Cerner Corp. F2Q08 (Qtr End 06/28/08) Earnings Call Transcript

Jul.22.08 | About: Cerner Corporation (CERN)

Cerner Corp. (NASDAQ:CERN)

Q2 2008 Earnings Call

July 22, 2008 4:30 pm ET

Executives

Marc Naughton – Sr. VP & CFO

Mike Valentine – Exec. VP & GM of U.S.

Jeff Townsend – Exec. VP & Chief of Staff

Trace Devanny - President

Analysts

Charles Rhyee – Oppenheimer

Bret Jones - Leerink Swann

Anthony Vendetti - Maxim Group

Ross Muken – Deutsche Bank

Richard Close – Jefferies & Company

Atif Rahim – JP Morgan

Sean Wieland - Piper Jaffray

Sandy Draper - Raymond James

Steve Halper - Thomas Weisel Partners

Dushan Batrovic – Cannacord Adams

Operator

Welcome to the Cerner Corporation’s second quarter 2008 conference call. (Operator Instructions) The company has asked me to remind you that various remarks made here today by Cerner’s management about future expectations; plans, perspectives, or prospects constitute forward-looking statements for the purpose of the Safe Harbor Provisions of the Securities and Litigation Reform Act of 1995. Actual results may differ materially from those indicated by forward-looking statements.

Additional information concerning factors that could cause actual results to differ materially from those in 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 SEC.

At this time I would like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation; please proceed.

Marc Naughton

Good afternoon everyone and welcome to the Cerner call. I will lead off today with a review of the numbers followed by sales and operational highlights from Mike Valentine, Executive Vice President and General Manager of the U.S. Trace Devanny, our President, will discuss our global efforts and our physician practice business. Trace will be followed by Jeff Townsend, Executive Vice President and Chief of Staff, who will discuss innovation. Neal Patterson, our Chairman and CEO, is travelling.

Now I’ll turn to our results, bookings revenue, operating margin earnings and cash flow performance were all at above expected levels and our outlook for 2008 remains strong. Moving to bookings our total bookings revenue was $404.2 million which is above the high end of our guidance range. Our bookings in the year ago quarter of $487 million included $98 million of UK bookings and about $20 million over-attainment related to hardware.

Adjusting for those items this quarter’s bookings are up 10% over the last year. Moving to backlog our total backlog increased 10% year-over-year and ended the quarter at $3.3 billion. Contract backlog ended the quarter at $2.7 billion which is 10% higher then a year ago. Total backlog and contract backlog reflect a $178 million adjustment related to the cancellation of the Fujitsu contract which I’ll discuss in a minute.

Support revenue backlog was $0.6 billion. Our revenue in the quarter increased 4% over Q2 2007 to $402.8 million which is at the high end of our guidance. The revenue composition for Q2 was $120.6 million in system sales, $109.7 million in support and maintenance, $161.8 million in services and $10.7 million in reimbursed travel. System sales revenue was down 7% compared to Q2 2007. This decline was expected and in our guidance due to the extremely tough hardware comparable.

As with last quarter growth in software was offset by significant declines in hardware revenue. We expect system sales to grow in the second half of the year as we now have the tough hardware comparable behind us. Services revenue which includes managed services and professional services grew 9% compared to the year ago quarter driven primarily by its strong managed services growth.

Our professional services revenue was up 1% year-over-year. The lower growth rate of professional services was a result of slightly lower billable headcount in the US and [less] services revenue in the southern region of England related to the contract reset discussions and subsequent exit of Fujitsu as a prime contractor. As we mentioned last quarter we are hiring in our US services organization and expect our growth in the second half of the year to improve.

Support and maintenance revenue grew a solid 12% reflecting our delivery on system implementations. Looking at a geographic view of revenue, our domestic revenue grew 6% year-over-year and our global revenue declined 2%. As previously mentioned the strength in hardware sales during the first half of 2007 was primarily driven by global hardware sales particularly in Q2. This tough comparable coupled with the lower services revenue in the southern region of England led to the lower year-over-year global revenue despite strong growth in most of our other global business models and regions.

