Last year, the Kansas City Royals won the world series for the first time since 1985. Another Kansas City institution, Cerner (NASDAQ:CERN), which has been thought by some to have been struggling a bit for the past year, is trying to get back on top of its division. Cerner is by far the largest publicly traded specialist vendor in the healthcare Information Technology (HCIT) space. To carry the analogy a bit further, the leading team in the HCIT has been Cerner. Cerner is big, one of the industry pioneers and has recently hit what have been described as some "air pockets" in terms of demand. Jonathan Bush, the CEO of one of Cerner's major competitors, athenahealth (NASDAQ:ATHN) (and also a cousin of the former presidents), has proclaimed loudly that Cerner and its largest direct competitor, privately held Epic Healthcare, are going to "collapse like big black swans."
The reason for the disparagement is pretty straightforward. athena's technology for the HCIT space is based exclusively on the cloud while both Epic and Cerner can be thought of as legacy vendors that have some cloud-based applications but still derive much of their revenues from traditional on-premise software. Another potential competitor in the league is Veeva (NYSE:VEEV). Today, Veeva sells CRM solutions within the pharmaceutical industry and its Vault product provides content management solutions across the healthcare space but it has suggested that it can and will enter the HCIT space more directly with a cloud product over the coming years.
The purpose of this article is both to focus on whether or not there is any significant likelihood of Cerner "collapsing like a big black swan." and if the company can resume its steady growth pattern that allowed it to enjoy a premium multiple for many years. By definition, a black swan is a metaphor that describes an event that comes as a surprise and which has a major effect that is rationalized after the fact with the benefit of 20/20 hindsight. The advent of the cloud in the HCIT space is hardly a surprise. It will have a major impact and it will be well to consider how Cerner is preparing for the transition.
In addition to athena and Epic there are hosts of other competitors in this space from IBM (NYSE:IBM) and McKesson (NYSE:MCK) to much smaller vendors that have best of breed, point solutions. Other significant vendors that are not household words include companies such as CareFusion (NYSE:CFN) and Leidos Holdings (NYSE:LDOS). While it is not really feasible to review all of the competitors and to determine if any of them are the culprits in Cerner's recent spate of "air pockets," I will try to take a look at some salient elements within the competitive landscape.
Like the shares of many enterprise software vendors, Cerner shares have been under pressure for several months now, having retreated from $73 at the end of July to current quotes in the low $50 range. The shares have dropped by 12% in the last two weeks mainly as a function of the company's disappointing bookings for the company's December quarter and bookings guidance for 2016. Competitor athena is down by 25% since the start of December with much of that move occurring just this month. Competitor McKesson, which is really a giant in the healthcare space that is far more than just an HCIT vendor has lost 28% of its value the past six months. Self-evidently, owning stocks in the overall healthcare space has not been a move towards financial health over the past six months or so.
Cerner was founded by Neal Patterson and two colleagues from what was then Arthur Andersen, a large accounting firm that was the parent of Accenture (NYSE:ACN) in 1979. The company actually was not originally a software vendor - there were almost no application software vendors in 1979. Cerner delivered its first HCIT software in 1984 and has grown steadily since that point. It developed a technology that is known as Health Network Architecture (HNA) that is still one of the core foundations of the company's product suite. Subsequent to the release of HNA, the company introduced Millennium, a platform technology that allows users to add modules that integrate into a unified system. Millennium was a factor in accelerating Cerner's growth. Many of Cerner's current products are still based on Millennium technology. The company's revenues quadrupled in eight years through 2005.
Along the way, Cerner has had its share of unfavorable publicity. Most infamously, there was a memo from CEO Patterson to company managers that threatened the staff with dismissal and loss of benefits because of the fact that people were not coming to work before or leaving after standard business hours. The report was written in exceptionally earthy language and was denounced as totally inappropriate. In addition, there have been some botched implementations and some biased research that the company has paid for which have misstated the actual benefits of implementing HCIT systems. Some of the lawsuits, while not catastrophic, have been costly and embarrassing. Attempting to automate the record keeping of community hospitals that have limited IT expertise is inevitably going to lead to some controversies and some failures.
To a certain extent, Mr. Patterson has been a lightning rod for controversy. In 2010, after a series of apparently vocal disagreements, the company president left Cerner and for several years, Mr. Patterson was both CEO and COO as well as Chairman. A new president was finally appointed in 2013. Mr. Patterson, now 67, remains the company's CEO and Board Chairman. Cerner acquired Siemens Health services for $1.3 billion early last year. More on that later.
