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Cerner (NASDAQ:CERN)

Q2 2011 Earnings Call

July 28, 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 Nill - Chief Operating Officer

Zane Burke - Executive Vice President

Analysts

David Larsen - Leerink Swann LLC

Richard Close - Avondale Partners, LLC

Bret Jones - Oppenheimer & Co. Inc.

George Hill - Citigroup Inc

Atif Rahim - JP Morgan Chase & Co

Sebastian Paquette - Goldman Sachs Group Inc.

Donald Hooker - Morgan Stanley

Jamie Stockton - Morgan Keegan & Company, Inc.

Sean Wieland - Piper Jaffray Companies

Operator

Welcome to Cerner Corporation's Second Quarter 2011 Conference Call. Today's date is July 28, 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 prospectives 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, Regina. Good afternoon, everyone, and welcome to the call. I'll lead off today with the review of the numbers. Zane Burke, Executive Vice President of our client organization, will follow me with sales highlights and marketplace trends. Mike Nill, Executive Vice President and Chief Operating Officer, will discuss operations. 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, will be traveling today and not be joining us on the call.

Now turning to our results. All key measures in Q2 were at or above our expected levels. Bookings were very strong and exceeded the high end of our guidance range by $80 million. Our income statement performance is very good, with revenue and adjusted EPS above our guidance and consensus, and continued strong margin expansion and earnings growth. We again had excellent cash flow performance with strong levels of free cash flow reflective of good earnings quality.

Moving to the details. Our total bookings revenue in Q2 was $650 million, which is the second-best result in company history, second only to Q4 of '09. Bookings exceeded the midpoint of our guidance range by about $100 million and we're up 39% from Q2 of 2010. Bookings margin in Q2 was $540 million or 83% of total bookings. I thought it'd be appropriate to provide some additional color on the strong bookings performance.

With respect to the $100 million overattainment, about half of the upside is related to 2 large contracts that were included in our original bookings guidance coming in above the risk-weighted amounts we forecasted. These contracts were HealthSouth, which we announced this morning, and our seventh ITWorks client contract that Mike will discuss later. The remaining $50 million of upside came from strength across all business models that led to a record 23 contracts over $5 million in the quarter.

Looking at the mix of long-term contracts, the ITWorks deal and overall strong hosting bookings led to bookings from long-term contracts being around 35% of total bookings, which is the high end of historical levels which have averaged around 29%. Note that even if you adjust long-term bookings down to historical levels, our bookings still would have exceeded the high end of our guidance range and grown approximately 30% year-over-year. In short, this was an outstanding bookings quarter, no matter how you slice it.

Our bookings performance drove a 21% increase in total backlog to $5.41 billion. Contract revenue backlog of $4.74 billion is 23% higher than a year ago. The full revenue backlog totaled $679 million, up 7% year-over-year. Revenue in the quarter was $524.2 million, which is up 15% over Q2 2010. The revenue composition for Q2 was $157 million in systems sales; $138 million in support and maintenance; $217 million in services; and $12 million in reimbursed travel.

Systems sales revenue reflects 15% growth from Q2 of '10 driven by strong growth in software and subscriptions. Technology resale was basically flat, the strong growth in device resale offsetting decline in traditional technology resale. Services revenue was up 18% compared to Q2 of '10, with strong growth in both managed services and professional services. Support and maintenance revenue is 8% over Q2 '10.

Looking at revenues by geographic segment. Domestic revenue increased 18% year-over-year to $450 million. Global revenue of $74 million was down 1% year-over-year, but was up 5% sequentially, and we expect positive year-over-year growth for the remainder of the year, based on strong global bookings in the first half of the year and a strong pipeline.

Moving to gross margin. Our gross margin for Q2 was 81.2%, which is down 160 basis points year-over-year and down 40 basis points sequentially. Gross margin continues to be impacted by strength in device resale, which carries a lower margin than our traditional hardware resale and an increase in third-party services. As we have discussed previously, we expect gross margin to remain in the low 80s, but we still expect to continue expanding operating margin, which we did again this quarter despite the lower gross margin.

Looking at operating spending. Our second quarter operating expenses were $311.2 million before share-based compensation of $6.6 million. Our total operating expense was up 9% compared to Q2 of '10, with a majority of the growth driven by an increase in revenue-generating associates in our services business.

Sales and client service expenses increased 11% compared to Q2 of '10, driven primarily by growth in managed services and professional services. Our investment in software development increased 2% compared to Q2 of '10, reflecting continued leverage of our R&D investments. One way we are leveraging these resources is by moving some of them to support growth initiatives, such as ITWorks.

G&A expenses increased 14% year-over-year, driven by personnel and non-personnel expenses related to increased hiring and training, and expenses related to our resource systems acquisition.

Moving to operating margin. Our operating margin in Q2 was 21.8% before share-based compensation expense. This is up 160 basis points compared to Q2 of '10 and in line with our target of 100- to 200-basis point increase in 2011.

Moving to earnings and EPS. Our GAAP net earnings in Q2 were $72.0 million or $0.42 per diluted share. GAAP net earnings include share-based compensation expense, which had a net impact on earnings of $4.1 million or $0.02 per share. Adjusted net earnings were $76.1 million and adjusted EPS was $0.44, which is up 26% compared to Q2 of '10. Our tax rate in Q2 was 35.2%, and we expect our tax rate to remain at approximately 35% for the rest of the year.

Now I'll move to the balance sheet. We ended Q2 with $1.01 billion of total cash and investments, up from $949 million in Q1. Total cash and investments include $682 million of cash and short-term investments, and $330 million of highly rated corporate government bonds with maturities over 1 year. Our total debt is $115 million. Total accounts receivable ended the quarter at $504 million, which is up $35 million from Q1. Contracts receivable or the unbilled portion of receivables, were $158 million and represent 31% of total receivable compared to 28% in Q1.