We remain bullish about our global prospects and expect new global revenue growth in the second half of the year. Moving to gross margin, our gross margin for Q2 is 82.2% which is up 310 basis points from a year ago. The higher gross margin percent reflects the lower hardware sales and growth in software. This is also reflected in the system sales margin percent which increased from 57.3% in Q2 2007 to 62% this quarter.

We also had improvements in our support, maintenance and services gross margins which increased from 93.8% to 94.4% year-over-year driven by lower third party costs. These stronger gross margin percents again led to margin dollars growing faster then revenue with margin increasing 8%, well above the 4% growth in revenue. As we have indicated we view the 8% growth rate in gross margin as more reflective of our performance then the 4% growth in revenue given our gross margin neutralizes the impact of the fluctuating levels of third party sales.

Before covering operating expenses and earnings I’d like to provide a quick update on the status of the southern region in England. As most of you know Fujitsu who is a prime contractor in the southern region withdrew from contract [reset] discussions with the government in May. The government has publically stated its intention to replace Fujitsu with one of the existing prime contractors which would be BT who is our prime in London, or CSC who is a prime in the other three regions where iSoft is the software provider.

Until a new prime is named we cannot predict the impact it will have on us but we currently expect to play an ongoing role in the automation in the southern region. Note that our balance sheet currently reflects billed and unbilled receivables related to the Fujitsu contract that represents over 10% of total receivables. While there will be some period of time before Fujitsu and the government unwinds their contract and we settle with Fujitsu we currently expect to fully recover these receivables.

In the interim we have recently signed an agreement with Fujitsu to provide transition services for the eight trusts that have already gone live in the southern region. We expect this contract to provide a bridge until a new prime is named. In connection with the execution of this agreement we did receive a payment toward the outstanding receivable balance.

As I mentioned we also reduced our backlog by $178 million for bookings we had taken for the southern cluster but not yet recognized as revenue. Our expectation is that the future contracts in the region will result in bookings that are at least as much as this backlog adjustment.

Moving to operating expenses and earnings, our operating expenses in Q2 were $266.4 million before options expense and the third party supplier settlement mentioned in our release. This is up 6% over a year ago. Sales and client service expenses were up 6% with managed services growth being the primary driver. Software development was up 5% which is in line with expected levels. G&A expense was up 4% year-over-year. After having a large impact on G&A expense in Q1 foreign currency translation only had a $200,000 impact in Q2.

Moving to operating margins our operating margin in Q2 was 16.1% before options expense and the third party supplier settlement. This is an increase of 230 basis points over the last year. This quarter our operating margin was impacted by about 80 basis points due to approximately $20 million of zero margin revenue from our projects in England. We remain on track for our goal of achieving 20% operating margins in 2009.

Note that our path to 20% continues to include the assumption that we will be able to recognize margin on our UK contracts. We are making good progress on the work necessary to support margin recognition on our London contract and should be in good shape to begin recognizing margin by the end of 2008. As we continue to work through the accounting our current expectation is that that it will be a one-time catch-up of margin in the quarter we begin recognizing margin on the contract.

This is a change from our initial view which did not include a catch-up entry but instead assumed the deferred margin would be spread over the balance of the contract. In spite of this one-time margin catch-up our current expectation is that the ongoing margin will still be adequate to support our path to 20% margins.

The size of the catch-up entry has not been determined. We will break it out when it occurs and it is not included in our guidance. Given the status of the south region there is some uncertainty as to when margin recognition will begin in that region. However we expect to be able to leverage the work supported margin recognition on our London contract to support beginning margin recognition in the southern region not too long after a new prime contractor is put in place.

