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Cerner (NASDAQ:CERN)

Q4 2010 Earnings Call

February 08, 2011 4:30 pm ET

Executives

Jeffrey Townsend - Chief of Staff and Executive Vice President

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

Michael Valentine - Chief Operating Officer and Executive Vice President

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

Analysts

Glenn Garmont - ThinkEquity LLC

Michael Cherny - Deutsche Bank AG

George Hill - Citigroup Inc

Atif Rahim - JP Morgan Chase & Co

Steven Halper - Stifel, Nicolaus & Co., Inc.

Jamie Stockton - Morgan Keegan & Company, Inc.

Stephen Shankman - UBS Investment Bank

Sean Wieland - Piper Jaffray Companies

Operator

Welcome to the Cerner Corporation's Fourth Quarter 2010 Conference Call. Today's date is February 8, 2011, and this call is being recorded.

The company has asked me to remind you that various remarks made here today by Cerner's management about future expectations, plans, perspectives and prospects constitute forward-looking statements for the purpose of the Safe Harbor provisions of the Security and Litigation Reform Act of 1995. Actual results may differ materially from those indicated by the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements may be found under the heading Risk Factors under Item 1A in Cerner's Form 10-K together with other reports that are on file with the SEC. At this time, I'd like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation.

Marc Naughton

Thank you, Jennifer. Good afternoon, everyone. 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, CEO and President, is traveling today, but he will be dialing into the call.

Now I will turn to our results. All key measures in Q4 were at or above our expected levels. Bookings were very strong and exceeded the high end of our guidance range by nearly $100 million. Our income statement performance was very good with adjusted EPS above our guidance and consensus, revenue at the midpoint of our guidance range and continued strong margin expansion and earnings growth. We again had excellent cash flow performance, with record levels of free cash flow reflected a strong earnings quality.

Moving to the details. Our total bookings revenue in Q4 was $626 million, which is the second best result in company history. Bookings significantly exceeded the top end of our guidance range and were up 26% sequentially and only slightly down from the record level in Q4 '09 that included two large contracts with investor-owned health systems.

Mike will discuss our bookings in more detail, but performance was strong across the board, including software, managed services and professional services. And during the quarter, we signed two new ITWorks clients and our second RevWorks client. Booking margins in Q4 was $530 million or 85% of total bookings. For the full year, bookings revenue was $1.99 billion, up 9% from 2009.

Our total backlog increased 17% year-over-year to $4.94 billion. Contract revenue backlog of $4.29 billion is 19% higher than a year ago. Support revenue backlog totaled $655 million, up 6% year-over-year.

Revenue in the quarter was $500.2 million, which is up 7% over the very tough comparable in Q4 '09. The revenue composition for Q4 was $164 million in System Sales, $132 million in Support and Maintenance, $195 million in Services and $9 million in Reimbursed Travel. For the year, revenue grew 11% to $1.85 billion.

System Sales revenue was the second highest result in company history and down only 4% from the tough System Sales comparable in Q4 '09. System Sales were up 23% sequentially with strong growth across software, sublicensed software and hardware revenue. For the year, System Sales grew 9%. Services revenue was up 19% compared to Q4 '09 and 16% for the year with strong growth in both managed services and professional services. Support and Maintenance revenue increased 7% over Q4 '09 and 5% for the year.

Looking at revenue by geographic segment. Domestic revenue increased 8% year-over-year to $432 million. Global revenue was up 5% year-over-year to $68 million. For the full year, Domestic revenue grew 12% to $1.56 billion, and Global revenue grew 5% to $288 million. As a preview to the annual update of our detailed business model that we'll provide at our investment community meeting on March 10, I'd like to provide with you with the total revenue and growth by business model for the full year 2010.

Licensed software grew 6% to $268 million with double-digit growth in the first three quarters and a Q4 result that was the second highest in company history behind Q4 '09. Technology resale was up 16% to $176 million as growth in device resale and sublicensed software offset a decline in traditional hardware resale.

Subscriptions and transactions increased 7% to $106 million. Professional services revenue was $455 million, which is up 15% and reflects increased implementation activity. Managed services grew 19% to $294 million driven by continued strong demand for our hosting services. Support and Maintenance was $517 million, which is up 5%, and Reimbursed Travel was up 7% to $32 million. We'll go into more business model detail at our investment community meeting coming up.

Moving to gross margin. Our gross margin for Q4 was 81%, which is down 200 basis points year-over-year. Gross margins were impacted this quarter by continued strength in device resale and an increase in third-party services. Going forward, we expect gross margins to remain in the low 80s. But we still expect to continue expanding margins at the operating level. For the full year, gross margin was 82.7%, down 50 basis points year-over-year. System Sales margin increased 290 basis points sequentially but were down year-over-year due to higher levels of hardware at lower margins.

Looking at operating spending, our fourth quarter operating expenses were $295 million before share-based compensation expense of $7 million. Total operating expense was up 2% compared to Q4 '09. For the full year, operating expenses were $1.15 billion, up 6% from 2009.

Sales and client service expenses were up 8% compared to Q4 '09 driven primarily by growth in managed services and professional services. For the full year, sales and client service expenses were up 9%.

Our investment in software development was down 6% compared to Q4 '09, reflecting continued leverage of our R&D investment. For the full year, investment in software development was flat. Going forward, we expect our R&D investment to grow but at a rate that is less than our revenue growth rate. G&A expense decreased 14% year-over-year in Q4 and grew 1% for the full year.