Cash collections were $509 million and third-party financings were $19 million, representing 4% of total cash collected. Our DSO in Q2 was 88 days, which is up 1 day compared to Q1, and flat compared to Q2 of 2010. Operating cash flow for the quarter was $122.1 million.

Q2 capital expenditures were $30.3 million and capitalized software was $20.6 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $71.2 million. We expect capital expenditures in the second half of the year to be higher than the $50 million we have spent first half of the year. We still expect to continue generating strong operating and free cash flow.

Moving to capitalized software. The $20.6 million of capitalized software in Q2 represents 29% of the $70.5 million of total spending on development activities. Software amortization for the quarter was $19.9 million, resulting in net capitalization of $0.7 million or 1% of our total R&D investments. For the rest of the year, we expect capitalized software to be between $20 million and $22 million per quarter, and amortization of $19 million to $20 million per quarter.

Now let me go through the guidance. For Q3 revenue, we expect revenue between $520 million and $540 million, with the midpoint reflecting growth of 15% over Q3 of 2010. For the full year, we expect revenue between $2.09 billion and $2.12 billion, up from our previous range of $2.07 billion to $2.12 billion. We expect Q3 adjusted EPS before share-based compensation expense to be $0.46 to $0.48 per share, with the midpoint reflecting 24% growth. For the full year, we expect adjusted EPS between $1.80 and $1.83, with the midpoint reflecting 23% growth. This is up from our previous range of $1.78 to $1.81.

Q3 guidance is based on total spending before share-based compensation expense or approximately $313 million to $318 million. Our estimate for the impact of share-based compensation expense is $0.02 to $0.03 for Q3 and $0.10 to $0.11 for the full year.

Moving to bookings guidance. We expect bookings revenue in Q3 of $560 million to $600 million, with the midpoint of this range reflecting 17% growth over record bookings in Q3 2010.

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 record level of bookings and revenue, continued margin expansion and earnings growth, and strong levels of operating and free cash flow generation.

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

Zane Burke

Thanks, Marc. Good afternoon, everyone. Today, I'll be covering our sales results and marketplace trends. I'll start with the results. We had another quarter of record bookings, with strong growth both in our client base and our new footprints. Our bookings revenue in Q2 of $650 million represents 39% growth over last year and is all-time high for the second quarter.

Bookings this quarter included 23 contracts over $5 million, which is an all-time high. 9 of these contracts were over $10 million. The strength of our bookings this quarter came from a broad range of solutions and services. We had strong contributions from all business models, with particular strength in licensed software, professional services and managed services. As Mike will discuss, we signed another ITWorks contract which contributed to the strength in professional and managed services bookings.

Additionally, we were selected by HealthSouth, the nation's largest provider of inpatient rehabilitative healthcare services to provide a wide range of services and solutions for 97 rehabilitation facilities across 26 states. This is another example of a highly regarded investor-owned health system selecting Cerner, based on our proven ability to deliver value. It's important to note that this purchase is unrelated to ARRA, as rehab facilities are not eligible for stimulus dollars. We believe this represents the beginning of a trend where providers are automating across transitions of care and preparing for future healthcare models.

Our agile business units also continued to drive contribution across a wide range of solutions and services, with noteworthy strength in Lighthouse clinical process optimization, women's health, laboratory, emergency, oncology, the Cerner Network and Hub, revenue cycle, medical devices and community hospitals.

An area of particular strength I want to highlight this quarter is our physician solutions. After a strong Q1, we had record bookings quarter in Q2 and our year-to-date physician bookings are up over 50%. These include strength in selling directly to physician practices and through our health system client base. As I discussed last quarter, the improvements we made to the physician-user interface and workflow have been recognized by the industry and our strong year-to-date performance reflects this. We continue to see a desire in the marketplace to purchase a fully integrated inpatient and outpatient solution, as providers look for tighter linkage across venues in anticipation of bundled payments and being accountable for managing health and providing high-quality outcomes. We are very well positioned to meet these needs, and it is now showing up in our results.

We also differentiate from others in the industry with our ability and willingness to inter-operate with other systems. This gives clients who have already made a significant investment in non-Cerner ambulatory solutions flexibility that most other suppliers can't or won't offer. Another highlight for the quarter was strong performance by our DeviceWorks organizations, including good levels of iBus device connectivity sales and a strong quarter of reselling CareFusion and other devices. As we have discussed, our device resale business is expected to more than offset the decline in traditional hardware resale that we have been experiencing, as more clients select our hosting option. This is playing out so far this year, and I expect us to continue expanding our relationship with device manufacturers going forward.

Moving to new client development. Our competitiveness was very strong in Q2, with 34% of our bookings coming from outside our core Millennium base. This success crosses all segments, ranging from small hospitals selecting our community works offering to large multi-facility IDNs buying a broad suite of solutions and services.

Our proven track record and success of our installed base plays a big role in our ability to get these new footprints. As an example, we are getting the attention of many prospective clients based on the leadership of our client base in receiving initial Meaningful Use dollars. Meanwhile, some other installed bases struggle with certain requirements, such as getting data out of their systems.

Our clients have already received over $100 million, which we believe leads the industry in dollars received. Given our installed base has the most live CPOE sites and is using CPOE at the deepest level in the industry, we believe our clients will continue to lead the industry in receiving Meaningful Use dollars.

I believe our competitive differentiation will continue to increase as we approach Meaningful Use Stage 2 and other industry requirements. We're having several discussions with prospective clients that are trying to meet Stage 1 requirements with their legacy systems, but are looking to align with a more proven and strategic supplier to meet their Stage 2 and 3 requirements, along with positioning themselves for healthcare reform, value-based purchasing, ICD-10, HIPAA 5010, ACOs, data analytic capabilities and other industry shifts they think will challenge their existing supplier. Because these requirements play out over an extended amount of time, I think our window of opportunity to gain market share will remain open for several years.