Moving to earnings and EPS, our GAAP net earnings in Q2 were $35.3 million or $0.42 per diluted share. GAAP net earnings include stock option expense which had a net impact on earnings of $2.1 million or $0.03 per share. In addition our settlement with a third party software provider related to our hosting business impacted our sales and client service expense by $8 million and net earnings by $5 million.

Excluding these items adjusted net earnings were $42.5 million which is 26% higher then our originally reported Q2 2007 adjusted net earnings of $33.8 million. One note on the prior period comparison recall that we had an R&D write-down and tax item in Q4 2007 that had a prior period impact and was adjusted in our quarterly results for Q1 2007, Q2 2007 and Q3 2007.

For Q2 2007 the impact of those items was a $4.2 million reduction to net earnings leading to Q2 2007 adjusted net earnings of $29.6 million in our release this quarter instead of the originally recorded $33.8 million.

Moving to EPS our adjusted EPS for Q2 2008 was $0.51 which is $0.01 higher then the consensus estimate and at the high end of our guidance range. On the third party supplier settlement, I’d like to provide some background and perspective.

As mentioned in our release we reached a settlement during Q2 with a third party provider of software related to the use of their software in our remote hosting business. The settlement included compensation for use of the software since inception of our hosting business. For perspective the $8 million settlement only represents about 1% of the more then $500 million of cumulative revenue generated during the period for which we are settling.

As part of the settlement we also agreed to purchase approximately $15 million of additional software license through 2009 which is well supported by the backlog in this business of nearly $1 billion. The additional license purchases will be amortized over the hosting period for each applicable hosting contract.

I’d also note that our tax rate of 35% was about 1% below our planned level. As required by FIN 48 the interest on an income tax refund we received this quarter was run through income tax expense resulting in a one-time reduction to our tax expense of about $700,000. As I’ll discuss in a minute we also had over $2 million more amortization then we expected in Q2 which more then offset the benefit from the lower tax rate.

Now I’ll move to our balance sheet, we ended Q2 with $291 million of cash and $102 million of auction rate securities. Total debt was $185 million. The $102 million on the balance sheet for auction rate securities reflects and approximately $4 million reduction from par value. We continue to view this impairment as temporary due to the underlying credit rating of the securities and our intent and ability to hold the securities until the market recovers.

As I mentioned last quarter the vast majority of our auction rate securities are AAA rated and backed by the US Government unlike many ARS that represent collateralized mortgages or corporate debt. I would also note that the $4 million temporary impairment does not impact the income statement but is reflected in comprehensive income on the balance sheet. We believe our $291 million of cash available, $90 million line of credit and free cash flow should more then meet the company’s cash needs.

Total accounts receivable end of Q2 at $398 million. Contracts receivable or the unbilled portion of receivables was $99 million or 25% of total receivables which is down from 36% last year. The decline in our contract receivable balance was driven by a few large balances becoming billable based on the contracts and a higher level of third party financing in the quarter. Third party financings were $29 million or 7% of the $426 million of total cash collections.

Our DSO was 90 days in Q2 which is down two days compared to last quarter. Operating cash flow for the quarter was $85 million which is up from $62 million a year ago. Q2 capital expenditures were $23 million. Capitalized software in Q2 was $18 million. Free cash flow defined as operating cash flow less capital expenditures and capitalized software was $44 million.

This compares favorably to the negative $5 million of free cash flow in Q2 of last year. Note that we do expect operating free cash flow to go down in Q3 from the record levels in Q2 but we still expect good free cash flow for the rest of the year. Year-to-date we’ve generated $47 million of free cash flow positioning us very well to meet our targets of $80 million to $100 million for the year.

Moving to capitalized software the $18.1 million of capitalized software in Q2 represents 26% of the $70.6 million of total spending on development activities. Software amortization for the quarter was $13.4 million resulting in net capitalization of $4.7 million or 7% of the total. On software amortization we had previously expected our amortization to increase beginning in Q3 with an [inaudible] release of Millennium. However we now expect that release to be available in early 2009. Due to the longer period of time between releases we identified a small amount of capitalized software that had become generally available and should begin amortization before the next Millennium release.