Moving to operating margins. Our operating margin in Q4 was 22.1% before share-based compensation expense. This is an all-time high and up 110 basis points compared to Q4 '09, which was also a record. For the full year, operating margins were up 230 basis points to 20.8%. The margin expansion was driven primarily by a combination of increased profitability in our professional services, managed services and support business models along with ongoing leverage of investments in R&D and SG&A expense. For the next few years, we believe we could expand operating margins 100 to 200 basis points per year through ongoing efficiencies across our business models and expense leverage.

Moving to earnings and EPS. Our GAAP net earnings in Q4 were $70.6 million or $0.82 per diluted share. GAAP net earnings include share-based compensation expense, which had a net impact on earnings of $4.3 million or $0.05 per share. Adjusted net earnings were $75 million, and adjusted EPS was $0.87, which is up 17% compared to Q4 '09. For the year, adjusted net earnings were $252.8 million, and adjusted EPS was $2.96.

Our tax rate in Q4 was 32.8%, which benefited from the extension of the R&D tax credit. For the full year, our tax rate was 34.7%. Note that applying this annual tax rate to normalized Q4 tax expense would have reduced results by $0.02.

Now I'll move to our balance sheet. We ended Q4 with $835 million of total cash and investments, which is up from $770 million in Q3. Total cash and investments include $571 million of cash and short-term investments and $264 million of highly rated corporate and government bonds with maturities over one year. Our total debt is $93 million, which is down from $119 million last quarter due to payments made during the quarter. Total accounts receivable ended the quarter at $477 million, which is up $14 million from Q3. Contracts receivable or the unbilled portion of receivables were $140 million and represent 29% of total receivables compared to 30% in Q3.

Cash collections were $498 million, which is an all-time record. Third-party financings were $21 million, representing 4% of the total cash collected. Our DSO in Q4 was 87 days, which is down from 91 days in Q3 and down from 90 days in Q4 '09.

Operating cash flow for the quarter was an all-time high at $121.7 million. Q4 capital expenditures were $27 million, and capitalized software was $19.2 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was a record for a fourth quarter at $75.6 million. For the full year, operating cash flow grew 31% to $456 million, and free cash flow grew 98% to $273 million. Free cash flow represents more than 100% of net earnings for both Q4 and the full year, demonstrating strong earnings quality.

For the full year, capitalized software was $81 million, and capital expenditures were $102 million. As we discussed previously, we spent less on capital expenditures in 2010 than the $130 million to $150 million range we initially expected. In 2011, we anticipate capital expenditures to be closer to that range, but we expect to continue generating strong operating and free cash flow.

Moving to capitalized software. The $19.2 million of capitalized software in Q4 represents 27% of the $71 million of total spending on development activities. Software amortization for the quarter was $19 million, resulting in net capitalization of $0.2 million or less than 1% of the total. In Q1, we expect capitalized software to increase to approximately $21 million as development time increases and administrative and vacation time decreases relative to Q4. We expect amortization in Q1 to be approximately $19 million.

Now I'll go through the guidance. For Q1 revenue, we expect revenue between $475 million and $490 million with the midpoint reflecting growth of 12% over Q1 '10. For the full year, we expect revenue between $2.05 billion and $2.1 billion with the midpoint representing 12% growth.

We expect Q1 adjusted EPS before share-based compensation expense to be $0.73 to $0.77 per share, reflecting about 20% growth. For the full year, we expect adjusted EPS between $3.50 and $3.60 with the midpoint reflecting 20% growth.

Q1 guidance is based on total spending before stock compensation expense of approximately $295 million to $300 million. Our estimate for stock compensation expense is approximately $0.05 for Q1 and $0.20 to $0.22 for the full year.

Moving to bookings guidance. We expect bookings revenue in Q1 of $435 million to $465 million with the midpoint of this range reflecting double-digit growth.

In closing, we are pleased with our results in Q4 and the full year with all key metrics at or above our expected ranges. Specifically, we are pleased with our strong levels of bookings and record revenue, continued margin expansion and earnings growth and continued strong levels of free cash flow generation. And with that, I'll turn the call over to Mike.

Michael Valentine

Thank you, Mark. Good afternoon, everyone. Today, I'm going to discuss sales and operational results and comment on the marketplace trends.

Starting with results highlights. Our bookings revenue in Q4 of $626 million included 22 contracts over $5 million, which ties an all-time record set in Q3. 13 of these contracts were over $10 million, which is a level only surpassed in Q4 of '09 when we had 15 contracts over $10 million. For the year, we had a record 77 contracts over $5 million, including 43 over $10 million. By nearly all measures, 2010 was a good top line year for Cerner.

Looking at competitive wins, our bookings from new footprints were strong with 26% of bookings coming from outside of our core Millennium installed base. This contributed to a record level of new footprint bookings for the year, reflecting our strong competitive position that is a result of the depth and breadth of our solutions, readiness to meet Meaningful Use and proven services capabilities.

We remain bullish about our new footprint opportunities going into 2011 as many competitors still have longer term solution gaps, constrained services capabilities and other types of uncertainty surrounding them. One example of our strong competitiveness is our selection in Q4 by a large academic medical center that purchased solutions to meet Meaningful Use for their inpatient and outpatient facilities. We competed against a private company that has historically done well in the academic space, and at the same time, we are displacing a large ambulatory vendor on the outpatient side. So all in all, a good solid win.

