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Cerner (NASDAQ:CERN)

Q3 2011 Earnings Call

October 27, 2011 4:30 pm ET

Executives

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

Michael R. Nill - Chief Operating Officer

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

Zane M. Burke - Executive Vice President

Analysts

Atif A Rahim - JP Morgan Chase & Co, Research Division

Richard C. Close - Avondale Partners, LLC, Research Division

Michael Cherny - Deutsche Bank AG, Research Division

Steven P. Halper - Stifel, Nicolaus & Co., Inc., Research Division

Kipp R.F. Davis - Barclays Capital, Research Division

Stephen B. Shankman - UBS Investment Bank, Research Division

George Hill - Citigroup Inc, Research Division

Jamie Stockton - Morgan Keegan & Company, Inc., Research Division

Donald Hooker - Morgan Stanley, Research Division

Sebastian Paquette - Goldman Sachs Group Inc., Research Division

Charles Rhyee - Cowen and Company, LLC, Research Division

Operator

Welcome to Cerner Corporation's Third Quarter 2011 Conference Call. Today's date is October 27, 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. Please proceed, sir.

Marc G. Naughton

Thank you. Good afternoon, everyone, and welcome to the call. I will lead off today with a review of the numbers. Zane Burke, Executive Vice President of our client organization, will follow me with sales highlights and marketplace trends. Mike Nill, Executive Vice President and Chief Operating Officer, will discuss operations. 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 should be able to join for Q&A.

Now I will turn to our results. All key measures in Q3 were at or above our expected levels. Bookings were very strong and exceeded the high end of our guidance range. Our income statement performance was excellent with revenue and adjusted EPS above expected levels and continued margin expansion and strong earnings growth, and we had very strong cash flow performance.

Moving to the details. Our total bookings revenue in Q3 was $650 million, which is the second best result in company history, second only to Q4 of '09. Bookings exceeded the high end of our guidance range by $50 million, and we're up 31% from Q3 of '10. Bookings margin in Q3 was $534 million or 82% of total bookings. As Zane will discuss, the strength of bookings spanned across all business models. Our bookings performance drove a 21% increase in total backlog to $5.66 billion. Contract revenue backlog of $4.96 billion is 24% higher than a year ago. Support revenue backlog totaled $691 million, up 8% year-over-year.

Revenue in the quarter was $571.6 million, which is up 24% over Q3 of '10 and about $30 million over our guidance. The revenue composition for Q3 was $189 million in system sales, $139 million in support and maintenance, $233 million in services and $11 million in reimbursed travel. The upside relative to our guidance was largely driven by higher system sales, as well as very strong services revenue.

The system sales revenue reflects 41% growth from Q3 of '10, and included greater than 20% growth in licensed software and subscriptions and over 50% growth in technology resale. The technology resale growth included record levels of device resale, reflective of rapidly increased traction in the resale of CareFusion and other devices. Even with strong software growth, the even stronger growth in technology resale led to lower system sales margins of 55%. However, when you look at the growth in system sales margin dollars, it mimics the growth in revenue at a very strong 37%.

Services revenue was up 22% compared to Q3 of '10 with strong growth in both managed services and professional services. Support and maintenance revenue increased 6% over Q3 of '10.

Looking at revenue by geographic segment. Domestic revenue increased 27% year-over-year to $499 million. Global revenue was $72 million and grew 5% compared to a year-ago period.

Moving to gross margin. Our gross margin for Q3 was 78.9%, which is down compared to 82.9% of a year ago and 81.2% in Q2. The decline in gross margin was driven by the record levels of technology resale that I discussed, as well as an increase in third-party services. While significant upside in technology resale and higher third-party costs led to gross margins slightly below our target of 80% range, we still drove very strong gross margin dollars with growth of 18%. We also drove solid operating margin expansion despite the lower gross margin.

Looking at operating spending. Our third quarter operating expenses were $323.3 million before share-based compensation expense of $7.5 million. Total operating expense was up 14% compared to Q3 '10, with the majority of the growth driven by an increase in revenue-generating associates in our services businesses. Sales and client service expenses increased 16% compared to Q3 of '10, driven primarily by growth in managed services and professional services.

Our investment in software development increased 8% compared to Q3 of '10. We expect to continue growing our R&D investments in coming years to accelerate innovation in areas Mike and Jeff will discuss. We expect to be able to do this with R&D still growing slower than revenue, so we maintain the leverage we have achieved from our R&D investments. G&A expense increased 16% year-over-year, driven by personnel and other expenses related to increased hiring and training.

Moving to operating margins. Our operating margin in Q3 was 22.4% before share-based compensation expense and was up 70 basis points compared to Q3 of '10. We still expect operating margin expansion in Q4 and for the full year to fall within the 100 to 200 basis point range we targeted at the beginning of the year.

Moving to earnings and EPS. Our GAAP net earnings in Q3 were $78.8 million or $0.45 per diluted share. GAAP net earnings include share-based compensation expense, which had a net impact on earnings of $4.6 million or $0.03 per share. Adjusted net earnings were $83.5 million and adjusted EPS was $0.48, which is up 26% compared to Q3 of '10.

The tax rate for adjusted net earnings was 36.1%. This is about 1% higher than we projected due to a lower mix of non-U.S. earnings. The higher tax rate reduced EPS by $0.01. We expect our tax rate to remain at approximately 36% for Q4.

Now I'll move to our balance sheet. We ended Q3 with $1.09 billion of cash and investments, up from $1.01 billion in Q2. Total cash and investments include $755 million of cash and short-term investments and $335 million of highly rated corporate and government bonds with maturities over 1 year. Our total debt is $134 million.

Total receivables ended the quarter at $548 million, which is up $44 million from Q2. Contracts receivable or the unbilled portion of receivables, were $103 million and represent 19% of total receivables compared to 31% in Q2. The favorable shift to a lower mix of contracts receivable is driven by a combination of increased billings that brought down contracts receivable and strong sales in the quarter that drove up accounts receivable. Cash collections were a record $533 million. Our DSO in Q3 was 87 days, which is down 1 day compared to Q2 and down 4 days compared to Q3 of '10.

