued at little over $19 billion. This values operating assets at around $18 billion, the equivalent of 5.5-6 times trailing annual sales of $3.2 billion and over 40 times trailing earnings of $425 million.
A History Of Growth
Cerner's history of focusing on R&D and organic growth has resulted in a steep improvement in its operations. Cerner posted less than $1 billion in sales for 2004, which it has more than tripled to $3.2 billion on a trailing basis. This implied that annual sales have grown at a rate of 12%-14% per annum. Net margins have improved further, boosting net earnings a little more, while the company managed to limit total dilution to about 15% of the outstanding share base.
This new deal will push sales towards $4.5 billion, while it will actually reduce the immediate growth profile of the business given that Siemens' business has reported steady revenues in recent times. Yet trailing R&D expenses of about $1 million per calendar day will increase by nearly 80% to $650 million, potentially boosting the pace of organic growth rate in the periods thereafter. Earnings would be north of $500 million per annum, valuing the business at earnings multiples in the 35-40 times region.
Cerner released few other details in the deal presentation, press release and discussion with analysts. The company revealed the purchase price and anticipated sales, and admitted that the unit did not manage to grow revenues much in recent years.
That being said, no details regarding the profitability or margins of the business have been revealed. The company stressed that more information would be provided going forwards, and also wanted to stress that a deal was not necessary to boost current growth given the huge organic growth rate. Rather, Cerner saw the acquired assets as an opportunity to boost its R&D investment and organic growth rate in the years to come.
It is no surprise that given the appealing deal multiples, shares of Cerner have managed to gain 2% over the past week in what has been a difficult trading week. The deal has been really nice in my eyes as Cerner adds 35%-40% in annual revenues by sacrificing just about 7% of the current market valuation.
Part of the limited enthusiasm for the deal, with shares up about 2%, is related to the uncertainty about profitability of the business, lack of prior growth of the unit and the potential for duplication of services to clients. The latter could potentially result in lost revenues, a concern the company downplayed in the conference call.
As such, I like the deal very much for Cerner's shareholders given the very appealing both absolute and relative valuation and the strategic nature of the transaction. Yet unfortunately, the overall valuation of Cerner's own core business remains too steep for me despite the impressive growth trajectory and appealing deal. So I will not be picking up shares at this time.
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