Cerner probably has one of the broadest suite of solutions in the HCIT market. It would be tiresome at best and perhaps counterproductive to discuss all of the solutions and lines of business that the company offers. Just as an example, the company offers no fewer than 33 modules for Hospitals and Health systems and of course these solutions nowadays are offered both for desktops and on mobile devices. The company was a pioneer in developing the healthcare data warehouse where it competes against Teradata (NYSE:TDC). It offers all kinds of operational analytics where it is obviously going to compete against IBM. It has 10 products that target physician practices and procedures.
Undoubtedly, the company's clinical and financial integration systems generate many of the controversies in which the company has been involved over the years. The fact is that every hospital around the world is looking to maximize their revenues by insuring the right patients get billed for the right services. Almost all hospitals today either have or are trying to acquire what are known as Electronic Health Reporting agnostic revenue management solutions.
There is really little controversy that the market for what Cerner sells is vibrant and growing. Just one example - Cerner won an enormous deal with the DOD that aggregates $11 billion over 10 years to replace the Department of Defense HER system in 55 hospitals and 350 clinics as well as in mobile venues such as ships and submarines. (It should be noted that the procurement, while based on Cerner EHR technology, is for an end-to-end solution and as such other vendors including Leidos, Accenture, Henry Schein (NASDAQ:HSIC), and Intermountain Healthcare, a non-profit and a host of smaller business, will all get a piece of the $11 billion procurement.) I cite that example because supposedly the market for DOD IT projects is exceptionally constrained these days and vendors selling everything from storage hardware to advanced technology contracts have moaned about their inability to get the DOD to open the procurement spigot. An award of this magnitude might suggest just what the priorities are in the overall IT world and how large is the potential for the HCIT market.
Most recently, the demand for HCIT was bolstered by the stimulus program. While the stimulus program was supposed to be about "shovel ready projects" in fact a part of it concerned very strong incentives and subsidies for hospitals to automate their patient records and to install electronic systems to monitor billing, treatment and outcomes at some significant level of detail. It is hard to ascertain how much demand was shoved forward by those subsidies, which have finally ended but overall it doesn't seem as though there was much shifting of demand that is now being paid for.
I'm simply unable to discuss the competitive factors in the space at any but the highest level. There are literally thousands of HCIT vendors who sell against Cerner and many of them partner with Cerner as well depending on the specific situation. The most comprehensive service that reviews the vendors in the HCIT space is an organization called KLASresearch. The latest KLAS report suggests that Cerner is at the top of the competitive pile when it comes to recognition and interest globally due to the company's size, strong functionality and its flexibility in contracting and implementation. The list of product markets that's tracked by KLAS is truly mind-boggling. The company gives out "Best of KLAS" awards in 90 categories of healthcare software products. As it happens, Epic Healthcare wins in more categories with Cerner and athena in second and third position, respectively.
I think it is reasonable to say that technology is unlikely to be the gaiting factor in the near term within the HCIT space. The vendors would all seem to have technology that is "good enough." The differentiators are going to be price, sales execution, post sales implementation and service capabilities and breadth of footprint rather than whose solution in a specific sub-market has better perceived functionality.
It is obvious that athena has a far more web-centric set of solutions than any other significant vendor with a broad HCIT platform. Cerner certainly has a full suite of cloud offerings and over time it will doubtless become more cloud-centric. In general, HCIT has been slower than some other applications to move to the cloud due to security concerns. Those concerns seem to be abating.
The other basic issue in terms of the cloud is interoperability. Neither Cerner or Epic is particularly interoperable with athena. Obviously, there are competitive motivations behind that technology decision but in whole or in part, the issue of interoperability has retarded cloud deployment. Overall, from what I can read, Cerner, despite its use of a hybrid cloud-hosted platform, is good enough for most users when it comes to its cloud capabilities.
Regardless of Cerner's position in the cloud, it is true that athena is growing more rapidly in percentage terms than is Cerner. The consensus revenue growth rate for athena is forecast to be 20% this year and the consensus revenue growth rate for Cerner is forecast to be 13%. But the fact is that athena is less than a quarter the size of Cerner. Even if athena continues to grow at twice the rate of Cerner as is forecast for 2017 by the consensus, it would be a long time indeed before the market share gains of the former would visibly impact the revenue growth of the latter.
Whatever may have caused the so-called "demand air pockets" that plagued this company earlier in 2015 and may have led to its disappointing bookings guidance, I think it is fair to say that neither the health of the HCIT market, the impact of the cloud on-demand for Cerner's solutions or Cerner's company's specific competitive positioning was a major factor in impacting growth last year. Indeed, I don't really think that growth was an issue for Cerner last year - what was an issue was growth perception. And I think that's important as it suggests to me that there is nothing intractable or systemic that is going to prevent Cerner from resuming a measured and consistent growth trend in the future.