Operating cash flow for the quarter was a record $129.2 million. Q3 capital expenditures were $23.9 million, and capitalized software was $20.8 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $84.5 million. We expect capital expenditures to increase in Q4, but we still expect to generate strong free cash flow.

Looking at next year, we do expect an increase in capital expenditures compared to the low $100 million range we have been at for the last 2 years. Some of this will be driven by the construction of additional space at our Kansas City, Kansas campus that is needed for our growing associate base. We do not expect this to have a material impact on our free cash flow as the construction will span multiple years, and we will also be receiving incentives that will offset a portion of the construction costs.

Moving to capitalized software. The $20.8 million of capitalized software in Q3 represents 29% of the $72.4 million of total spending on development activities. Software amortization for the quarter was $20.9 million or $0.1 million more than what we capitalized.

Now let me go through the guidance. For Q4 revenue, we expect revenue between $575 million and $595 million, with the midpoint reflecting growth of 17% over Q4 of '10. This equates to a full year revenue between $2.16 billion and $2.18 billion, up from our previous range of $2.09 billion to $2.12 billion, and represents full year growth of 17%. We expect Q4 adjusted EPS before share-based compensation expense to be $0.51 to $0.53 per share, with the midpoint reflecting 18% growth. This equates to full year adjusted EPS between $1.83 and $1.85, which is up from our previous range of $1.80 to $1.83 and reflects 24% growth. Q4 guidance is based on total spending before share-based compensation expense of approximately $325 million to $330 million. Our estimate for the impact of share-based compensation expense in Q4 is $0.03.

Moving to bookings guidance. We expect bookings revenue in Q4 of $630 million to $670 million. This reflects modest growth over our strong Q4 '10 results, but would lead to full year bookings of about $2.5 billion, which is 24% growth over 2010.

I would also like to provide our initial thoughts on 2012. The initial version of our 2012 plan supports the current 2012 consensus estimates for revenue and earnings per share. As always, we will continue to update our outlook on future earnings calls.

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

Zane M. Burke

Thanks, Marc. Good afternoon, everyone. Today, I'm going to provide highlights of our sales results and cover marketplace trends. Starting with our results. We had another record quarter of bookings driven by robust demand in our client base and strong competitiveness in new footprint opportunities. Our bookings revenue in Q3 of $650 million represents 31% growth over last year and is all-time high for a third quarter. The strength in bookings this quarter was very broad with all business models contributing at least 24% growth. We also had an all-time high level of large contracts, with 25 contracts over $5 million and 16 over $10 million.

The strength in our bookings is more impressive when you consider that we had a lower than normal level of contribution from long-term contracts, with no ITWorks or RevWorks clients this quarter. As Mike will discuss, our outlook for these businesses remains strong. We just didn't have any deals this quarter.

One driver of the strength in our bookings and revenue this quarter was record results from our DeviceWorks organization. This quarter's strength included record levels of RxStation sales along with strong levels of reselling CareFusion Pyxis medication dispensing devices. In addition, we had strong iBus device connectivity sales and strong resale of devices such as infusion pumps, beds and monitoring devices. We also had 3 clients purchase Smart Rooms for the entire units of their hospital, which contributed to sale of multiple solutions and devices. Overall, we are seeing strong traction in this business as clients recognize the value of connected devices, and device manufacturers recognize the value of our device connectivity platform and the strategic relationships we have with our clients.

Q3 was also a record quarter for our physician solutions and included the 2 largest PowerWorks contracts in our history. With our record Q3 results, our year-to-date bookings for physician solutions now exceed our full year plan. We are clearly gaining traction and market share with the usability enhancements we have made and our ability to offer robust physician solutions that are fully integrated across inpatient and outpatient environments.

As Mike will discuss, we are continuing to raise the bar on our physician solutions by further enhancing our usability and our mobile capabilities, which will widen Cerner's differentiation in the marketplace. A major validation of the strength of our physician solution also include -- occurred in Q3 when a major IDN chose to replace their existing outpatient solution with Cerner Solutions, displacing our primary competitor in the process. They are also adding [ph] our revenue cycle solutions for both inpatient and outpatient, which validates the improvements we have made in that space as well.

Moving on to our global results. As Marc mentioned, our global revenue grew 5% year-over-year in Q3 after being down in the first half of the year. We continue to see gradual improvements in most global markets and have some noteworthy areas of strength such as Canada, Australia and the Middle East.

In England, there has been a lot of coverage of proposed changes to the National Program. In the near term, we do not expect this to have a significant impact on Cerner as we expect our existing contracts to be honored. In the intermediate term, we believe the changes are a positive as they create more opportunities for us to sell directly to trust [ph] in all regions. We are very well positioned to do this and have already seen an increase in RFP activity.

Another indication of strong global activity was the attendance by global clients at our Cerner Health Conference. Global attendance was up 34% compared to last year and included attendees from 13 countries.

Moving to the overall marketplace and our competitiveness. We gained market share again in Q3 with 29% of bookings coming from outside of our core Millennium installed base. We continue to see both greenfield opportunities and opportunities in several of our competitors' client bases. Their clients are concerned about our competitors' ability to keep up with Meaningful Use requirements, particularly when looking beyond Stage 1.

In coming years, we believe this vulnerability of our competitors' installed base will increase with the requirements for Value-Based Purchasing, other stages of Meaningful Use, ACOs and data analytics capabilities. As a result, we believe we are in the early stages of a multiyear market share shift. And we believe we are extremely well positioned to be a major share gainer during this time due to depth and breadth of our solutions that are ready today to help clients meet industry demands. Further, our unmatched services and delivery capabilities provide an important differentiator compared to competitors that can't offer timely and predictable results.

A recent example of our competitiveness is Ventura County Health Care Agency selecting Cerner for a broad suite of Millennium solutions for 2 hospitals and over 40 ambulatory clinics. This selection over our primary competitor was driven by the strength of our integrated inpatient and outpatient solution, our predicable services delivery model and our ability to demonstrate a total lower cost of ownership.