Moving to our global results. As Marc mentioned, our global revenue was flat year-over-year, but we had another strong global bookings quarter and expect good global revenue growth for the rest of the year.

A Q2 highlight was our contract with Sidra Medical and Research Center, which selected Cerner to help them become the first hospital in Qatar to have a fully integrated healthcare system. This contract further demonstrates our strong market presence in the Middle East and positions us for additional business in the region. We also continue to deepen our presence in Abu Dhabi, where we brought our maternity solution live at 6 hospitals, representing our first women's health to go live in the region.

Other areas of global strength from the quarter were Canada and England, where we continued our momentum after a strong Q1, and Australia where we had a solid bookings quarter along with 2 important go-lives in Victoria. We expect our strong global bookings in the first half of the year, along with the strong global pipeline, which translate to good contributions to our income statement in the second half of the year and beyond.

Turning back to the U.S., I want to provide some marketplace observations. Similar to what I indicated last quarter, the marketplace is very strong and we are seeing unprecedented levels of demand. As you would expect, we continue seeing strong demand as our clients move toward their Meaningful Use roadmaps. The rising bars for Stages 2 and 3 is creating more incremental purchasing, as more of our clients begin to purchase solutions to meet the more challenging requirements, such as medication administration and structured physician documentation.

While Meaningful Use is a major topic with clients, we spend just as much time, or more, talking to clients about solutions and services to prepare for other regulatory requirements and industry trends that require planning beyond Meaningful Use. These include revenue cycle capabilities to prepare for ICD-10 requirements, clinical process, quality optimization and reporting capabilities to be ready for value-based purchasing, as well as solutions and services to facilitate ACO strategies. It is important to note that there are major financial incentives for providers to adopt technology beyond what is required for Meaningful Use. Just in our client base, we estimate there is approximately $3 billion of annual revenue at risk tied to value-based purchasing, Medicare 30-day re-administration rules and quality reporting requirements, which begin in 2013. This ramps to an estimated $5 billion of revenue at risk in 2017, when the programs are fully implemented.

Our ability to demonstrate capabilities to help clients navigate through Meaningful Use while preparing them to address the changing world beyond Meaningful Use, makes us an attractive choice compared to many competitors who are focused only on achieving the Meaningful Use hurdle. We are finding our that our innovative platform and data analytics capabilities are becoming an increasingly important competitive advantage, as most competitors are roll-ups of multiple systems that have not been integrated -- and those that are integrated using non-relational database, which makes getting data out of the system for data analytics very difficult. The awareness of these challenges is becoming more widespread in the industry, and we believe this will be very good for Cerner.

I believe all the factors I have discussed will drive a multiyear period of strong demand that aligns very well with our core solutions and services, and not just a 12- to 18-month way that some people expect. Because of the multiple steps related to Meaningful Use and the different levels of existing adoption across the industry, all of the purchasing related to stimulus will not occur at once.

Further, all the other industry dynamics such as healthcare reform, value-based purchasing, ICD-10 and HIPAA 5010 will extend the wave of demand. This extended growth period will also be augmented by increasing contributions from our new initiatives such as ITWorks and RevWorks as they begin to drive more income statement contribution.

Before closing, I'd like to provide some comments on our acquisition of Resource Systems. For those of you who aren't familiar with Resource Systems, they provide the care tracker point-of-care electronic documentation system currently utilized by more than 3,000 organizations, primarily within skilled nursing and assisted living facilities. This solution is very complementary to and will be integrated with our long-term care, EMR. There are more than 15,000 long-term care facilities in the United States and it's expected to grow significantly as the population ages.

Additionally, we believe that as ACOs place a focus on pre-acute and post-acute care, many of these care venues defined as post-acute today will evolve to fit a proactive model of managing health. We're already seeing strong interest for the integrated long-term care solutions that we are now uniquely positioned to offer. In summary, I'm very pleased with our strong results in Q2 and I think we are well positioned for an outstanding year.

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

Michael Nill

Thanks, Zane. Good afternoon, everyone. I'll start today by discussing ITWorks. As Marc and Zane mentioned, we signed our seventh ITWorks client in Q2. This client is a health system with approximately 700 beds across 3 main facilities and is our largest ITWorks client so far. This is also a displacement of a competitor that had been providing IT services to this client for 10 years.

Our focus will be addressing infrastructure issues, completing the Meaningful Use roadmap, optimizing clinical processes and driving CPOE adoption.

Similar to other ITWorks clients, they're on a quest for better service and greater value than they were receiving from their existing IT services company. Our existing ITWorks clients also played a significant role in this client's decision. They had excellent reference calls and site visits with 2 of our existing ITWorks clients. It's noteworthy that one of the reference clients had only been an ITWorks client for 3 months but was able to share their positive experience with transitioning to Cerner, the rapid improvement in service and the value they are receiving by aligning with us.

We have quickly proven that ITWorks is not just another IT outsourcing service. ITWorks involves a strategic alignment with our clients that goes beyond traditional outsourcing. While part of the service does lead to the expected benefit of leveraging our scale to improve their basic IT operations, clients see the most significant progress at accelerating clinical adoption and innovation at the edges of healthcare.

As we intended, ITWorks is following the pattern of our CernerWorks managed services business. It's a simple model. If we provide a high-quality service that provides superior value to our clients, it'll make for a compelling value proposition and client adoption will accelerate as proof points are established. We now have the proof points and the adoption is just beginning to accelerate.

We believe that as we continue to get closer to the edge of the healthcare through ITWorks, that it will change Cerner, our clients, and ultimately, healthcare. And along the way, it will contribute to many years of strong predictable growth for Cerner.