This quarter reflected bookings highs for the year across all business models, including licensed software, technology resale, subscriptions, professional services and managed services. Almost all of our business units had strong quarters and years with 15 of 16 units exceeding plan for the year. Areas of particular strength include Lighthouse, clinical process optimization, women's health, critical care, lab, physician practice, Healthe network and hub, revenue cycle, medical devices, imaging and community hospitals.

Now I'll discuss some details around the progress we made across several parts of our business. In our DeviceWorks business, we had a great quarter and a great year. Device resale revenue more than doubled over 2009 levels, contributing to strong growth of total technology resale despite a decline in our traditional hardware resale.

As we have discussed earlier, traditional sales of data center equipment continue to be pressured by the success of our own hosting capabilities. We are more than offsetting this trend by growing sales in new areas, such as these medical devices, where we add value to our clients by offering a single source for devices that are connected to an EMR at a workflow level. And we have become a strategic reseller to the device manufacturers because we can help them differentiate their devices and provide them access to our large install base.

Also in our Device business, sales of our iBus device connectivity solution nearly doubled in 2010, including a breakout year at bringing iBus outside of our installed base and proving the ability to connect devices to our competitors' systems.

DeviceWorks is a great example of our ability to recognize a market opportunity, quickly bring value to the marketplace through innovation and make it a meaningful contributor to Cerner's growth. To put this in perspective, cumulative revenue from Device and iBus sales have exceeded $125 million since we launched the business in 2007, and we believe we have just scratched the surface of the growth opportunity. For example, our relationship with CareFusion, which got off to a good [ph] start in 2010, will add meaningfully to our growth opportunity and the value that we provide our marketplace.

In the physician practice space, 2010 was a major turning point for us as the improvements we have made to the user interface and workflow began to be recognized by the industry. In addition to improving the look and feel of our physician solutions, we reduced the time it takes to perform common functions by 35% and the pure number of clicks by 43%. This success is reflected in a strong year for our PowerWorks business, which had over 30% bookings growth driven by selling through our large installed base and being included as part of several new footprint sales.

Our ability to offer a fully integrated EMR that is very competitive across inpatient and outpatient venues is attractive to the growing number of hospitals and health systems that are influencing physician practice decisions or consolidating physicians. A good example of this is our success at the academic medical center I mentioned that selected us in both venues. We will continue to make significant IT investments to further advance our physician EMR and billing solutions over the next 12 months.

In addition to our strong integrated inpatient-outpatient offering, we differentiate from others in the industry with our ability and willingness to interoperate with other systems. By providing an option that doesn't require changing out all systems when the client doesn't want to lose the value of existing investments they have made, we are an attractive option compared to other suppliers that force the reinvestment because of their inability to connect to other systems.

Moving to our Professional Services business. We had a strong quarter and a strong year. This organization continues to contribute nicely to the top and bottom line and represents a visible element to our revenue and earnings growth. Operationally, we are on schedule with the large multiphase projects that were signed in Q4 of '09 and are doing a good job of keeping up with the initial stimulus demand. Our hiring and training processes are working well, and we are in a good position to stay on top of the demand as we move through the year.

Beyond our traditional implementation services, we had a record year of bookings for our Lighthouse clinical process optimization services as many clients create their plans for stage two of Meaningful Use. Our CernerWorks Managed Services business had another great year and continues to represent a strong marketplace differentiator. We continue to gain efficiencies and reduce the total cost of ownership, such as our transition to Linux last year. Our growth prospects for managed services remain strong, including opportunities to do more global Managed Services business.

Collectively, our proven and scalable professional services and our industry-leading managed services capabilities create a major differentiator in the marketplace when compared to others with fewer capabilities and greater reliance on third parties. Our newer services, including Cerner ITWorks and Cerner RevWorks, represent further differentiation as well as a very large growth potential.

In ITWorks, we added four clients in 2010, including two in Q4. Recall that ITWorks involves a strategic alignment with our clients where we take over their IT operations and leverage our scale and services capabilities to improve quality and project throughput. The momentum with our ITWorks offering is building, and the pipeline of prospects increased significantly in the second half of 2010 largely because our clients are viewing ITWorks as a way to strategically align with Cerner during a very critical period of execution.

Our other Works business, Cerner RevWorks, which was launched after ITWorks, is off to a very good start. Building on a substantially improved patient accounting solution, RevWorks goes beyond solutions and transactions and provides operational services to help healthcare organizations improve their end-to-end revenue cycle functions.

We signed our first RevWorks client in Q2 and are already seeing positive financial and operating results. Our second RevWorks client was signed in Q4, and we are targeting several more in 2011. With ICD-10 looming and the new payment structures associated with accountable care organizations, we expect a major wave of revenue cycle activity in the coming years and believe we are extremely well positioned for it.

As Jeff will discuss, we are building the foundation for another leg of growth beyond stimulus, and our Works and white space solution offerings. This foundation is our cloud-based Healthe Intent platform that we launched last year. We announced last quarter that initial offerings on this platform would be free to our clients to help drive rapid adoption and quickly prove the benefits of the platform. These offerings include Semantic Chart Search and sepsis rescue agent. We are getting great feedback from our clients about these solutions, and I believe these capabilities will further differentiate Cerner and strengthen our competitiveness. I also expect these initial offerings to become proof points to set the stage for successful launches of additional solutions on our cloud platform.