We also established a new footprint with a large investor-owned company that owns or operates 200 ambulatory surgery centers and 14 surgical hospitals to implement a suite of clinical and financial solutions in majority of their surgical hospitals in order to achieve Meaningful Use. This footprint is notable because it significantly increases our presence in the surgical hospital and ASC markets.

Looking at general market place conditions, we continue to see robust demand and expect it to continue for years to come. Our conviction that the marketplace is strong was reinforced at our recent health conference where we had over 10,000 total attendees, including a 15% increase in client attendance. We came away from the conference impressed with what our clients have accomplished, which is evidenced by the great progress our clients have made with Meaningful Use achievement. It is clear that our clients recognize the importance of working closely with us going forward as they face a rising bar and new challenges in the year to come.

From a macro view, we recognize that healthcare is likely to be targeted as part of the solution to the U.S. deficit, but we believe the stimulus plan will remain intact, and that other programs such as Value-Based Purchasing will drive ongoing IT adoption. While some levels of cuts to our clients' funding are likely, we expect any future cuts to continue to be tied to quality and outcomes, which will make IT adoption essential to remaining competitive. The linkage of reimbursement to quality and outcomes creates major financial motivation for IT adoption beyond Meaningful Use. As we have indicated, our client base could have approximately $3 billion of annual revenue at risk tied to Value-Based Purchasing, Medicare 30-day readmissions rules and quality reporting requirements beginning in 2013. This ramps to an estimated $5 billion of revenue at risk in 2017. These are significant levels of revenue, and we are working closely with our clients to mitigate their risk.

In summary, I'm very pleased with our strong results in Q3. And I think we are very well positioned for a strong finish to the year and ongoing success in years to come.

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

Michael R. Nill

Thanks, Zane. Good afternoon, everyone. Today, I'm going to discuss ITWorks, RevWorks and projects we are focused on that will further differentiate Cerner in the marketplace. I'll start with ITWorks. While we didn't gain any new ITWorks clients this quarter, we did have approximately $20 million worth of scope expansion bookings from existing ITWorks clients. This activity proves the benefit of the tighter alignment that is created with ITWorks and is evidence that there is still room to grow after the initial relationship is established.

I've mentioned in the past how the success of our existing ITWorks clients is creating new demand as the word of our success gets out into the market. This was evident at the Cerner Health Conference where we had a separate track that provided prospective clients access to existing ITWorks clients. Prospects were able to hear firsthand about the acceleration of clinical adoption, increased associate satisfaction and rapid adoption of emerging technologies that has occurred at our current clients. Perhaps the most powerful statement about ITWorks at the conference was made by the CEO of an existing client who stated that becoming an ITWorks client was the best decision he made in his 30-plus year career.

We also have good activity associated with RevWorks at our healthcare conference. While RevWorks is ramping slower than ITWorks, we are building some strong examples with our initial clients and remain confident that the RevWorks business will be a big contributor to our growth in the coming years. We are building the foundation for success to rapid growth in adoption of our patient accounting solution while also building out broader revenue cycle capabilities.

At our health conference, 2 existing RevWorks clients led a very well-attended session where they shared the success they've had thus far increasing net revenue and reducing operating expenses. They also highlighted the benefits of being strategically aligned with Cerner in an environment where revenue continues to be more closely tied to clinical information.

Moving to the ambulatory market. I mentioned last quarter that we were gaining traction with RevWorks in the ambulatory setting. In Q3, we built on this success, and we were selected by a large ambulatory client for full billing services for over 300 providers.

Now I'll discuss some of the initiatives we are focusing on as we head into 2012. Our recent health conference served as a launch for several new services and capabilities that will continue to differentiate Cerner in the marketplace and create fuel for our growth.

Our Cerner Skybox cloud services is a service which we have previously discussed with you that formally launched at our conference. Skybox a suite of on-demand infrastructure and software services that are deployed, hosted and managed by Cerner. These services currently include storage, messaging, back-up and virtual desktop. The level of interest in these services was extremely high at the healthcare conference and our pipeline is strong. We will continue to expand these services as we move into the next year.

As Jeff will discuss, our investment in cloud capabilities also enables our Healthe Intent platform, which today includes Healthe Intent Chart Search and Sepsis Agent. Our conference also served as a launch for key initiatives aimed at building on solution workflow enhancements, which we have made over the past several years. We've already had significant success in the marketplace with capabilities such as our MPages web-based development kit that allows for the creation of Role-venue cockpits of information for our clients. At our healthcare conference, we launched Project Go, which will build on the success of MPages and also leverage the significant advancements in mobile technologies. Our solutions have always been device-agnostic. And clients currently have great flexibility with the way they can access our system. But the next step for us is to optimize mobile devices as they are now to the point where we can accommodate a majority of the clinician workflow. Therefore, as part of Project Go, we are increasing our focus on developing applications for Apple and Android devices with a simple mantra of making these apps smart, fast and easy.

I'm very excited about where we're going with this, and I think it's really going to be a game changer. We have already -- we already have the most robust suite of solutions with the deepest functionality in the industry. By driving the clinician experience to the next level, I think we can significantly increase our competitive advantage.

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

Jeffrey A. Townsend

Thanks, Mike. As Zane and Mike have mentioned, CHC was a great chance for us to get a pulse of our clients and the momentum of the industry. As our client base continues to aggressively march along the Meaningful Use journey, we are beginning to see a second wave of opportunities emerge. As we've mentioned in prior calls, there is a historical pattern of second order effects that emerge when an industry is digitized. We think that we are on the front edge of that cycle within healthcare.

One thing that is very clear is that our clients are facing an unprecedented amount of challenges and change. With the activity around Meaningful Use, healthcare reform and the continuous policy tinkering to address the budget deficit, the pressures on our clients are substantial. For the most part, their only lever is information. As a result, we are in a window that is so busy getting to the next milestone or dealing with the next activation date of a policy. There is little time for our provider clients or the industry to imagine a future state, let alone prepare for it. As both Zane and Mike have mentioned, the new pace of change is helping fuel several of our works offerings and creating opportunities for new ones, which I will discuss shortly.