We also had a strong good quarter in our revenue cycle business, where we continue to drive benefits at our initial RevWorks clients, with ongoing improvements in net revenue and reduction in operating expenses. We are also rapidly increasing the number of live patient accounting sites by selling 8 new footprints, and bringing 15 hospitals and 19 clinics live in Q2. We now have a total of 62 hospitals and 302 clinics live on patient accounting.

An element of RevWorks we have not discussed as much in the past that is gaining traction is our ambulatory revenue cycle offering. We have contracted with over 60 ambulatory clients for full billing office services so far this year, and we have a strong pipeline moving forward. Similar to ITWorks, we believe that we have a compelling value proposition with RevWorks that will lead to accelerated adoption as we build the proof points.

In our professional services business, we had record bookings in each of the last 2 quarters. As I said last quarter, our professional services organization is the largest and most experienced healthcare IT services organization in the world. Our unmatched experience, coupled with our proven implementation tools and methodology, serve as a major competitive differentiator, particularly in the market environment where clients want predictable costs and predictable results. I'm pleased that we have been able to keep up with the hiring and training which has allowed us to stay aligned with our strong demand and quickly turn new hires into valuable revenue-generating associates.

Our CernerWorks managed services business had another outstanding quarter with very strong bookings and operational performance. CernerWorks is the foundation that has led to the launch of other service offerings such as ITWorks, and we believe it will be the platform for several other offerings in the future. With almost all new clients selecting our managed services offering and our existing U.S. client base steadily migrating, we have a substantial platform to leverage as a channel to roll out additional solutions and services.

A good example is Cerner's Skybox cloud services that I mentioned last quarter. We called it Skybox. It's a new suite of on-demand infrastructure and software services that are deployed, hosted and managed by Cerner. These services currently include storage, messaging, backup and virtual desktop. We intend to rapidly expand the portfolio of services over the upcoming quarters by packaging existing CernerWorks capabilities into cloud-based offerings. Our speed to market with these services are very fast, as evidenced by the fact that we have already sold 2 of these services to 2 clients for a total of $8 million of bookings this year.

In closing, when you consider all of our works and professional services capabilities, the common factor is that we have invested in creating highly scalable, reliable and predictable services that create great value for our clients. And this approach has led to an unmatched suite of services offerings that differentiate us in the marketplace and drive a significant portion of Cerner's predictable revenue and earnings growth.

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

Jeffrey Townsend

Thanks, Mike. I frequently use this time to share some of our broader initiatives, but today I thought I'd also share some of the more specific offerings underway that are positioning Cerner and our clients as a platform for interoperability, a platform to measure and improve outcomes and a platform to engage consumers.

As both Zane and Mike have shared, there is a growing momentum that continues to move the innovation bar on our ability to get beyond Meaningful Use of functions and to extract true value from the growing digitization of the medical record across communities.

As I've shared from time to time, our clients are aggressively taking advantage of the potential to share information across the fragmented provider landscape. With increasing levels of interoperability expectations also comes new challenges to organize and communicate information across the geographic region. We continue to disrupt some of the more complicated challenges with interoperability through deployment of our cloud services such Search, which has grown by 104 terabytes since last quarter, a 260% increase. To frame this progress more broadly, I want to share some stats on our progress around connectivity as well.

As we continue to expand our connections and those of our clients, we have seen a 20% increase year-over-year in e-prescribing transactions, with over 30,000 providers now activated.

Our clinical transaction network is currently capable of linking to over 60 unique EMR suppliers, 20 of which are now actively connected. Our Cerner Network hub services now includes over 80 health systems, with 75% of those connecting to 2 or more non-Cerner EMR systems.

Across our clinical exchange, HIE projects, we now have 23 HIE deployments, with 8 of those being regionally focused, actively sharing continuity of care documents between acute and ambulatory EMR systems.

As our cloud-based portfolio of decision support agents expand, the progress in connecting providers regardless of their data sources becomes more and more important to position our clients for the journey towards ACOs and population health management.

Shifting towards quality in outcomes, there is an accelerating momentum towards creating alignment of clinical context and reimbursement. And there are no signs from the policy front that this direction will change course.

The expectation that healthcare becomes much more data-driven has broken through the surface, and more and more quality-in-outcome measures are finding their way into the reimbursement calculation. EMS quality measures, value-based purchasing and Medicare 30-day readmissions are just the beginning of a growing expectation that will change how providers are paid. Without addressing any of the current budget discussions, the current course is that at risk medical reimbursement will move from 4% in 2013 to 7% in 2017. As Zane mentioned, this is a $5 billion revenue risk in our current client base alone.

To make this more challenging, several of these programs are budget neutral, with winners and losers separated by comparison performance levels. We foresee that information management will become an increasing priority for our clients and in the market more widely. Our cloud-based data management solutions, our expertise in managing large data sets for research and our access to granular, realtime clinical information puts us in a unique position to innovate at a pace to meet the dynamic requirements ahead. We are quickly approaching an environment where reporting about what has already happened is too late, as the intervention must occur realtime, with embedded and proactive decision support.

As an example of our commitment in this space, Cerner is currently in a unique position within our industry as being certified by The Joint Commission for ORYX core measures, as well as CMS-approved for submission of inpatient-outpatient hospital quality measures which will include the e-submission of Meaningful Use measures going forward.

Many of these innovations are a byproduct of our own experiences as we attempt to manage the health of Cerner's population. As I shared last quarter, using Cerner Associates and family members as a Living Lab, we have bent Cerner's healthcare cost curve, while also improving the health and productivity of our associates. This has included firing our third-party administrator, launching new age on-site clinics and pharmacies, incorporating biometric measurements for our population, realigning the economic incentives for our associates in our health plan, revamping our cafeterias to focus on healthier choices and rolling out data-driven wellness management programs. These initiatives have led us to truly bend the healthcare cost curve with our per member costs now tracking well below the national average and realizing $4 million in savings in 2010 -- all while the health status of our associates has steadily improved.