Moving to the geographic mix of our results. As Marc indicated, our results this quarter were stronger in the U.S. than globally. Outside the U.S., our results continue to be impacted by the weak global economy, but we still had a decent quarter and bounced back to 5% revenue growth after a decline in Q3. Our full year global revenue growth of 5% is respectable given the challenging economy, and we had good results in England, Spain, the Middle East and Australia.

The fundamental problem of healthcare cost growing faster than the overall economy exists in almost all countries, and IT continues to be viewed as a way to break this trend. From a solution standpoint, we are now prepared to take our CommunityWorks solution to select global markets to allow for a lower cost Software as a Service delivery model. We are also much better positioned to grow our managed services offerings outside of the U.S. in 2011. As a result, we remain bullish about the global HIT market, and there is no other HIT company with our global footprint or capabilities.

Turning back to the U.S. marketplace and looking back on 2010, the demand inside our installed base, greenfield opportunities and replacement opportunities played out pretty much like we had expected. In our base, I am pleased with the strong demand for solutions and services that go beyond Meaningful Use stage one. Outside of our base, I'm very pleased with our competitiveness as we had a very strong win rate in 2010 and expect it to continue, if not improve, in 2011.

I believe our capability to go beyond Meaningful Use, along with our services capabilities and capacity, will continue to differentiate us as we move further into the stimulus era. This belief is reflected in our strong 2011 outlook. And looking beyond 2011, we still believe this will be a multiyear opportunity with each stage of the stimulus requirements building on the prior stage and additional demand for solutions and services being driven by the second order effects of stimulus and health reform.

Regarding health reform, we continue to expect it to change many things in the healthcare landscape and create new opportunities for Cerner. We expect the increased volumes created by covering the uninsured to result in capacity constraints that IT can help manage. And changes in reimbursement models and reporting requirements will be another fundamental driver for IT.

The evolution of new care delivery models such as ACOs will also require technology investments and create opportunities for Cerner to play an expanded role in driving higher quality, better coordinated and more efficient care.

Before closing, I wanted to comment on the recent activity in the House aimed at repealing elements of health reform and stimulus. Our opinion is that this activity is unlikely to result in any material changes, particularly when you consider the long-standing bipartisan support for HIT. There is really no debate that IT is a necessary element in our nation's focus on bending the healthcare cost curve while also improving quality. And we believe there will continue to be a shift to aligning provider reimbursements more directly with the quality of care and outcomes. This, along with other changing regulatory requirements, like bundled payments, value-based purchasing and the move to ICD-10, create a significant opportunity for Cerner to become more strategic to our clients as they look to navigate these fundamental changes.

In closing, I am very pleased with our results in 2010 and expect us to have a strong year in 2011 and beyond. We are extremely well positioned to benefit from the stimulus-driven demand in coming years and have many legs of growth beyond stimulus. With that, I'll turn the call over to Jeff.

Jeffrey Townsend

Thanks, Mike. Today, I'm going to discuss our progress on innovation and our Employer and Network businesses.

Last year at this time, I discussed our vision for a New Middle in healthcare. We believe a New Middle can facilitate the sharing of relevant clinical and financial information between payers, consumers and providers, resulting in enhanced care and reduced friction.

In 2010, we introduced our cloud-based Healthe Intent platform, which is a key building block for a New Middle. Our first offering on this platform is Chart Search, which leverages knowledge of the clinical meanings of words and phrases located within the EMR as well as the context in which those documents and files were produced to create algorithms that identify and rank the most important information contextually.

This capability allows the physician to efficiently search for a patient's health record and identify relevant information in a matter of seconds without localized knowledge of how the organization manages their chart. For example, it will no longer be necessary to explore the post-op notes, radiology report or discharge summary. Just enter the clinical concept.

In our early pilots, we've begun to see the potential of this first piece of a much more comprehensive, intelligent platform. Seeing the early patterns of use, both the clinical intent and practice preferences of an individual clinician comes to the surface, creating opportunities for a new wave of contextual computing that is more efficient and intelligent to a specific user and patient combination. We think this launches a new wave of microapps, which otherwise would have to be pieced together manually.

As I indicated last quarter, we are offering this cloud-based service as a free subscription with no license or operating fees in order to speed adoption and set the stage for future cloud services. There has already been a high level of interest in this offering, and leveraging our CernerWorks investments, we were able to complete the technical elements of the implementation without disruption to the operational system. Our goal is to have a majority of our U.S. clients using it by the end of this year.

Beyond the power of the search capabilities, we believe this platform provides an opportunity to accelerate what has been slow progress in the industry at solving the challenges of interoperability across a large amount of unstructured clinical data, varying nomenclatures and manual mapping of metadata. We are anticipating the next wave of challenges across the industry as dealing with information that is coming from outside the four walls of the practice. We're jumping from the current state environment that is focused on Meaningful Use, which will eliminate the paper record over time while at the same time attempting to share a subset of clinical information.

Moving to the ability to contextually share the entire record without a localized burden. By quickly deploying this in our installed base, we expect to create a major proof point that will impact the continuity and coordination of care across nearly 1/3 of the U.S. market.

In parallel, leveraging our experience from the national H1N1 surveillance project, part two of our Healthe Intent platform launch is our first national health agent. Called the St. John sepsis rescue agent in recognition of Cerner's first client, it is an intelligent surveillance agent using clinical algorithms developed in collaboration with our clients that can assist in detecting the conditions that indicate a patient may be developing sepsis, a potentially fatal condition in which the bloodstream is overwhelmed by bacteria.