So what then did drive the somewhat disappointing results that Cerner posted for 2015? Cerner had little organic growth for the year and it did miss initial revenue expectations by 10%. I should at this point remark that everything is relative. Overall revenues for Cerner reached $4.4 billion, which was a significant increase from the prior year even though the Siemens merger accounted for essentially all of the increase. EPS, which increased from $1.65 to $2.11 was up by 28%, much closer to the company's initial forecast. And both operating cash flow and free cash flow showed strong trends in the latest reported quarter reflecting much better execution in terms of collecting receivables although there is still work to do to reduce DSO to the levels that had been consistent at around 66 prior to the Siemens merger.
So I suppose the question has to do with just this - why did Cerner miss its revenue targets significantly if overall HCIT demand remained unchallenged, if Cerner's competitive position didn't deteriorate and if the cloud was not a significant issue for this company in terms of its revenue streams? And the simple answer, I think, is what is meant by growth? No, I will not try to reprise the act of one former president who used some legalistic definition of the word "in a vain attempt to exculpate himself from significant ethics charges."
It wasn't all that amusing back in 1998 during the Clinton testimony, and it is even less amusing these days for obvious reasons. But the fact is that the Cerner enjoyed massive bookings growth last year even after factoring in the assumed impact of the Siemens merger. In fact, bookings growth was so strong and so much above traditional patterns that it has led to the company moderating its bookings forecast for the year, which in turn has been a significant factor in the disappointing share price performance.
Just to reprise the record for readers not familiar with the specifics, bookings dollars hit an all-time high of $1.59 billion in the September quarter, which was no less than 44% growth for the period. Bookings in Q4 dropped to $1.348 billion, which still was 16% growth but $100 million below prior guidance and the first time in four years that the company had missed its bookings guidance. But the market can be unforgiving and some observers and investors have put together a scenario in which the company missed revenue targets for three quarters - although dramatically exceeding bookings targets over that span, and then had a quarter of missed bookings targets, although revenue was actually a bit of an upside. The company then provided what was felt to be disappointing bookings guidance for 2016, although it increased its EPS and revenue targets for that period modestly.
So the real issue wasn't really the success of the sales force in selling the product, it was converting the bookings into revenue at historical rates. And another issue is why did the company lower its booking targets for this year from what analysts had previously anticipated? Cerner has 24 analysts who cover the company and provide forecasts and all of them have attempted with more or less success to try to provide a reasonable scenario for the disconnects that one might see in the numbers.
For what it is worth, I think the backlog numbers are answer enough. Organic Cerner revenues grew minimally last year, perhaps a bit more than minimally in constant currency, and the backlog jumped by more than 40% as reported and more than that in constant currency. As a corollary, Cerner had significantly greater growth in what it calls long-term bookings in 2014 such that the amount of current backlog available to be converted to revenue was far less than normal at the start of 2015. Not only is the word "growth" not as straightforward as might be thought, but when it comes to revenue in a specific time period, not all bookings are created equal.
It is certainly fair to say that when it came to providing guidance, Cerner and its financial management simply messed up. But the mess up really conceals the health of the company's business despite the need to cut revenue growth targets for most of the past year. It seems reasonable to conclude that whatever else was happening during the period, real growth at Cerner wasn't slowing down meaningfully or at all.
Another issue is of course the ultimate impact of the purchase of the Siemens HCIT base. For some years now, Epic Systems has been attempting to target the Siemens base and by all accounts that effort was a reasonable success. Indeed, had that not been the case, there is no way the deal with Siemens would have happened at the price that it did - no one would sell a growing business in the HCIT space for just a bit more than 1X trailing revenues. So, it was inevitable that a certain amount of the Siemens base would go to Epic - the question is how much.
It is probably not unreasonable to believe that some inherited consulting revenue ultimately went to Epic during the period and was a factor in last year's revenue miss. How much of a factor is simply not determinable at this point. Like all mergers, there will be things that go well and things that constitute problems. All early indications are that Cerner is maintaining a high retention rate of its Siemens customers who are migrating to the Millennium platform.
But it would hardly be surprising given the magnitude of the numbers to suspect that some of the revenue miss last year had to do with Epic takeaways of some installed Siemens customers, particularly in the consulting sphere. And it seems to me, just based on the company needing to reduce quarterly revenue estimates three times in a row in the wake of the Siemens acquisition that there was some significant misunderstanding by financial management of the dynamics of the acquisition and of the composition of the company's backlog.
The Investment Case and Cerner's Valuation
I think it would be surprising if companies in the healthcare IT space didn't have high valuations that might put off many investors from taking a look at companies in the space. The HCIT space can, in some ways, be thought of as the Eden of the tech investment world. It enjoys steady and consistently rising demand, the customers are incredibly sticky because of the complexity of the systems and the vendors have one of the best "land and expand models" ever conceived of by man.