We are using the success we've had at Cerner to shape our employee services offerings and provide insights to create solutions for our provider clients. We will soon be intended to drive healthier outcomes for new reimbursement models such as the Accountable Care Organizations. A recent example of building on the success we have had at Cerner is our KC Slimdown Challenge, which is a Kansas City metro-wide weight loss competition that is modeled after a successful challenge at Cerner that has led to over 20,000 pounds being shed by our associates.

The KC Slimdown Challenge expands this to individuals and employers in Kansas City and is aimed at improving the overall health and wellness of the community. There are already more than 80 employers participating in the challenge.

As part of this challenge, all participants will be introduced to Cerner Health and receive a personal health record at no cost that will allow them to securely track and interact with all aspects of their health. We have seen the use of PHRs in our own associate base increase significantly over the past several years, where we have found different ways to engage, connecting them to their health providers and making them feel accountable and empowered to manage their health. Using Cerner Health as a platform, we believe that we can scale our own experiences to an entire community.

As you know, we also have a much broader vision than just providing the PHR, and we will use Kansas City as our first regional initiative to prove the value of an engaged consumer. This begins with the weight-loss competition, which we are using to drive PHR adoption and jump-start the creation of a network of employers, consumers, doctors and other stakeholders. As we drive adoption and create these connections to stakeholders, we will be advancing many of the necessary building blocks towards our vision of creating a New Middle.

By having the providers, consumers and employers connected, we will have the ability to facilitate more seamless coordination of care across all venues, provide a medical home, reduce friction in the payment process and incent proactive health engagement rather than reactive sick care.

As I discussed in our investor day in March, the financial opportunity associating with providing these elements across the communities is substantial. Just in the Kansas City region alone, we believe we could reduce the cost of healthcare by billions of dollars and generate hundreds of millions of dollars of revenue for Cerner while doing this. We have a lot of work to do to get there, but I believe we are on the right path.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question today comes from the line of Bret Jones with Oppenheimer.

Bret Jones - Oppenheimer & Co. Inc.

The first question, I was wondering in terms of the HealthSouth deal, since you talked about that, is that structured the same way as most of your contracts where you'd recognize the software license upfront?

Marc Naughton

This is Marc, Bret. On that contract, because of the timeframe that it's going to be engaged, there's actually very little revenue recognition that came in upfront on that deal. A good portion is software, but that will spread out over a period of time.

Bret Jones - Oppenheimer & Co. Inc.

Okay. Would that tie to the deployment schedule they talked about on their call?

Marc Naughton

Generally, yes.

Bret Jones - Oppenheimer & Co. Inc.

Okay, great. And then on the services gross margin, Marc, you mentioned some third-party services and I was wondering is that for implementations?

Marc Naughton

There's some related to implementations. There are also some related to some of our RevWorks clients. So we are bringing it, using some limited third parties for certain roles. The vast majority of the work is done by Cerner Associates. We're bringing those on at a good clip and I'm not short of those, but for certain skill sets, we will supplement with third-party consultants. So not significant, but there are some that do implementation. But most of it is not implementation.

Bret Jones - Oppenheimer & Co. Inc.

Okay. And then just one last question for Zane. Zane, you mentioned the delay of Stage 2 and that delay provides incumbent vendors the additional time to meet the requirements, and I'm just wondering, what are you hearing in terms of the timeline for those customers on when they'll make a decision on whether they'll switch, post-Stage 1, for the replacement market?

Zane Burke

Bret, it's -- I think that the elongation is a slight net positive for us in terms of having a bigger runway there. And so we're seeing that it's not slowing purchases down, but I think it's going to give us more runway in terms of meeting the Stage 2 guidelines for them.

Bret Jones - Oppenheimer & Co. Inc.

So you are not hearing customers talk about the fact that their incumbent vendor now has more time to meet those? It's going to stretch that decision timeframe out for them?

Zane Burke

No. Fundamentally, people are really beginning to look beyond that and where their vendor is going to be able to take them around some of the -- beyond Meaningful Use. And I think there's a fair amount of folks that are concerned about their core supplier being able to meet the Stage 2 requirements regardless of the 1-year elongation.

Operator

Your next question comes from the line of Sebastian Paquette with Goldman Sachs.

Sebastian Paquette - Goldman Sachs Group Inc.

In terms of o U.S., I mean, clearly you announced some building activity in the Middle East, for example. And Canada and the U.K. seem to be stable. But going forward, do you think o U.S. will be able to keep up kind of roughly similar proportions to total sales as it's posting right now?

Marc Naughton

Yes. This is Marc. I think from a global standpoint, you saw the top line kind of declining a little bit throughout last year, so the Q1 and Q2 were stronger, Q3 and Q4 were a little lower. I think we're seeing the opposite trend this year, where you're going to see Q1 and Q2 starting a trend back up. So we'd expect those to continue to trend up. So year-over-year, we'll have an increase in our global. Whether it will be the significant increase we've seen in the U.S., maybe not, but it still reflects the strengthening of certain targeted areas in the global markets x Continental Europe, which is still not contributing anything at this point.

Sebastian Paquette - Goldman Sachs Group Inc.

Got you. And then just to tag onto the replacement cycle conversation, you mentioned that you're in discussions with several clients on legacy platforms. I'm just wondering if you could help put that into context with the level of conversations you've had historically. And then where is kind of the point where the rubber hits the road there? If the Stage 2 delay won't have a significant impact in your mind, where do you think will be the kind of, the main criteria for these hospitals deciding to make that switch?

Zane Burke

This is Zane. I think there's been a continual -- we've seen a demand peaking and growing, and like I say, we've seen it get even hotter, if you will. So there's more that think there's more runway to them. I think we see this a 5-year -- 5- to 7-year horizon because there's so many things coming at our clients. There's the next wave. Right after Stage 2, there's Stage 3. There's the other bundled payment elements that both Jeff and I have discussed in our comments. And I think clients are -- I think you're going to see buying behavior for the next 5 to 7 years at pretty high levels.