Using the outcome of the Chart Search processing, relevant clinical data is tagged for detection, looking for a combination of clinical indicators to trigger the monitoring agent and ultimately respond back to the provider organization when a threshold has been met. Early results based on the initial client use of this algorithm have reflected remarkable reductions in sepsis mortality rates. And we believe that moving this capability to a health agent in a cloud creates an opportunity for us to quickly improve the outcomes of nearly 750,000 Americans who are affected by sepsis each year.

Another area where we were helping coordinate information across the fragmented delivery system is with our Cerner Network services. The Cerner Network creates better clinical integration and coordination of care by facilitating secure electronic flow of data between hospitals, physician practices and other stakeholders regardless of the EHR system being used.

In 2010, total bookings for Cerner Network nearly tripled from the previous year as our clients looked at us to help them build out enterprise HIEs and leverage our Cerner Network capabilities to help meet Meaningful Use requirements, such as e-prescribing, submission of summary care records and reporting of quality measures. The total volume across the Cerner Network has increased substantially. And now nearly 50 million clinical and financial transactions go across the network each month.

We've also continued to make strong progress at growing our relationships with employers. As you know, employers pay for a large portion of healthcare, and getting them to engage will be a critical part of improving the quality and efficiency of care. In 2010, we had five employers choose to use our employer clinic model and three chooses for wellness plans. In the future, we will be introducing additional capabilities that cross the employer and providers spaces such as eCare and personalized plans for health. We'll share more on this at our March Investor Day.

In summary, the connections and networks we are building across employers, consumers and providers, combined with the intelligence we are building into our Healthe Intent platform, position us to disrupt and systemically accelerate the move towards a New Middle in health care. With that, I would like to open up the call for questions.

Question-and-Answer Session

Operator

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

Michael Cherny - Deutsche Bank AG

So I just want to dig in a little bit more on the bookings number. You guys, obviously another incredibly strong quarter, I think well above what everyone was expecting. I just got Alan's [ph] file and it seems like the contract wins were still the same kind of relative the range. So it seems like bookings in terms of new contract size is going up. Can you just give a little sense of -- a little more color of the types of contracts you're winning? Dig into maybe a little bit more about that 22 contracts over $5 million, 13 over $10 million. Give us some more characteristics of whether or not we're actually seeing a increase in contract size wins.

Marc Naughton

Yes, this is Marc. I think just a little color on the bookings. It was broad strength kind of across all of the business units. We did mention we had a couple of ITWorks deals in the quarter and one RevWorks deal. Just to kind of let everybody know, one of those clients was both an ITWorks and RevWorks client, and it was a pretty small place. So the total of that bookings would have been maybe mid-$20 million. And the other one was a decent-sized deal but not a number changing deal. So there wasn't a lot of the big deals that we saw in the year-ago quarter come through, but it was very broad. One of the exciting things from my standpoint was one of the deals that we mentioned was over $10 million [ph] -- where we beat the private company and an ambulatory provider to take both the inpatient and outpatient provider status for that health system. So we're very excited about that. Mike, is there any more color that you want to provide on the bookings side?

Michael Valentine

Well, I think specifically, the engine's generally working well when we have about a 25% contribution from new business and the rest comes from the base. And as Marc pointed out, there weren't anomalies in the form of large transactions other than a couple of the Works deals that were signed. So I think it was good, solid execution on the install base combined with good execution on the new footprint, new business side.

Marc Naughton

And Michael I just indicated, that as we look out, and did our forecasting for the year, as we prepared for this call, the pipeline feels very solid that we can continue to see that kind of performance.

Michael Cherny - Deutsche Bank AG

And then just digging a little bit more on the Works side, both IT and RevWorks, I know you mentioned that the ITWorks pipeline has increased, you're targeting a few more RevWorks clients. How do you think about the addressable market from a near-term, maybe next 12, 18, 24 months in terms of how quickly do you think you can execute on some of these contracts? And then how quickly do you think you'll be able to go live on these versus more traditional contracts?

Michael Valentine

This is Mike, Michael. I think the lead time is going to be a little bit all over the board. We've already shown that it could happen as quickly as 90 days, and others are going to take literally probably in the 12-month range. So while we're seeing in our pipeline moving forward, we're expecting more of a three- to six-month range for bringing on new business in the Works, both RevWorks and ITWorks.

Marc Naughton

Michael, this is Marc. So on the ITWorks, getting the deal done is the kind of the time frame Mike was talking about. These deals tend to, the day they sign, become effective, and we're in charge. So there's not a lot of ramp-up. It's a quick change of the workforce, and we're running their stuff almost immediately.

Operator

Your next question comes from the line of Glenn Garmont from ThinkEquity.

Glenn Garmont - ThinkEquity LLC

I guess first, Marc, you specifically called out the professional services margin in your discussion of operating margin. And just wondering if you can update us what the margin is in that business today and remind us what you see as the peak in that business. And then my second question, I guess this one would be for Mike. Mike, can you just talk about maybe some of the unique things that Cerner is doing to address kind of the smaller or the community hospitals to kind of target that segment? And then I know you don't break out bookings by segment, but maybe characterize the bookings that have up come from kind of the smaller and the community hospitals, how that's been trending over the past couple of quarters.