We triggered amortization on that software this quarter resulting in a $2.4 million increase in amortization expense part of which was a catch-up for prior quarters. We expect amortization expense to go back down by about $1 million next quarter compared to this quarter excluding the catch-up.

Upon the release of the next generation of Millennium in early 2009 we would expect to increase amortization expense by about $4 million to $5 million per quarter. This increase will be partially offset by the completion of amortization of amounts capitalized in 2003 which will reduce amortization by about $3 million per quarter leaving a net anticipated increase in amortization expense of $2 million per quarter.

While we had previously expected the larger release to go GA sometime this year the increase in amortization expense associated with the smaller releases starting a quarter earlier will result in our full year amortization basically being in line with what we expected.

Now I’ll go through the guidance, looking at Q3 revenue we expect revenue in the $410 million to $425 million range which is about 12% growth over last year. For the year we continue to expect revenue growth of approximately 10%. We expect Q3 EPS before options expense to be $0.55 to $0.56 per share. The Q3 guidance is based on total spending before options expense of around $270 million.

For the year we remain comfortable with current consensus EPS before options expense and the third party supplier settlement of $2.17 plus $0.01 over attainment this quarter leading to an estimate of $2.18. Outside of this guidance could be achieved if we were able to begin recognizing margin on our contract in London. Note that this guidance assumes we have no material negative impact for foreign currency exchange for the remainder of the year.

Our estimate for options expense for Q3 2008 and 2008 is approximately $0.03 and $0.12 per share respectively. For bookings, we expect bookings revenue in Q3 of $370 million to $400 million with the mid point of that range reflecting growth of about 8% over Q3 of last year.

In summary we are very pleased with the results in Q2 including exceeding the top end of our bookings guidance, delivering revenue at the high end of our guidance with an outlook for solid double-digit growth the rest of the year, continued progress on our margin expansion initiatives, strong earnings growth in excess of 20%, and record free cash flow position us very well for our full year of free cash flow target of $80 million to $100 million.

With that I’ll turn the call over to Mike.

Mike Valentine

Thanks Marc, good afternoon everyone. Today I’m going to cover sales, operational highlights, and some marketplace trends. From a sales perspective we had a strong quarter. While the top line still reflects a large year-over-year decline in hardware the rest of our business is performing well. In Q2 we did $404.2 million of bookings which is an all time high level of bookings for a second quarter that doesn’t include UK bookings.

As Marc mentioned earlier our results in Q2 last year included $20 million of hardware over attainment. Our growth against Q2 of last year adjusted for this was about 10%. We had a good mix with 10 contracts over $5 million, seven of which were over $10 million. We continue to have good bookings contribution from outside of our Millennium installed base which 23% of contract bookings for new Millennium footprints coming in this quarter. Our [RFP] activity is strong and our pipeline is at record levels with the continued strong level of net new footprint opportunities in our radar. We also had another record level of activity in our vision center which eclipsed the all time high level set last quarter.

To put it in perspective year-to-date our client activity is up more then 40% in our vision center which is encouraging given that vision center visits have historically been a good leading indicator of sales activity in coming quarters. Operationally we had good quarter that included a wide range of solutions going live at a wide range of venues around the world.

Last quarter I indicated that we were going away from reporting conversion counts and transitioning to providing relevant color about our different operational groups and initiatives. This quarter I want to provide you with some perspective on our professional services organization as I think the breadth of services and quality of results is impressive.

The organization is the largest and most experienced health care IT focus consulting group in the world with over 2,000 associates that have an average Cerner experience of nearly five years. In addition 20% of our professional services associates have an average of nearly six years of clinical experience prior to Cerner which further distinguishes our experience levels from other health care consulting groups.

In addition to traditional implementations we continue to have great success with our solution center which accounts for more then 20% of our implementations around the globe. The solution center includes a structured implementation process, several steps of which are done at our headquarters where clients find an enhanced ability to focus on their project and have direct access to Cerner experts.