Marc Naughton

This is Marc. Some of what they're looking at is obviously the "got to get to Stage 2 and to Stage 3 Meaningful Use." But as Zane indicated, they're looking beyond that. So as they're going through their supplier review, of their existing supplier and potential future suppliers, it's a very broad strategic look that they're taking at things. And this additional runway the Stage 2 deferral is giving us is going to get let them go through that process. And we, as Zane said, think that is very good for us because we show very well when you get beyond "just get me to Stage 3 of Meaningful Use."

Sebastian Paquette - Goldman Sachs Group Inc.

Got you. Yes, I just got the file from Alan [ph]. It looks like the percentage of contracts and new clients looks it did tick up a bit in the second quarter there. So maybe their placement activity is accelerating.

Operator

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

George Hill - Citigroup Inc

I guess maybe, Marc or Zane, could you guys talk about what else you're seeing in the for-profit space right now? What other opportunities might be available and kind of where they are?

Zane Burke

Sure, this is Zane. Historically speaking, the investor-owned segment has not made a huge investment in the clinical information systems, with the exception of Tenet being on the early side of that. We've seen a lot of interest across the investor-owned segments. And I think you have to think about that very broadly in terms of across the transitions of care. So when you think about what we're -- an example of HealthSouth being in the rehab space. I think you'll continue to see that, where what's occurring there is they recognize there's a need to digitize their health records to begin to prepare for what health -- what true health reform is going to look like around value-based payments, around ACOs. And they realize that the access to the data is key to their business models moving forward. So we continue to see a very active marketplace in the investor-owned segment.

George Hill - Citigroup Inc

Okay. And then maybe just 2 brief follow-ups as they pertain to the same market. Bookings growth has been strong. You look -- aside from the big deals that contributed in the quarter, I guess what's the key piece of functionality that we're seeing the vast majority of clients buy right now that's kind of driving growth? Last year or 2 years ago, I remember Ob/Gyn was hot. We saw EMR, eMAR be hot. I'd say, so what's kind of the hot widget now? And maybe then just some color on what you're seeing on the ability to displace ambulatory vendors in ambulatory facilities where you guys own the inpatient relationship with the affiliate or the ambulatory facility.

Zane Burke

The core measures is a big driver, so trying to get to -- so you start with that core EMR system, CPOE and then the ability to get to the core measures in those quality reporting is a key differentiator for us. And our proven ability to be able to have -- we have the most CPOE systems live and implemented. That's the core competency of what we're doing. And our ability to do the core measure reporting on top of that is very key as people look forward to Stage 2, Stage 3 and those quality measures.

George Hill - Citigroup Inc

Okay.

Marc Naughton

And George, just on the ambulatory question. We -- clearly our recent improvements and successes in that space relative to our solutions has positioned us well. We have the ability to go to our existing clients and the new clients who've made a significant ambulatory investment and offer to connect that investment into our solutions. We're highly interoperable and happy to do that. We're also seeing a subset of our clients who say, "I want to go all with one supplier," and our capabilities now in the ambulatory space allow us to compete effectively there as well. So we expect that to be a very big driver of our business as we go forward, because there is a mishmash of things out in the ambulatory space to some extent. And I think that will consolidate over time into people selecting certain suppliers.

Operator

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

Jamie Stockton - Morgan Keegan & Company, Inc.

I guess, Zane, getting to this replacement cycle topic, I was curious. If you took the conversations that you're having with clients that are thinking about replacing their existing vendor, could you drop them into 3 buckets for us: one being facilities that are deciding to rip and replace completely; second being facilities that are looking to implement some incremental functionality from Cerner, but maybe not rip and replace everything until a few years into the future. ;And then the third being facilities that are going to wait until after Stage 1?

Zane Burke

I think the Stage 1 piece is effectively -- we're very much on the end of the Stage 1 procurement, just given the timelines that are out there. So with the exception of the community of some smaller community works models, where we can go at a faster implementation cycle -- and we still have runway there on that, on the Stage 1 elements. And we'll have runway there for several quarters. But as it relates to the -- so that piece, it kind of goes into the smaller end of the marketplace. Most are actually in a full rip and replace when they're having the conversation around the Stage 2, what they need to do, so that they'll say, "I can get to a minimum Meaningful Use around perhaps the ED or around orders in that space." Leverage that for their Stage 1 Meaningful Use and then go meet Stage 2 on a Cerner platform. And to do that, they're going to do a pretty much of a rip and replace in that model. There are some cases where we may have a footprint and we're adding to that footprint. But I would put that as the small minority of the situation. So I think if you're looking at -- I wouldn't put them in 1/3, 1/3, 1/3. It's probably -- you've got that smaller end of the segment which is very active and very good for us. And then you've got the rest of the marketplace that's attacking Stage 2 and beyond, and that is a full rip and replace mode.

Marc Naughton

Okay. And this is Marc, Jamie. It may actually be a combination of all 3 of those elements. I think there are a fair amount of clients who are waiting for Stage 1. They'll get there on their current supplier. They're going to make a decision to go with a different supplier thereafter. And while they're looking to rip and replace, it's probably going to be incrementally accomplished as they layer in solutions from that new supplier over a period of time. There'll be some big bangs where they'll replace everything at once. But I think it -- that extends this market a little bit longer to be more of a 3- to 5-year market, as people do layer in their strategy of rip and replace through some incremental steps.

Jamie Stockton - Morgan Keegan & Company, Inc.