Marc Naughton

Glenn, this is Marc. On professional services, we finished the year at 30% margins. I think we can look to continue to grow those as the demand we have is allowing us to get a pretty high billable rate for these people. So I think overall we would expect to be able to increment that up into the low, maybe to the mid-30s. But I think that's kind of the near-term view of that, that we're at 30. That's a very strong result, but I think we can go up from there. Mike?

Michael Valentine

On the community hospital or the smaller-size market size, we're really approaching it in two veins. So for 75 beds and below, we've introduced the CommunityWorks offering. It's Software as a Service. It's not a highly customizable. So it's a fixed set of solutions with a fixed set of capabilities. And we've had a lot of success with it. Last year was our real first year of -- full first year of operation. I won't talk about total bookings, but we added about 20 clients to our base, and I would expect it to be at least that much into 2011. So it's a very active marketplace. And I think we're in a little bit of a sweet spot relative to if we can get to the right price point, we win from a clinical capabilities perspective nine times out of 10. So the way we're approaching that market is very different than the way we approach the broader market. It's more of a telesales model with specific touches once we find lead opportunities versus a main account strategy that we have in our broader base. That being said, the 100 beds to about 300-bed-hospital market size has been a very active market. It continues to -- 2010 was a good year for us. It was probably top two-ish relative to the total number of new clients we've -- new footprints we delivered in 2010. I would expect that to be the same into 2011. And it consists of both new entries into the marketplace as well as some rebounds coming from other suppliers that the clients are voting -- there's a little bit of vote of no confidence on their current platform and they're coming back to the marketplace. There's many more rebounds on that front than we really initially expected. And so that's been good news, and that's really what's fueled the high number of new footprints in that community hospital market.

Glenn Garmont - ThinkEquity LLC

And so, Mike, just a quick follow-up. The 100 to 300, are you selling basically core Millennium on a hosted basis? Is that really what you're selling to that segment?

Michael Valentine

Yes, they tend to buy a full clinical and revenue cycle suite of solutions. So it's generally both.

Operator

Your next question comes from the line of Sean Wieland from Cerner (sic) [Piper Jaffray].

Sean Wieland - Piper Jaffray Companies

So Marc, last quarter, you said having larger bookings numbers than we guided to is going to be a precursor to us being able to deliver above that amount, talking about your guidance range. You gave us a bookings number that was in excess of $100 million above the high end of your guidance range. It doesn't look like that's really materially translating into upside to your guidance in '11, and I wanted to hear your commentary on that.

Marc Naughton

Yes, I think the key there, Sean, was the indication that we do have two ITWorks deals and the RevWorks. While those aren't a huge amount, they're getting close to being representative of the $100 million increase over the top end of our budget. For the most part, clearly, when we talk about our bookings, it is a precursor to future results. As has happened in the past, a lot of that excess performance is going into our backlog, which is saying that it stopped and giving us a lot of visibility for future periods. And that's, of course, what the ITWorks, the RevWorks deals do. We're also getting a lot of uptake on the services side. Those spread out over a period of time. So I think we're in a situation where holding a very strong software this quarter. We're very pleased with that. Most of the bookings is going, to the extent we get over-attainment, is more likely to go into the backlog and help us deliver in future periods than provide a onetime shot to the income statement. And I think if our bookings continues to be at the current spread between all of our business units as what we've seen, then I'd probably expect to see that going forward, especially as we start seeing more and more of these ITWorks opportunities coming. That's why we try to give you a little bit of flavor on the bookings. While we don't talk in detail about the bookings, I try to give you a sense of some of the longer term ones that might have impacted the current bookings.

Sean Wieland - Piper Jaffray Companies

Could you just help us out by maybe quantifying how much longer it takes you to turn ITWorks and RevWorks bookings into revenue versus, say, the average bookings that you've historically performed at?

Marc Naughton

Yes, I mean, the ITWorks and RevWorks are seven- to 10-year deals. And so it takes seven to 10 years of ratably taking that revenue into the income statement. A normal deal, as you know, is going to have a percent of software that will come in, in that quarter or the next quarter. Services are probably spread out over -- if it's just one phase, a 12-month period. And then either hosting or hardware. And once again, to extent that a lot of these new clients are hosted, that adds another seven-year element to the deal. So that's why the bookings strength across the board is hitting a lot of these longer term categories.

Operator

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

Jamie Stockton - Morgan Keegan & Company, Inc.

I guess the first one, Mike, which is real quick, have you seen any change in sentiment from hospitals as a few states have started to issue Medicaid checks, Medicaid EHR incentive checks?

Michael Valentine

No, I really haven't seen any fundamental changes in behavior. I think they're constantly dealing with challenges in the flow of funds and challenges in the impacts on those funds. So we haven't seen anything in our volume directly, no.

Jamie Stockton - Morgan Keegan & Company, Inc.

And then, Jeff, I had a question about your Health Information Exchange efforts. I was just wondering if you could give us an update on how that's going. Obviously, there have been some companies getting involved in HIE space, insurance companies purchasing some of the existing players there. I was wondering how you guys are doing at connecting Cerner clients.

Jeffrey Townsend

So broadly, in our numbers, what's driving our growth in our network activity is providers going in, actively building what I'll call their own private HIEs. So while the states are in various stages of procurement for something to layer across the state, we're seeing a lot of activity in local markets where they're trying to connect up as much as they can to control that traffic as they all are marching towards a broader HCO-type agenda. So we probably don't describe that enough, but at least half of the end points or the transactions are with non-Cerner EMRs. And in our library, we are up to 30 to 40-some-odd different non-Cerner platforms that we're connecting and are interoperating with, which makes our other efforts in the cloud like, search and sepsis. We now have exposure to the traffic coming out of those.