A year ago, at CHC, we first launched the series of offerings around our Healthe Intent platform. This was the beginning of a journey to create a meta data layer, agnostic to the source EMR to better position our clients for future proofing around the increasing use of quality standards, performance measures and eventually managing health of populations.

Our Chart Search efforts are an important building block to our future roadmap. With about 80 clients engaged today, capturing greater than 30 million documents and 500 million results at a typical client, we are quickly building foundational data for the Healthe Intent platform. As the platform has grown over the last year, we are now beginning to deploy sophisticated machine learning algorithms to support both mapping of clinical concepts, as well as creating an environment to advance clinical decision support algorithms such as sepsis. As an example of the new landscape of opportunities, last quarter, we launched Cerner Math to accelerate our ability to discover and develop clinical agents using a hybrid of published evidence and our Health Facts research platform.

How healthcare is paid for and what is paid for is becoming more and more dynamic, challenging our provider client organizations to more rapidly blend the clinical and financial environments together. As an example, the more recent ACO guidelines have improved several of the requirements and will likely cause several of our client organizations to once again strongly consider starting this journey. One core element of the regulations is quality measures, with the anticipation of more and more measurements and clinical context being mapped to payment. We use the term future proofing internally as a design element for our solutions to adapt to new requirements virally without requiring implementation projects or major upgrades to achieve compliance. The Healthe Intent platform is playing a strategic role in making this possible, allowing for deployment to occur at a nationwide scale.

The next natural progression beyond measurement is management. As our clients adapt to an increasing rate of change, they will evolve more and more towards the learning organization model. We see this progressing towards a management system for healthcare. Not only managing the health of populations but managing the performance and innovation of care delivery in unison. Similar to the life cycle when manufacturing digitized, creating enterprise resource planning platforms, we are seeing early stages of this evolve as more and more of the EMR becomes digitized, providing greater insights and correlations to the delivery environment.

A key element of driving to a future state is aligning with our clients. Historically, measures of success with clients were tied to a project or implementation. But as the industry morphs from a focus on Meaningful Use process-based measures to a focus on outcomes, measurement and value, Cerner's success will be tied to that of our clients and vice versa. It was clear to us at our healthcare conference that our clients see the importance of becoming more aligned, so we can face the current industry challenges together. It was also very clear that they're looking to us to not only be accountable for helping them meet current challenges but also to keep pushing for an improved future state. Managing costs, resources and outcomes will drive a growing portfolio of new solution opportunities, all of which demand a different type of distribution and activation method.

I want to highlight 2 activities within the quarter that build upon this evolving landscape. Our recent acquisition of Clairvia fits well with the topic of my comments today. For those of you who aren't familiar with them, Clairvia provides workforce and patient management solutions to more than 400 organizations. Their predictive models are EMR agnostic and enable healthcare organizations to align resources with actual patient needs in real time, thereby cutting costs and improving patient outcomes.

With this acquisition, we are solidifying our commitment to the workforce management marketplace and interoperable cloud-based solutions such as Healthe Intent and CareAware, which focus on providing positive clinical, operational and financial returns for our clients. By adding this rich data set to the clinical context, the ability to provide more sophisticated algorithms and timely utilization of scarce resources, we should be in a position to improve the management of labor and skills across the continuum of care.

The second would be one of our newer works as I mentioned earlier. Last quarter, we signed our first QualityWorks client. Bundling together our Lighthouse and decision support offerings into a service-oriented model very similar to the approach of our other offerings in the Works space, we are now highly aligned with the clinical, operational and financial performance of the clients' organization. This provides clients the ability to gain access to both Cerner's scale and skill to adapt to the changing environment and requirements both at the local and national level. This is one of our earlier examples of creating a new style of alignment with our clients. And as we have seen with our other works offerings, we anticipate that the increasing industry demands will make this an attractive offering for our clients as they navigate the uncertainty ahead.

To summarize, we are seeing innovation opportunities accelerate in the current environment to take more and more advantage of a digitizing platform as the urgency to extract the benefits of having more information is becoming more and more acute.

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

Question-and-Answer Session

Operator

[Operator Instructions] And your first question is coming from the line of Charles Rhyee with Cowen.

Charles Rhyee - Cowen and Company, LLC, Research Division

I wanted to talk about the bookings here in the quarter, obviously a very strong number. You mentioned that there were no new ITWorks or RevWorks contracts, but you did talk about some scope expansions. And I think last quarter, Marc, you gave some metrics to help us kind of compare sort of excluding the long-dated bookings, do some -- and your comparability year-over-year. Is there any metric you can kind of give us here? And how big were the scope expansions maybe as a percent of the bookings?

Marc G. Naughton

Well, I think if you look at all of the -- relative to the long-term booking that we talked about being in a range of 25% to 30%, I think it was probably 26% in Q3. So it was pretty much right at the lower end or, if you will, at the range that we have talked about relative to the contribution from those long-term bookings.

Charles Rhyee - Cowen and Company, LLC, Research Division

Okay, great. When you -- then, if we look to the next quarter booking here, $630 million to $670 million, if I recall, maybe in the last quarter or the quarter before, you still had some expectations for a few more ITWorks contracts by sort of year end, sort of the -- what's sort of built in to your 4Q bookings guidance here of $630 million to $670 million? How should we think about that?

Marc G. Naughton

Yes, I think we kind of expect the ITWorks opportunities to maybe come one a quarter, one every other quarter. So they're not going to hit everyone. Just like in Q3, we didn't have a new one hit. With regard to Q4, I think a similar percentage relative to long-term bookings, kind of in the 25%, 26% range is kind of what our guidance is based on. So I think we're -- that's kind of what we would expect. If we get a new sizeable ITWorks deal, that could be a little bit higher, but that might be an opportunity for some bookings upside.

Charles Rhyee - Cowen and Company, LLC, Research Division

Okay. And then maybe the last question here. On the revenue guidance, if I look at the new range and you back it out, we're obviously looking at a fairly sizeable 4Q. Should we think about it similar to your 3Q, since the strength in the technology resale would be favorable [ph] like the CareFusion side that, that is going to come mostly in the system sales? Is that the fair way to think about it?