That's what I was trying to get at, is what portion of the business are you -- is there an opportunity for you to displace some technology years from now even though maybe the hospitals are going to be able to attest for Stage 1 or Stage 2 here in the next year, 2 or 3. And I guess the other question that I had was around the strength that you're seeing in ambulatory. I was curious -- and my guess is that it's primarily probably being driven by owned physician groups, but if there was any color that you could give on the difference in growth between owned groups for the hospitals that you're in versus just whatever you're seeing in the affiliated or independent docs, that would be great

Zane Burke

Jamie, it's Zane. It's very broad-based, so we did see a lot of activity in the owned physician space in the second quarter in terms of more significant size of those opportunities. But we actually had a broad selection across the independent physician networks as well. So we're very pleased with where we are in that side.

Jamie Stockton - Morgan Keegan & Company, Inc.

And then a real quick, last question. Australia -- I mean, what's the incremental bookings opportunity there, would you say?

Marc Naughton

Greater than $1.

Zane Burke

That was Marc. I'll just be clear.

Marc Naughton

No, clearly, Jamie, when we're talking about global, we think there are areas that have focus on healthcare and have the funds available to go and begin some very important projects. And certainly, Far East has elements of that, that we think could be very interesting.

Operator

Your next question comes from the line of Atif Rahim with JPMorgan.

Atif Rahim - JP Morgan Chase & Co

A question on the market uptake. So the Stage 2 recommendations that have been made, how do they compare relative to your expectations? And what's the feedback you've gotten from clients so far on that?

Zane Burke

They were pretty much in line. There were a couple of things that were kind of hidden in that new recommendation which are very positive for Cerner, particularly around meds administration and around the physician documentation. So there was a tightening of that around Stage 2, which is beneficial for us, because our percentage of clients that have purchased those solutions is still -- we still have opportunity, a fair amount of white space in that area, and that does create some good opportunity for us. And just anecdotally, what it did do was kind of reward people that were able to meet Stage 1 today and give them a longer period for Stage 2. So our clients, in general terms, are better positioned actually to achieve their Meaningful Use dollars given the high level of CPOE adoption. So for the most part, we are very pleased with how this plays out, as well as giving us more opportunity in the marketplace to do a -- on the replacement market.

Atif Rahim - JP Morgan Chase & Co

Got it, okay. And then a question for Marc on the bookings mix, the long dated contracts were a little higher than we've seen in the past. Does the timeline remain the same? I think it's been, call it 5 to 7 years in the past, or is that changing with the ITWorks contract?

Marc Naughton

That's still a consistent timeframe.

Operator

Your next question comes from the line of Richard Close with Avondale Partners.

Richard Close - Avondale Partners, LLC

A couple of questions here. One is on Lighthouse. What kinds of growth are you experiencing in Lighthouse this year as compared to last year?

Jeffrey Townsend

This is Jeff. I think Zane kind of hit on probably our largest growth area. And as everyone is implementing heads-down to hit these targets, the quality measures and moving those quality measures into the right range has become the majority of the short-term focus. And we've seen in that core measure area within a relatively short time period, over 50% of our clients now have signed up or adopted that particular measurement package. I think as the movement goes from reporting how you're doing to "you have to perform at a quality level in the upper quartile," we expect to see that grow more significantly.

Zane Burke

And just to layer onto Jeff's comments would be that even though 50% of our clients have selected us for the core measures, those measures continue to -- the bar continues to get higher, which is good for us, both from a competitive standpoint, as well as from an additional opportunity perspective. So that raised bar -- the bar continues to grow higher and will create additional opportunity in that space as well

Richard Close - Avondale Partners, LLC

I guess what I'm looking for a little bit is, I believe at your Analyst Day you talked about in 2010 it generated around $100 million -- not sure if that's bookings or revenue. Would you expect to exceed those levels for 2011?

Marc Naughton

Yes, this is Marc. I think we would -- it's kind of early. We'd probably expect to see Lighthouse be a little stronger this year than it was last year, and can see the -- continue to see improvement in that. Starting off a fairly -- there's a -- trying to recollect the exact number, but given what I think is a little bit lower bar than that, growth would be -- in this marketplace is likely. But it should be kept more incremental until we get a little further down the road when these quality and core measures are going to be very important.

Richard Close - Avondale Partners, LLC

And then just real quick, is there anything we should know about the margin profile of the Skybox offering? And how does that compare to other services you provide?

Michael Nill

This is Mike. We expect the Skybox offering -- and in fact, the ones we sold already to be in line with the very good margins we received from the rest of our business. So it is not a low margin business. It is very attractive and will improve the overall position for Cerner.

Operator

Your next question comes from the line of Donald Hooker with Morgan Stanley.

Donald Hooker - Morgan Stanley

I guess we have the number of comments about the replacement market that you guys made, and people are asking about that. I guess a reciprocal of that, if you look across, say, the U.S. hospital space, what percent of hospitals at this point, half-way through 2011, do think you'd scratch off the list of customer prospects? And what percent of hospitals have a vendor in place and are pretty much happy with what they have, do you think?

Zane Burke

It's interesting. I think there is more than half of the hospitals in America, I would say, today are at least pausing to make sure they are riding the right horse, and are they making the right selection, because the train is moving very quickly. And the things that are coming at our clients over the next 7 years, there's something each and every year that's a higher hurdle. And so what we're looking at is between -- and we see certain suppliers who are not capable of meeting that long-term hurdle, current course and speed. And I think -- and our clients see that as well, and the prospects as well. It's well more than half, in my mind, of the marketplace will go through a full reselection process. And I would anticipate that would happen over that 5- to 7-year period.

Marc Naughton

And then, this is Marc. I would be a little more aggressive and indicate that there are people who probably might be very happy with their suppliers today who, when all of these requirements come to light -- interoperability, sharing of data, reporting, are going to find out that maybe the one they selected isn't the best answer. So I think there are people who might be happy today that are going to be in the same place as half the market is today, looking to see if they do have the right person. So I think Zane's comment for the near term is accurate, but I think going longer term, people are going to be taking a very close look. And the requirements only get harder.