Jamie Stockton - Morgan Keegan & Company, Inc.

Just one more real quick question for Mike on the patient accounting system. Could you give us the number of facilities that have implemented that now and how many you've got in the pipeline?

Michael Valentine

Yes, let me pull the number up. The short math that I have on my punchline slide that we've been ticking off our organizations with is we've doubled the size of the base over the course of the last 18 to 24 months. And we expect to do the same on the forward-looking 18 to 24 months. So it's a rapidly growing solution set, and we're making great progress on both the inpatient side and the physician billing side.

Jamie Stockton - Morgan Keegan & Company, Inc.

Is that something like 80 facilities today going to 160 or something along those lines?

Michael Valentine

Yes, something like that.

Jeffrey Townsend

That'd be close.

Operator

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

George Hill - Citigroup Inc

Mike, with respect to the source of the new business, given where penetration levels are with respect to hospitals that have already chosen a clinical technology partner, where are you seeing the new business come from? How much of it is greenfield in that 100 to 300 bed setting and how much of it is displacements of what might be legacy technology?

Michael Valentine

I would say that about 60% of the new business that we're competing for is just pure greenfield where they're on a legacy platform, they don't have a great path forward and they're entering the marketplace for the first time in, say, the last five or six years. The remaining 40% are really rebounds and/or their circumstances have changed such that they need a system. So they have either defected from a broader system or otherwise. I would say that we've been surprised at the size of the rebound marketplace. It's larger. It's more active than it was in the first part of 2010, the last part of 2009. And we're seeing a lot of activity going into 2011 and potentially beyond. So we're optimistic that even for those on a platform that is very active in terms of defection rate, even if they're staying on that platform for stage one of Meaningful Use, we're optimistic that potentially, they'll come to market for stage two or later on downstream. So it's a long-winded answer, George, to say the rebounds make up a larger percentage than we expected, and we expect that trend to continue into the next probably couple of years.

George Hill - Citigroup Inc

And then I'll just say safe to assume then that your churn rates of people are getting -- there's a very low number of rebounds of people coming off Cerner, so your churn rate, I'm sure, still remains pretty low?

Michael Valentine

Right.

George Hill - Citigroup Inc

And then, Marc, one more quick question. You talk about the 100 to 200 basis points of operating margin expansion going forward. That seems an expansion of numbers that you've talked about in the past. Can you talk about what drives you there? And then I'll say for either Mike or Marc, what percentage of Cerner clients right now do you think meet stage one of Meaningful Use?

Marc Naughton

Relative to the operating margin growth, I know I've been in the range of kind of 100 to 150 basis points. I think as we look at the opportunities to continue to get leverage in the model, look at our pipeline that we have lined up for 2011, I feel more comfortable expanding that to go up to 100 to 200. I think that's what the business can deliver. And I think that I felt pretty comfortable, after going through our forecast and our planning process for the year, that that's an appropriate range to talk about.

Michael Valentine

George, on the Meaningful Use, I'll talk about at the hospital facility level. We're tracking every client, as you would expect. And right now, we would project that about in the next two years, about 80% of our base will achieve Meaningful Use at a systems level. Then, of course, they have to prove that they're Meaningful users. Probably 60% of that comes in 2011, and the remainder comes in 2012. That's when they're ready. Now when they submit, it'll be a different story. But that's when they'll be ready from a systems perspective.

George Hill - Citigroup Inc

Have you guys quantified what the opportunity is within the base just as those guys move from Meaningful Use one to Meaningful Use two?

Michael Valentine

Quantify the economic impact for them?

George Hill - Citigroup Inc

For you?

Marc Naughton

George, this is Marc. We have not talked publicly about kind of what stage two and three bring. But given that you've got med administration and a long list of things that are related to stage two in addition to a lot of our clients wanting to get ready for a variety of other things, such as pay for performance and quality, we think that once the flurry to get to stage one Meaningful Use is done, there's actually going to be a platform that people are going to want to build off of. So while we haven't quantified that, we do think that's going to be a good opportunity kind of in the out years.

Operator

Your next question comes from the line of Steven Halper from Stifel, Nicolaus.

Steven Halper - Stifel, Nicolaus & Co., Inc.

Marc, what tax rate are you assuming in your 2011 guidance?

Marc Naughton

I'd use 35%, Steve. We kind of finished the year 34.7%. I think 35% is pretty reasonable to use going forward.

Steven Halper - Stifel, Nicolaus & Co., Inc.

And then I know this is a very small number, but the interest income picked up in the quarter, from the third quarter. Is there anything unusual in that number?

Marc Naughton

I think that probably this quarter, we got more cash. You'll notice we've put more money into our long term, and it's been sitting there for a full quarter, which slightly extends beyond 12 months our maturity dates. And that gives us higher yield. Sometimes, it's not a lot. Sometimes, it's significant. But I think if you're looking to kind of model going forward, if you were to put in $1 million, $1.2 million to $1.25 million of net interest income per quarter as we go forward, I think that's probably fair.

Steven Halper - Stifel, Nicolaus & Co., Inc.

And then you did indicate that your CapEx is going to be increasing off of a low number in 2010. Are there any large projects that you're undertaking in 2011?