Marc G. Naughton

Yes, I think within Q4, we're seeing a lot of strength in that technology resale. We've done a lot of good work as we talked to you about of trying to replace the hardware sales we used to have with device resale and other technologies, and that's going well. We've got some good traction in Q3. We see that traction continue in to Q4. So I think you're going to see a lot of a part of that upside being driven by strong technology. And [indiscernible] so relative to hitting the gross margin line, some of that upside of revenue won't hit the gross margin line as far because it will be some of that technology. And from an earnings perspective, keep in mind that the 36% tax rate compared to our 35% that we talked to you about previously, we had in Q3 and we expect in Q4, that costs us about another $0.01 of EPS every quarter that we have a 36% tax rate. So your assumption is correct. The higher revenue is going to be driven, a good portion of that, by continued strong technology.

Charles Rhyee - Cowen and Company, LLC, Research Division

And if I could -- last one, the last question here. Obviously, as your technology initiatives with device, selling more higher-end devices grows, do you think at some point it's worth breaking that kind of business line out separately? Or do you really kind of consider it as part of the overall system sales?

Marc G. Naughton

Yes, I think system sales is kind of how we break out things have that type of an impact and show the gross margins. It's still not such a significant amount, of $2 billion of revenue, that it's going to make be enough to break out separately. But we'll certainly continue to try to get some color to it as far as what helps it on an annual basis.

Operator

Your next question is coming from the line of Kipp Davis with Barclays Capital.

Kipp R.F. Davis - Barclays Capital, Research Division

We had a competitor this morning talk a little bit about the remaining market potential for the healthcare IT space. They were specifically talking a little bit more about the physician segment. But I guess, as we think about the decisions that need to be made for Stage 1, kind of where we are in that kind of ramp? And I guess, I'm just kind of wondering how are you guys sizing up the remaining hospital decisions to be made? I know some people are going with their incumbent or legacy vendors for Stage 1 and maybe they'll move on to Stage 2, but how are you guys sizing it up right now? What do you guys see, kind of what percentage have been made already?

Marc G. Naughton

Well, I think at this point, many people are looking to use their existing supplier to get to Stage 1, and that's something you can do even by automating the emergency room. That is not something that's going to get you beyond Stage 1 from a physician use perspective. So I think a lot of people that we talked to and we talked about on this call are using that as their strategy. There are still greenfields out there, and there are still people making decisions as to how they are going to get to Stage 1 and buy a new technology. But at this point, we could see people getting to Stage 1 using their existing supplier and then looking for other options. And that's one reason that we see an increase in our pipeline and strength going into 2012 as those decisions for some of our competitors are coming back into the marketplace. The good news is the that they'll have some funding from the stimulus State 1 dollars they've received. So it's not a bad market when they've got capital available to them through that, and they realize that they're going to need to change their technology supplier.

Kipp R.F. Davis - Barclays Capital, Research Division

Got you. Great. And then, just another quick one. I know you guys were kind of talking about second-order effects. So you've got folks that are already investing in a major clinical system. As you guys think about not even '12, but '13 and beyond, what are the main second-order effects that you guys are seeing drive client demand? I mean, is it ITWorks? Is it RevWorks? Is it DeviceWorks? I mean, it seems like DeviceWorks is working very well now. Is there something that you're really highlighting as early demand within some of those categories, as we kind of think about where demand's going to be driven from after the majority of decisions are made for Meaningful Use and people start to think about different options in terms of their healthcare IT journey?

Zane M. Burke

Kipp, this is Zane. I think there's 2 parts to answer your question which are: the first part which you've touched on which are the works and some of those elements and some of Jeff's comments around the DeviceWorks piece, so ITWorks, RevWorks, DeviceWorks in our core base. So that gives us a lot of growth opportunity. But also, we see a 5- to 7-year horizon for changes in the core EMR against our competitors as they stumble to deliver the solutions necessary. So we actually see robustness on both sides of the ledger. The second-order effects you could say are in our core client base, as well as in the competitive marketplace in placing new systems.

Jeffrey A. Townsend

I'll give you a couple of quick examples. For most part in the EMR space, the purchasing and the most meaningful use is around function. So you hear a lot about CPOE, and we've talked about that in the call for probably the last 2 years. As you move forward and everything is digitized, you now have conversations around diabetes or congestive heart failure. So conditions, being able to take and utilize all of the data in the system about that patient and apply a completely different level of decision support to coordinate care both across venues, as well as implement evidence faster. So that second-order effect is -- you're seeing now in Washington a policy change that says, "Here is I won't pay for" or as Zane mentioned, readmissions that occur within 30 days eventually may become your cost. So that's driving a whole new series of need to say, "How do I manage that patient once they leave the facility and make sure they don't come back" which is a whole another series of solutions that sit on top.

Operator

Your next question is coming from the line of Steve Halper with Stifel, Nicolaus.

Steven P. Halper - Stifel, Nicolaus & Co., Inc., Research Division

Just a question on the technology and device resale. Is it safe to assume that, that's pretty much short-cycle bookings? So you're booking them enough in the quarter and then those gets shipped or recognized right away? How does that -- just how's the rev rec work?

Marc G. Naughton

Yes. Steve, this is Marc. That traditionally would be what you would see in a lot of device resales. So you take the revenue upon shipment of the device. In some of our agreements, certainly CareFusion is an example, the revenue comes when the cabinets are installed. So there's actually a deferral between the time that the booking occurs and the time the revenue happens. And you'll see a little bit of that and the kind of gross margins in the backlog because you'll see things that have -- in our backlog that have some costs with them and some lower margins, which is a little different than you see in the past. But usually, those will be some time and certainly the 6- to 9-months time frame. But if it's not that type of technology, if it's more traditional, then those usually will flip either that quarter or the following quarter.

Steven P. Halper - Stifel, Nicolaus & Co., Inc., Research Division

Right. So could you take a guess as to how much of the device resale comes from a previous deferral?