Donald Hooker - Morgan Stanley

Okay, and I think you are also -- sort of seem to be communicating that this revenue opportunity, even within an existing hospital, is more than just a year or 18 months. So when you think about Stage 1, 2 and 3, it's just now that again, you have a little bit more perspective on Stage 2, and certainly on Stage 1. How much of the revenue is really Stage 1 versus Stage 2 and 3? And does the margin kind of go down over time through the stages, in your mind, as you get towards the end of the process?

Marc Naughton

The elements, as Zane talked about, in Stage 2 in the med administration, physician documentation are both very substantial solutions to purchase. So I don't know that -- certainly going to Stage 2, there's still a significant amount of opportunity and revenue we would see from clients who are purchasing the solutions to make Stage 2. So it is not a significant dropoff from Stage 1 to Stage 2, depending on the client and what their current status is.

Donald Hooker - Morgan Stanley

Okay, got you. One last one, and I can't help it. The -- you mentioned some progress with that patient counting -- patient accounting system. Are those all basically sales to existing EHR hospital customers, or are those new customers?

Zane Burke

This is Zane. It's a blend of new clients. So many clients in their selection of their Meaningful Use and other -- and as they think beyond Meaningful Use, they think about what they need from a revenue cycle solution. And so they're selecting us on the new business aside, as well as our existing clients as they prepare for the future world, they're beginning to look at their revenue cycle solution as well, and make selections back into the base. But very much so on the new business side in particular.

Operator

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

Sean Wieland - Piper Jaffray Companies

A question on your consulting business, which you said was strong. Would like to know what your respective is on the industry's overall capacity to do the implementations that are out there and what your customers' ability is to find the necessary talent. And then a follow-up there is, has there been any movement on your bill rates in consulting?

Zane Burke

Sure, this is Zane. And Mike wants to comment on the backside. From a marketplace point of view, obviously, there is a heavy competition for talent out there and there is a huge demand. We have the largest consulting workforce in the industry and we've -- our hiring and training practices, and frankly, the strong network that we have of having a deep installed solution set has been very beneficial as we've grown our workforce and actually more than kept up with demand. So we're feeling good about our staffing. The flip side of that is our clients' abilities to staff those same roles. And they're struggling with that capability to do that, which is why you're beginning to see the ITWorks play out more and more, as well as other outsourcing types of arrangements where we can play the client-side roles. So again, it creates more opportunity for us as an organization, in our scale and our ability to actually hire, train and assimilate. And the network that we have is second to none in the industry. And so that's been very beneficial.

Michael Nill

Yes, this is Mike. Another point I'd like to add. This is a case where our size, we really use to our advantage. We do a considerable amount of the consulting work through our centers-based organizations, so we get greater leverage off the talent pool. So I believe we can get more productive use out of a smaller number of people and it's really only possible because of our size and scale. And in terms of the billing rates, we really see no -- Zane, you want to comment?

Zane Burke

Yes, just so -- well, probably just a slight incremental tick up here in the second quarter so -- which is good for our margin expansion as well.

Marc Naughton

Yes, and this is Marc. The billing rates have stayed relatively constant -- slight uptick. The utilization is going up because of, as Mike says, the utilization of the centers and other techniques and therefore driving more margin per associate than we have in the past.

Sean Wieland - Piper Jaffray Companies

Okay, that's very helpful. And one other question, can you tell us what percentage of bookings is coming from reselling third-party products like Pyxis, Celeron [ph] that kind of thing?

Marc Naughton

It's a very small piece of the bookings, because from the device resale amount, it's probably less than -- right around 5% maybe, some place in that vicinity. So it's very immaterial to us today. Obviously, our goal is to make it more material over time.

Operator

Your final question comes from the line of David Larsen with Leerink Swann.

David Larsen - Leerink Swann LLC

I may have missed this, but how much of the bookings was tied to ITWorks and also RevWorks this quarter?

Marc Naughton

We indicated that part of the overattainment -- so over $100 million of overattainment during the quarter, about $50 million of that came from some overattainment on one ITWorks deal that we had. And then obviously the other large deal in the quarter would've been from HealthSouth. So relative to contributing to bookings, neither of those -- they're both well under $100 million, so they're not giant deals, but those were the 2 good-sized deals. But only -- from a RevWorks, ITWorks, you only have the one component that contributed to bookings this quarter.

David Larsen - Leerink Swann LLC

And then when you say $50 million from ITWorks, does that include like -- let's say you're hired for an ITWorks engagement and you decide that you need to install a lot of Cerner modules and Cerner systems at that hospital client. Are those system sales included in that $50 million number?

Marc Naughton

The ITWorks contract is for services, for us to take over. They are non-Cerner infrastructure. Any sale of additional solutions, any support on those additional software solutions, any other activities that are beyond the scope of just running those non-Cerner applications would be additional revenue. So a booking for an ITWorks deal will be the amount of revenue over that longer period of time, as we discussed, that will come in just related to the services. That's part of the strategy, is that in itself might not be a high margin business, but the ability to sell additional software back and convert them to Cerner applications of course not only gets you incremental Cerner Solutions software dollars, but also starts the support stream running from Cerner. So those are the kind of add-on sales, in addition to being able to effectively help them manage their implementation and coexist it with Cerner Solutions. So a lot of strategic reasons for doing that, but those contracts, when we talk about them are just for the services.

David Larsen - Leerink Swann LLC

That's great. So for a 700-bed hospital, 3-hospital system, this could lead to more sales down the line for systems sales. Great.

Marc Naughton

Okay. At this point, I would like to thank everyone for being on the call. I know you're very busy. We thank you for your attention. We're very pleased with the quarter we had, and we'll talk to you a little bit later. Thank you very much,

Operator

Ladies and gentlemen, thank you so much for your participation. This does conclude our presentation today, and you may now disconnect. Have a great day.

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Source: Cerner Management Discusses Q2 2011 Results - Earnings Call Transcript
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