Recent Pullback Belies A Strong Growth Company: Key Takeaways From Cerner's Q4 2015 Earnings Call

| About: Cerner Corporation (CERN)

Summary

Cerner reported strong financials for 4Q15 and full year 2015. The company anticipates the strong growth to continue in 2016.

Health Care Information Technology is a rapidly expanding market and is expected to reach $100 billion annually by 2020. In this market, data will be king.

Cerner uses a "Camel's Nose" strategy to initiate and develop comprehensive, long-term client relationships and displace competitors.

Cerner also places a heavy emphasis on R & D that provides the company with competitive advantages based on both quality and comprehensiveness of product and service offerings.

On Tuesday, I published an article that discussed both the growing health care information technology (HCIT) market generally and Cerner Corp (NASDAQ:CERN) specifically. On Tuesday afternoon (2-15-2016), Cerner released 4Q15 results and held an analyst teleconference to discuss not only quarterly and full year 2015 results, but also to provide guidance for 2016. Here are some of the highlights, as well as the read through for investors.

Financial metrics were improved across the board in 2015

- For the full year 2015, revenue bookings (i.e. contracted future business that has not yet been performed or booked as revenue) was $5.43 billion, which was an improvement of 28% over 2014 and included a surprise to the upside of $200 million more than Cerner had guided to through the year.

- Revenue backlog (i.e. cumulative total of contracted future business that has not yet been performed but is scheduled) was $14.2 billion at the end of 2015, which was significantly higher than the $10.6 billion backlog at the end of 2014.

- Full year 2015 revenue was $4.4 billion, a 30% improvement over 2014. Broken down by business segment, full year system sales revenue improved 36% year-over-year and full year total service revenue improved 28% over 2014.

- Broken down by business model for the full year: Licensed software grew 24% to $564 million; Tech resale grew 21% to $330 million; Subscriptions increased 76% to $388 million (largely driven by new clients from the Siemens Health Systems acquisition); Professional services revenue grew 13% to $1.24 billion; Managed services improved 56% to $858 million; Support and maintenance was up 35% to $976 million; and Reimbursed travel was down 19% to $73 million.

- Domestic revenue showed a 29% improvement and international revenue grew by 37%.

- Gross margins improved slightly from 82.2% in 2014 to 83% in 2015. Adjusted net earnings were $741 million for 2015, and adjusted EPS was up 28% over 2014 at $2.11.

- At year-end 2015, Cerner had $686 million in total cash and investments, a reduction from $766 million at YE 2014. The cash decrease was attributed to stock repurchases throughout 2015. Cerner's total debt was $605 million.

- Full year operating cash flow was $948 million and free cash flow was $321 million. Cerner had capital expenditures in 2015 of $362 million and expects capital expenditures to increase in 2016 due to construction of the new corporate campus in Kansas City, but expects to offset these additional expenses via growth in operating cash flow.

2016 guidance is strong

- Cerner expects full year 2016 revenues of between $4.9 billion and $5.1 billion, which would reflect a 13% improvement over 2015 at the midpoint. 80% of revenue is scheduled to come from the backlog. Full year adjusted EPS is expected between $2.40 and $2.50.

- Revenue and bookings growth will be solid, but also "lumpy" from one quarter to the next. Management made mention that two major pieces of business that were expected to close in 4Q15 will not likely close until closer to mid-year 2016. Zane M. Burke, company President said of Cerner's approach to new clients, "… this is an ultimate relationship play… you're playing for the long term. You're part of this organization's business. We become one. And so it's not subject to the similar kinds of end of quarter or those types of elements. It's just one of those things where it will happen - and it's never fun when we're reporting every 91 days." Mr. Burke's point is that looking at Cerner's bookings quarter to quarter is likely to give a skewed picture of the business as some quarters will book more than others as a natural part of the industry, even though the process is continually ongoing.

2015 was the best year for new business in Cerner's history

- In 2015, Cerner had 153 contracts over $5 million, with 102 of those being over $10 million. Year over year, this reflected 37% growth of $5 million contracts and 62% growth of $10 million contracts.

- Management talks about clients in terms of "footprints". Each client has a scale and scope to their system, and providing a service, such as Electronic Health Records (EHRs), opens the door to provide additional services, such as revenue cycle management or population health systems, to the rest of the footprint. Each footprint can be thought of as an autonomously contained system - a large health network will have a more expansive footprint than a single stand-alone entity.

- In 2015, Cerner signed more than twice as many new footprints as in any year in its history.

The Camel's Nose

- Cerner signs many new clients who have contracts for certain HCIT services with Cerner competitors. More times than not, the Cerner competitors do not provide the same scope or comprehensiveness of offerings as Cerner. Cerner uses these opportunities to "poke the camel's nose under the tent" of new footprints and to begin displacing the competition from the footprint over time.

- The two most universal types of health care information systems are electronic health records and systems and software that help manage the revenue cycle in a health care setting. Not every HCIT company that provides one of these products also provides the other, and virtually no other HCIT company has the breadth of HCIT offerings or depth of service as Cerner. So, Cerner will enter contracts with health care entities that have existing contracts with Cerner competitors, but when the time comes to renew the contract Cerner hopes to sway the client to move the contract from Cerner's competitor to Cerner. Any sane health administrator wants to minimize the total number of vendors they have to deal with while maximizing the value they can get from the relationship, so frequently Cerner ends up displacing competitors in this manner.