Marc G. Naughton

I don't -- yes, I guess I really can't take a guess. I don't know that I have enough data points to tell you what the -- to try to do that analysis quickly in my head. I think you're -- we clearly are booking more of those in the quarter and then recognizing revenue from some that come in the past. So it's not a -- once again, it's not a significant period of time.

Steven P. Halper - Stifel, Nicolaus & Co., Inc., Research Division

Right. And my last question, and going back several years ago when you had these quarters of high hardware sales and it's dragged down the gross margin. You always used to talk about the productivity of the people who were doing the hardware resales and, yes, I remember that you used to talk about these people on a gross margin per employee perspective were among the most productive even though the actual margin is lower. Is that the same case on the device resale?

Marc G. Naughton

Yes, absolutely. Absolutely. The component of that, the activities that we have there can -- are highly leveragable from a headcount perspective. So it's the same story as it was in the past.

Operator

Your next question is coming from the line of Michael Cherny with Deutsche Bank.

Michael Cherny - Deutsche Bank AG, Research Division

I just want to dig in a bit on the physician side. Obviously, you set record quarter from a bookings perspective, including the 2 largest deals in your history. Can you just give a little more flavor in terms of what those types of customers? Are those customers that are affiliated with Cerner hospitals? Are these net new wins? I'm just trying to get a sense of where you're gaining the most traction, particularly in the physician market?

Zane M. Burke

This is Zane. Actually, Michael, it was actually across the board and, in fact, the 2 largest. One was a acute-care, an existing acute-care client, that was purchasing for the broad IDN. The other was a brand new footprint where they went ambulatory first, so a Cerner ambulatory first. So you just -- you're seeing it coming across the board. And our transaction count both from a small physician office all the way up to a very large IDN was very high.

Marc G. Naughton

And Michael, this is Marc. It's clear that the marketplace is looking for a single platform provider for both inpatient and outpatient. So that is a clear differentiator from what we offer the marketplace to what some other competitors might offer.

Michael Cherny - Deutsche Bank AG, Research Division

Perfect. And then just jumping back to the international, Marc. You gave some color on the U.K. Can you talk about some other geographies both from a -- either contribution in the quarter or new pipeline prospects that may stick out to you with regards to the last quarter?

Marc G. Naughton

Yes. I mean, relative to the globe, I think our opportunities very much mimicked the economic conditions of the very -- of the specific countries. So Western Europe, challenging economic conditions. They're not necessarily spending a lot. They're looking at new projects relative to healthcare IT. We see interests. The beginning of interest and the beginning of looking to do some types of procurements, but the money to fund those isn't there yet. I think on the flip side, we look at areas such the Middle East, Australia and Canada where the economies are doing fairly well. And we see some significant uptick and opportunities in those locations. So I think our global business will tend to very much follow kind of the economic trends that those countries are incurring. Our technology is going to be on the early WishList when they get to a point when they can start spending again. But right now, I'd say that the ones that are doing well are places where we're seeing a lot of opportunity.

Operator

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

Jamie Stockton - Morgan Keegan & Company, Inc., Research Division

I guess, Zane, first, a couple on the device resale business. Obviously, that's a hot topic. Would you say that the customers that you're dealing with and the types of equipment that you're reselling, that's it's broad enough and diverse enough that you comfortably expect this level of business to continue and to grow from here each quarter?

Zane M. Burke

Jamie, we're seeing -- the demand looks very strong. I think we're actually still relatively new in the relationship around the CareFusion side of that. And we've continued to grow that, and we were seeing a good momentum there. And I think there is more and more demand for those types of devices as we move forward.

Jamie Stockton - Morgan Keegan & Company, Inc., Research Division

Was it just a matter of time that caused it to really take off recently? Or was there any other dynamic that was in play?

Marc G. Naughton

Jamie, this is Marc. I think some of these relationships -- this is fairly new stuff for us. And it's not limited to a relationship with CareFusion. There's broad strength across a lot of the devices, especially when we bring in the iBus platform, the connectivity engine that we can provide. So you've got Smart Rooms. You've got all these other bunching of technology. In fact, our RxStation cabinets are doing very well in the marketplace. So it's a little bit of -- when you have our position with a client, they trust us. They know that they put their -- they're counting on us to get their automation right, and that makes it much easier for us to resell technology. We are able to resell technology that, that company stand-alone would have a difficult time selling into that client. So I think we're leveraging our relationship we built up over a number of years, but it's pretty broad. And I'd say from a demand standpoint, clearly, Q4 looks strong. It will probably have some level of strong quarters here, strong quarter there. There's going to be some variability just because of the nature of the business. What we'll try to do is, based on our forecast meetings that we do every quarter, give you a view as to what we think, and you'll be able to see it kind of from the revenue side.

Michael R. Nill

Yes, this is Mike. One other comment on that topic. I think the other item that's driving demand as we build out more solutions that take advantage of the technology, our fusion management solution integration of these devices into the medical record. That's what you're seeing. Acceptance and adoption of those solutions are really enhancing the clinical process. That's why you're seeing the growth in device sales increasing so rapidly.

Jamie Stockton - Morgan Keegan & Company, Inc., Research Division

Okay, and I appreciate that. Two more quick questions. Marc, on Australia, obviously, a lot of news recently around the potential to do a deal there. Are you assuming anything material in the fourth quarter for that?

Marc G. Naughton

Jamie, normally, when we're doing our guidance for bookings, we don't ever assume there's any large single deal that's going to be a huge contributor. As you know in the past, when we end up being significantly over our guidance, it tends to be driven by a couple of large deals happening. I don't think we have, particularly in this Q4 forecast, that is unique kind of compared to Q3 where there's one standout large deal that's in our number.

Jamie Stockton - Morgan Keegan & Company, Inc., Research Division

Okay. And then real quick, Zane, the Stage 2 decisions, I mean, when do we see those really start, do you think? That's my last question.

Zane M. Burke

I think you're beginning to see those Stage 2 decisions being made, and they will continue on to roll through.