Marc Naughton

I think the key is just continuing to incrementally build out our data center capabilities. That's something we kind of do in $10 million to $20 million chunks. We didn't do one in 2010 because using Linux and some other things have actually enabled us to reduce the size of the footprints and to leverage more of our data center space. But I think the demand we're seeing especially from new clients who are all going in to be hosted means we'll probably have to make that investment. So I'm going -- from a year where I am, barely over $100 million, am I going to get up to the $130 million and, obviously, the $150 million range I indicated, I think, to be conservative I want to have people put that number out there for their modeling. We'll see where we end up with, but that's really the one that's the biggest single project. Everything else is pretty much hardware to do the hosting and just normal CapEx requirements.

Steven Halper - Stifel, Nicolaus & Co., Inc.

So your free cash flow is probably going to remain flattish?

Marc Naughton

Yes, that's my indication. The increase in net income is probably going to be offset a little bit by the increased CapEx. So I think that'd probably be a rough estimate. Clearly, Steve, this year, we weren't expecting the level of free cash flow we threw off. We're very happy with it. And if we did that next year, I think I'd probably be pretty happy with it as well.

Operator

Your next question comes from the line of Stephen Shankman from UBS.

Stephen Shankman - UBS Investment Bank

Could you update us as to your ending head count and expectations for 2011?

Marc Naughton

This is Marc. The expectation for 2011 is that our head count will likely go up. The additions will be coming through the professional services and managed services. So in essence, every head we add will be one that comes relative to -- that's going to produce revenue. I think we ended the year probably right around 8,200 from a head count perspective. So up from where we ended last year. And I think we're going to continue to increment up. As you know, the way we bring people in is we bring people in at entry levels. So they're reasonably inexpensive. We train them very quickly, get them working in our factory, helping implement systems on our campus. So it's a fairly efficient approach to keep bringing people in, and we can do it in a fairly just-in-time methodology. But we would expect to grow our head count as we go forward.

Stephen Shankman - UBS Investment Bank

I guess you kind of covered it a little bit, but where do you stand right now in terms of passive utilization for implementation type services?

Marc Naughton

As I indicated earlier, our utilization rates are very strong. We still have capacity. Part of the approach is to make sure that -- our ability to start a client on a project as quickly as possible. Given a lot of them are hosted, a lot of that effort is getting them up and running in the data center and getting the equipment ready. We're able to do that immediately.

Michael Valentine

We added 140 head count to our capacity here in the U.S. in the consulting business model in 2010, and we plan on doing the same again here in 2011.

Operator

Your next question comes from the line of Atif Rahim from J.P. Morgan.

Atif Rahim - JP Morgan Chase & Co

A quick question on the sub-75-bed hospital market. Mike, since it's a turnkey solution there, could you give us what the average ticket size is for that kind of a hospital? How do go about contracting there?

Michael Valentine

I'll give you a little bit of a variable answer. We actually allow for a variety of solutions. So it's not a you buy one solution, one size fits all. You can buy revenue cycle only, you can buy clinicals, you can buy the combination of the two. Our average deal size in that space over the course of seven years is in the -- for a single set of solutions on the revenue cycle side, it could be less than $1 million. For the full suite, it can be as much as $2 million or $3 million.

Marc Naughton

And that would be the kind of software component. Keep in mind, most of those are hosted, which basically more than doubles that number. Then there's some levels of implementation. So the economics of those deals are pretty attractive to us.

Atif Rahim - JP Morgan Chase & Co

So we could say the deal size jump to, say, $10 million in some cases?

Marc Naughton

It's pretty hard to get to $10 million in the small ones. But certainly, they could creep up to $5 million.

Atif Rahim - JP Morgan Chase & Co

And then, I don't know if you could give us some more color on the competitive dynamics around this academic side that you won. Was it a competitive displacement of another vendor or was this something where you just went head-to-head against a private competitor? And what are some of the factors that helped you win that business?

Michael Valentine

It was both. It was a broad selection process. It was a displacement of an incumbent in both the inpatient and outpatient. And the dynamics were largely around alignment and the ability to execute their strategy into the future. So a big portion of our alignment was reaching into the academic side of the world, understanding their priorities and building a plan that met those requirements. So it was a broad, long selection process. We prevailed in the end, and we think it's a good example of execution. And really, one of the competitiveness issues that we've been investing in is around physician usability. That's especially important in an academic setting, and I think it was a good early proof point that the investments we've been making on that front are being recognized in the industry. And I think 2011's investments will put us in even better shape going forward. So I think that's how I'd describe that.

Atif Rahim - JP Morgan Chase & Co

Just last question related to that. And since they've just signed on in the fourth quarter, what's their expected timeline for meeting the Meaningful Use requirements? And would these guys qualify for stage one?

Michael Valentine

Their timelines put them in the 2012 timeline, time frame. And so their expectation is that they are going to achieve Meaningful Use funds.

Neal Patterson

Why don't I close here. This is Neal. So the guys have done a great job here, so there's not a whole lot left to be said. But I would say that this is a very good team. We have a very good rhythm going on. And what you're seeing in the numbers is really, there's a whole lot of strong execution behind that. The comment that Jeff made also basically kind of highlights the fact that we really think through innovation and investment in IT, that we can create a really big decade here for Cerner. So what we do is very hard and complex, but it's a very good, strong team behind us. So with that, I'll close. Thank you very much for your time, and have a great afternoon.

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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