- Zane M. Burke, company President on the earnings call: "I think there's a great opportunity in a number of bases where client companies have either sunset their solution or they're trying to do upgrades to solutions and platforms to prepare for future elements, and there's just a lack of confidence in those companies' and organizations' ability to invest and deliver contemporary solutions… over half of the marketplace is basically up for grabs. Our success around penetrating the non-Cerner EHR base with our population health solutions and our CareAware solutions is very significant."

- Mr. Burke: "So there are still competitors that are sunsetting solutions. There are competitors that have not kept contemporary architectures, and they don't age like fine wine. And so those are going to become more and more at play in that. So I feel good about the EHR market."

Cerner's R&D investment is paying off

- Cerner management touts the $2 billion invested in R&D over the past 5 years, and with good reason. These investments have led to better performance for the "traditional" HCIT functions of electronic health records and revenue cycle management. More importantly, they have led to the differentiated products and services that give Cerner its edge over competition, such as population health, physician and clinician experience, consumer patterns, interoperability with other outside HCIT systems, etc. Cerner clients have access to ALL of these services (and quite a few more, including customized solutions) through a single vendor.

- The ability to offer a wider range of services than competitors is important, but one of the biggest values Cerner adds to client experience is in how its fully integrated products and services extend client capabilities via data collection and analytics across all of the different platforms on offer.

- Once again, Zane M. Burke, company President, on the earnings call: "Another highlight was that we were recently selected to support the health insights of a statewide Medicaid population. The state will use HealthIntent's (Cerner's population health program) enterprise data warehouse solution to gain insights and intelligence from claims and clinical information across the state's Medicaid population, which will enable them to manage outcomes at an optimal level. This is a new market entry point for Cerner and is an additional example of how HealthIntent expands Cerner's reach beyond our EHR base."

- Cerner management believes EHR systems are in the process of evolving from simple storage systems, to active, intelligent systems that facilitate identification of clinical best practices, provide better personalized medical care to individual patients, and better nail down unit costs and other measurements of the cost of providing care in order to facilitate more efficient allocation of resources.

- Population health programs will provide data on the health habits and risks for participants in order to provide participants with information important for their own health and also macro data to the program administrators that will assist with identifying broader trends and issues that will lead to more effective pre-emptive identification of risks and better proactive engagement in preventive measures. This will not only help hold health care costs down, but also improve participant quality of life.

- Revenue cycle programs will identify reimbursement opportunities, help drive efficiencies across workflows, and "provide true visibility into the quality of care being delivered". In other words, they help increase organizational efficiency, which will help health systems outperform their peers.

- Cerner has a significantly stronger cloud-based presence than their "primary competitor" (as management refers to, presumably, Epic), and they exploit this advantage with smaller, community health care entities.

- Cerner systems are built on an open-system that is designed from the ground up to be interoperable with other systems and to encourage and enhance collaboration with third party and client developers. So, basically Cerner is taking an Android approach rather than an Apple approach.

Consolidation is a growing trend, and not just in HCIT

- The HCIT market is scattered among many, many players at the moment, with over 50 companies generating more than $250 million in revenue in 2015, and each of the top 10 generating in excess of $1.2 billion. The HCIT market is expected to grow to over $100 billion annually by 2020. History says smaller market players get consolidated into larger players as markets evolve. HCIT will be no different. However, there is a twist.

- Not only will the HCIT players themselves be merging and acquiring, their clients, the health care systems and providers, will also be consolidating. This will have a major impact on competition among HCIT players. For example, health System A uses Cerner systems across the board. System A acquires System B, which uses Cerner's revenue cycle program, but also uses a Cerner competitor's electronic health records system. In this scenario, it's likely that System B will be converting their EHR system to Cerner in order to integrate the two HCIT systems into a single unified whole.

- Zane M. Burke, company President on the earnings call: "Consolidation in the hospital market has remained active, and this is creating opportunities for Cerner. In the past three years, Cerner clients accounted for nearly 50% of hospital buying activity, creating an opportunity for more than 100 new footprints. Consolidation is not isolated to provider markets, with payers and HCIT suppliers also actively merging in an attempt to attain scale to compete in the evolving health care market."

The Siemens Health Services provides new footprints

- The Health Services acquisition is providing new clients with expandable footprints. Health Service clients are migrating to Cerner products and services at a high rate, including 40 sites newly signed up for Cerner's revenue cycle system, and numerous new population health services, ambulatory business office, surgery services, etc. Since each client is unique and not every client needs every service or product offering, some Health Services clients are migrating to more Cerner offerings than others, but, by and large, they are strongly expanding their HCIT connections with Cerner.

Final Note:

For those who may not have caught this in the news this week, here is a link to a story about a hospital in Hollywood, California, that had to pay hackers $17,000 to prevent malware that had infected the hospital's computer system from encrypting all of the files and rendering them useless. While this malware was in the system, the hospital had no access to computer files at all and had to operate using pen and paper. This is an example of how important the IT function is in health care today. Without access to IT services, it is almost impossible for a hospital to function effectively, and yet such systems remain vulnerable to attacks like this.

To my knowledge, this hospital is not a Cerner client. I only bring this up to point out how important the IT function is in health care.

Disclosure: I am/we are long CERN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is not a professional or licensed investment or financial advisor and the preceding article is intended for informational purposes only. It is not to be taken as ”buy, sell, hold”, or other specific investment or financial advice of any type. Before making any investment/financial decisions, investors are advised to conduct their own research to their own satisfaction and are solely responsible for the decisions and actions they take- the author bears no responsibility for any gains or losses of any investment decision made of any type based on this or any other article written by the author.