Operator

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

George Hill - Citigroup Inc, Research Division

Marc, with respect to the physician practice business you had highlighted in the second quarter, net [ph] bookings for the first half of the year that were up 50% where they were versus the first half of last year? Are we at the point yet with respect to the size of this business where you might be able to frame up the size of the physician practice market with some metrics, how many docs, maybe revenue size or contribution bookings in the quarter?

Marc G. Naughton

George, it's still a fairly minor component relative to total bookings and other elements of the business. So that's the good news. It's continued opportunity for us, but it's still -- I still think it's a little early to be focused a lot on those numbers for the size that they're contributing to date.

George Hill - Citigroup Inc, Research Division

Okay. And then maybe next one. I have 2 quick follow-ups. Next one is, with respect to the device business, as you guys characterize it now, you've touched on this, I think, in kind of a couple of pieces. But what's the value add of buying it from Cerner? And what value are you guys contributing to the device resale process?

Michael R. Nill

This is Mike. The value is that, and many of these devices when they're sold independently, they have their own level of intelligence. But it's not -- that information is not being fed directly into the EMR. And we have capabilities within our architecture to interpret that data and help drive the clinical decision-making process, and our clients recognize it. There's tremendous value connecting the 2 together versus buying the 2 components independently.

George Hill - Citigroup Inc, Research Division

Okay. And my last one, I don't know if Neal is listening. And if he's not, I'll leave this one for Mike. Everything seems to be going great. As members of the investment community, what are we missing?

Michael R. Nill

Nothing. You guys have figured it all out. Things are quite great.

George Hill - Citigroup Inc, Research Division

Sounds likely.

Michael R. Nill

No, I think -- I mean, George, I think things are going well [indiscernible] and feel like strong pipelines of business. We're executing very effectively against that business. And we certainly do our best to try to convey what we see as the future to you guys on a quarterly basis. So it feels pretty good.

Operator

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

Richard C. Close - Avondale Partners, LLC, Research Division

Quick question. ICD-10 more discussion in and around that, can you guys just talk a little bit how you're looking at ICD-10 and the types of opportunities you think you can get off of that transition, please?

Jeffrey A. Townsend

Sure, this is Jeff. Probably at a high level, the one big lever is all of our clients will move towards a common release here, addressing ICD-10 across our entire solution family so one lever for us [ph] kind of independent IC-10 is within the next 12 to 14 months will have the majority of our client base all sitting on one single release, which is -- we're pretty excited about from an innovation perspective that we will be able to add some of these new solutions on, such as some of the power chart touch that Mike talked about consistently across the base without having to deal with those variabilities. Inside of both revenue cycle, as well as the medical records process, physician documentation is creating, I'll say, more interest or focus on those areas where coding occurs. It's not only a back-end process around dropping the claim, but it drives things more upstream such as computer-assisted coding. And where we see some of the newer opportunities is moving that coding to actually the point of care, point of decision and get it out of the back office. So that's where working with our clients, we see greater opportunities, but it is creating a lot of activity within the base, which is all good.

Michael R. Nill

Yes, and this is Mike. I'll add a couple of additional comments. As Jeff mentioned, it is a significant event that all of our clients will be moving to this release. And the release is -- all the code has already been developed to support the ICD-10 requirements, and we're fully prepared to...

Jeffrey A. Townsend

Because we have that, and there's countries that do ICD-10 already.

Michael R. Nill

Right. So it's not new to Cerner. But in doing so, we have a couple of opportunities here. One is to apply the best practices that we've accumulated throughout the years and bring our clients to a higher level of productivity and performance from our applications. And in turn, that will result in probably lower support burdens for organizations, so it will free up capacity to continue to advance our solutions.

Richard C. Close - Avondale Partners, LLC, Research Division

Do you see any benefit of ITWorks or RevWorks directly from the transition?

Zane M. Burke

This is Zane. I'd say there's a very large opportunity for the services to help our clients, and that's going to come in a number of forms. Or so it could come from a RevWorks, ITWorks type of a model or it could come from our clients contracting with us to provide additional services assistance because many of our clients need that kind of help, and we have that expertise and the bench strength to do that.

Richard C. Close - Avondale Partners, LLC, Research Division

Okay. And then just final question here, Marc. I think you mentioned a 20% growth in license and subs, subscriptions in the quarter, and then the 50% on the technology or the device side. I just want to be clear that those are year-over-year numbers? And when we look at the year-over-year change in systems sales, I think it's like $55 million. You would still put a majority of that year-over-year change on the license and subscription, wouldn't you, in terms of the revenue contribution?

Marc G. Naughton

Yes, we had significant contribution across the kind of the upside. And the revenue portion of that this quarter was tech resale but strong software revenue as well and systems.

Operator

Your next question is from Stephen Shankman with UBS.

Stephen B. Shankman - UBS Investment Bank, Research Division

I guess on the macro environment, it seems like hospitals are tightening their budgets and spending as we go into 2012, although I would add that's not really too apparent in your results so far. So is this a phenomenon where, yes, there might be tightening their budgets a bit, but IT remains at the top of their pecking order? Any color you can provide as to what you're hearing from your clients would be very helpful.

Zane M. Burke

This is Zane. IT is absolutely at the top of the list. And there's so many things coming at our clients in terms of changes in the reimbursement and in the Meaningful Use elements that IT stays at the top of that list. And we're actually seeing no degradation from a budget constraint point of view.

Michael R. Nill

Yes, and this is Mike. More and more, as our clients are being driven toward quality outcomes, I mean, we -- it's a tremendous focus within Cerner to align our resources to drive that value for our clients. And I think they're more than willing to spend money on technology if it allows them to achieve their clinical quality goals and financial goals.

Operator

Your next question is coming from the line of Sebastian Paquette from Goldman Sachs.

Sebastian Paquette - Goldman Sachs Group Inc., Research Division

Zane, I think you mentioned some increasing traction from your key competitors. I was wondering if anything in that bake-off process is changing [indiscernible]?

Zane M. Burke

I think there is a realization of being able to hit the predictable timelines, the ability to get access to data is becoming a much more important element as we move forward and as people look to the realities of what's going to happen on the Medicare reimbursement elements. Those 2 things where it's a predictable outcome, the breadth and depth of solutions, and then the access to that data are so important that we are seeing -- we are starting to see that in turn towards that as we look forward.