ATHN has a P/E of 72X 2016 consensus estimates and an EV/S of about 5X and that is in the wake of the 35% share price decline since the start of trading this year - of course, it is a cloud vendor and bookings are growing at 30%-plus. And the comparable figures for Cerner are that it has a forward P/E of 22X and an EV/S of 3.6X. No one is trying to suggest that either of those two ratios constitutes an extreme bargain, but compared to long-term historic valuations or even the valuations the shares had less than a year ago, this is about as good an entry point as has been seen into the shares of this company in a long time.
Cerner's bookings growth for 2015 was no less than 28%, pretty much in line with the numbers at athena for the period and backlog jumped 27% for the year. The forecast for bookings growth is flat in Q1 and "some growth" for the full year. Cerner is a large company and it is not going to be able to grow bookings at a 28% rate for any extended period.
Management said that nearly 80% of the guided revenue is scheduled to come out of the backlog and further commented that it could deliver its revenue guidance even if bookings growth for the year was flat. Presumably the ills of the company's financial forecasting effort have been addressed.
I think that most of all the investment case for Cerner is predicated on the fact that the valuation compression of the past year has been predicated on looking at the wrong metrics. Yes, revenue did miss expectations for three out of the four quarters but that wasn't a function of demand, it was a function of the kind of bookings that went into backlog the prior year coupled with a bad read on what kind of bookings would take place in 2015. Cerner would be one of the great investments of all time if it could sustain 28% bookings growth even if it came with massive backlog growth. While it may seem that the combination of missed revenue expectations and missed bookings last quarter and lower bookings guidance for 2016 are harbingers of lower growth, a careful reading of the company's financials suggests that this is not the case at all.
Is Cerner's 12% growth in reported revenues worth a 22 P/E. Is it worth an EV/S of 3.6X? I should point out that subscription revenue increased by 76% to $388 million last year. As I have pointed out in other articles, subscription revenues inevitably lead to understated total revenues although in this case the magnitude of the numbers probably suppresses the reported growth rate by no more than a couple of percent.
I think that the reason the valuation metrics support the share price and provide reasonable upside given a less erratic market for enterprise software vendors is the visibility and the stability factors. Most enterprise software vendors are really at the mercy of the capital spending God. The correlation between capex in the broad economy and revenue growth for enterprise software is quite high and probably has and will continue to increase over time.
The correlation here is far less - even the "for-profit" hospitals do not buy HCIT as part of some capacity-based decision that is tied to macroeconomic conditions. I imagine that there is some room for margin improvement as well. The G&A line ballooned by 54% last year in the wake of the merger with Siemens. It would seem that there would be a high probability that there will be some economies to be anticipated in those expenses and even the growth of R&D, which was 38% last year is highly unlikely to sustain growth above revenue growth in future periods.
Stock based comp. is relatively low for this company compared to many other software vendors. Stock based comp. was about 16% of free cash flow and about 5% of non-GAAP operating cash flows. I think that Cerner, despite the weak start to its share price this year, has one of the better appreciation potentials in the mid-cap enterprise software world.
This has not been the happiest of new years for the holders of most enterprise software vendors. Cerner shareholders have nothing to cheer about either with their shares declining more than 15% year to date and by 24% over less than four months. For a company with a beta of 1.1, those kinds of moves are really outliers.
While some of the downward move is obviously a function of beta, much of the downward move is a function of misunderstood metrics regarding growth. Last year WAS NOT a slow growth year for Cerner. The growth of 28% in bookings coupled with a 40% increase in backlog are not hallmarks of a company having trouble in closing business. In fact, I think it unlikely that Cerner will ever again grow that fast absent a major acquisition and bookings are by far the best indices of growth that can be considered.
The fact that Cerner had a difficult time in converting bookings to revenue may have been excruciating for analysts and less than pleasing to investors but the dichotomy will be erased in short order, I believe. Indeed, given the level of the backlog, which ended the year at $14.2 billion vs. the revenue forecast for this year of $5 billion, it is not all that impossible for the company to exceed its forecasts.
Despite all that has been written on the subject, Cerner is maintaining its competitive position. Yes, athena is growing a bit faster from a much lower base, but overall Cerner remains one of the largest players in HCIT and it won the biggest deal that was up for grabs in 2015. The company does have a cloud strategy, it has a huge product footprint and the overall market for HCIT continues to grow steadily. The company seems to have gotten the acquisition of Siemens under control and partially as a result cash flow from operations was quite strong in Q4 and free cash flow increased significantly as well.
The company has achieved decent operating margins and their growth is really not part of the story. That being said, when I look at the increases in G&A and R&D last year, I do think it conceivable that the company could have some meaningful although not huge in operating margins.
Consistent growth, an entrenched market position, decent cash flow generation and a relatively compressed valuation. I think that Cerner is one of the better GARP stories in the enterprise software space. Investors ought to take advantage of the current multiple compression. The growth premium will presently return.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.