Sebastian Paquette - Goldman Sachs Group Inc., Research Division

Okay. But in general, with the bake-offs of -- for a new contract. Are you starting to see some market share consolidation or actually production in a number of vendors being allowed to sit?

Zane M. Burke

They're all different. So it just depends on the situation in terms of what you see and how it's contracted for and the relationships that are out there. So it's situational and much more so than I think there's a marketplace trend. Although clearly, we have shown our capabilities and ability to deliver. And the results that we're seeing from our clients in Meaningful Use upfront are being noticed. And so we are in every conversation as it relates to that. And then there's a situational competitors as you look at the landscape.

Marc G. Naughton

This is Marc. I would also give Mike Nill and his team a lot of credit for bringing our solutions to a point where they are easy-to-use. We are competitive relative to going against our best competitors from just the look and feel and solution itself. And that makes it much easier to when you add that to the elements that Zane talked about to be successful.

Sebastian Paquette - Goldman Sachs Group Inc., Research Division

And then last question here [indiscernible] purposes there's been a lot of discussion around infrastructure de-bottleneck of your competitors. I'm wondering if that's actually a key competitive advantage and B [ph], if you actually seeing from your competitors not be able to start a sleep [ph]?

Marc G. Naughton

So the question was basically talking about implementation bottlenecks that some of our competitors have been talking about and whether our ability to install quickly and timely is a benefit.

Michael R. Nill

It's a huge differentiator in terms of being able to get to the speed to value and the predictability, and we have the largest consulting implementation workforce in healthcare. It's core competency of what the team has built. And absolutely, that predictability is part of that model and our ability to go deliver with that large and experienced consulting workforce. So you hit one of the big ones on the head.

Sebastian Paquette - Goldman Sachs Group Inc., Research Division

I understand that you're able to begin implementation. Are you actually seeing your competitors not able to start new contracts?

Zane M. Burke

We can't really speak to their ability. We're winning, and we start. I assume when they win, they try to start. We just don't see that happen a lot.

Operator

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

Atif A Rahim - JP Morgan Chase & Co, Research Division

Question on the ambulatory RevWorks contract that you won. Is this the inaugural contract on that front? And what does the business model look like, who are your competitors -- or who are the competitors you're going up against? What helps you win this deal? Just some more color in that business.

Zane M. Burke

This is Zane. All right. This is not an inaugural contract. This just happened to be one of the largest contracts I think we've done in this space.

Atif A Rahim - JP Morgan Chase & Co, Research Division

I meant with the physician side, sorry.

Zane M. Burke

On the physician ambulatory side, correct. So we actually have thousands of physicians using our business software services. And I'm assuming you're speaking of the pure business office services arrangement and not the pure ambulatory [indiscernible]?

Atif A Rahim - JP Morgan Chase & Co, Research Division

Correct. Right.

Zane M. Burke

We have thousands of physicians using that model and it's a traditional revenue cycle based model and that's based.

Marc G. Naughton

So it's the services business, Atif.

Atif A Rahim - JP Morgan Chase & Co, Research Division

Okay. And the business model there, is it the straight percentage of collection that you compare this to? Or is it more sort of what you've done with RevWorks in the hospital side?

Zane M. Burke

That was more traditional straight percentage.

Atif A Rahim - JP Morgan Chase & Co, Research Division

Okay. Okay. And the competitors you run up against in that business?

Zane M. Burke

Kind of all of the standard people that are in there, across the board.

Operator

Your final question is coming from Donald Hooker with Morgan Stanley.

Donald Hooker - Morgan Stanley, Research Division

So you all provided some visibility into 2012. And I -- are you -- kind of when we think about bookings growth going into next year, I'm just trying to map out kind of the growth of the company over a longer period of time. Are we going to see that same kind of 25% or 30% kind of component of bookings being long-term in nature? Or is that going to kind of grow over next year? I'm just trying to map out in my head how this plays out kind of longer term.

Marc G. Naughton

This is Marc. I mean, just to be clear, we've had -- kind of our average percent from longer-term bookings in that 29% kind over the last 12 months. Actually, this quarter, 26%. It was a little bit below that. I think it's reasonable to assume we are going to continue kind of in that range. We expect certainly to see some impact from ITWorks and revenue works and see those deals start to come in, as well as strength in the rest of our businesses. So I don't know that I would grow that percentage significantly, but I think it's going to be one that's going to still kind of hover around the 29% to 30% range as kind of average of quarter-over-quarter.

Donald Hooker - Morgan Stanley, Research Division

And bookings continues to grow in your mind next year, sort of in line with revenues?

Marc G. Naughton

We would expect to see bookings growth. I mean, we don't give -- obviously with this call, we kind of less consensus as our view something we give on a quarterly basis to make sure we can provide the most up-to-date information. But clearly, with the opportunities we see clearly with our enhanced pipeline, we would expect to continue to see strong bookings performance.

Donald Hooker - Morgan Stanley, Research Division

Finally, I'll wrap it up with the -- I got to ask the balance sheet question. You have a lot of cash. I know you've sort of talked about how you think about using that going into next year. I mean, any incremental thoughts?

Marc G. Naughton

We continue to look at opportunities, to be opportunistic. We think we're starting to see the demarcation between the successful companies going forward and the ones that will be less successful. And I think that's probably becoming more apparent to some of those companies. So there may be opportunity to do an acquisition. That clock is ticking, though. We're getting very close to the point, as we've discussed previously, that, that will not be as attractive to us. We're just go and compete in the marketplace and win deals. And at that point when we make that call, we'll certainly look at what other options we have for that cash up to and including to return to the shareholders at some in some form or fashion. But we're going to continue to look at ways to invest in our business first given the choice.

I want to thank everybody for being on today. We're very pleased with the results of the quarter, and we look forward to a strong Q4 as well. Now thanks for coming in, and have a good evening. Goodbye.

Operator

Ladies and gentlemen, thank you for your participation in today's call. This does conclude the presentation. You may now disconnect. Have a good day.

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