We now see some of our competitors are trying to copy this approach because of its strong reputation in the marketplace. In both our traditional implementations and solution center projects we continue to benefit from our bedrock tools that help automate much of the design and build stages of the implementation and our method in methodology that provides the structure that leads to predictable outcomes, something that is increasingly important in today’s market of more risk averse buyers.

These tools and methodologies have helped us improve the quality of our implementations at a lower cost of ownership for our clients while also contributing to consistently increasing profitability in our services business. As some of our client base begins to balance their focus between implementing new software solutions and gaining the full benefit of what’s already installed we are positioning a portion of our consulting staff to be the driving force behind the proliferation of good practices and other learnings harvested from our experiences.

Essentially the strategy here is to tap into our learnings across our client base to help our clients improve their bottom line and quality by leveraging their investment in Millennium. We see this as a growth opportunity for our services business and a real win-win with our clients. Overall I think the depth and breadth of our services organization is an important differentiator for Cerner particularly when compared to others who rely more heavily on third party consultants.

Looking at the overall marketplace we believe the market remains solid. We are still seeing most of our demand being driven by CPOE and surrounding solutions such as clinical documentation, decision support, and closed loop medication administration. And we are very well positioned with the most proven and comprehensive solutions in these areas.

We are also seeing a pick up in revenue cycle demand. We believe this is being driven by the regulatory and reimbursement changes that are emphasizing paid for performance and quality. Most of the benefits attributed to the revenue cycle functions require a sound clinical foundation to already be in place. We see our clients approaching this in a two-step fashion; clinicals first and then revenue cycle. Given this environment going forward we feel that we have a solid target market opportunity in the 170 plus clients in our client base that haven’t updated their revenue cycle solutions over the last 10 plus years and with some recent successful revenue cycle go-lives and increasing sales we are starting the see the momentum build.

As I discussed last quarter other areas of emerging opportunity that represent what we call white space include RIS/PACS, device connectivity, and additional services such as application management services or AMS, and transformational services. Both AMS and transformational services have been strong contributors to bookings so far already this year.

Looking at the overall market our clients continue to be in solid financial condition and we are not seeing material impacts from the credit market issues. There also continues to be bipartisan awareness and support of health care information technology. While we don’t believe there is any one piece of legislation that will create a flood of demand for health care IT, we believe the ongoing recognition that IT is an important part of addressing the unsustainable increases in health care cost will support continued strong adoption of our solutions.

With that I’ll turn the call over to Trace.

Trace Devanny

Thanks Mike, hello everyone. Today I would like to discuss some good progress in our international business and physician practice business. On the global front we had a very solid Q2. As Marc mentioned our global revenue declined slightly year-over-year primarily due to declining hardware sales. But that is not reflective of the continuing progress we have made or of our strong international opportunity going forward.

Specifically we had good bookings contribution from global and more importantly have a strong outlook for the second half of the year. We also had a positive year-over-year increase in profitability despite the lower revenue which is consistent with the revenue decline being driven by hardware. In The Middle East we had a very strong bookings quarter and very positive Millennium deployment success.

In the past 90 days three important sites have gone live in the [inaudible] of Abu Dhabi including Sheikh Khalifa Medical City, Cornish Hospital, and Tawam Hospital as part of the contract with the Abu Dhabi health service. I believe these successful solution go-lives position us well for continued success in this region.

In the United Kingdom while uncertainty in the south has captured some media headlines important progress is being made on the ground. We continue to grow the number of sites and solutions live in England and we now have a total of 67 sites and 433 solutions live which is up from 61 sites and 313 solutions last quarter. In addition we continue to be very pleased with our progress on the Choose and Book program as we continued to see increased utilization with the total number of bookings to date now approaching 10 million.

In fact today more then half of all appointments are now being booked directly. Beyond increased volume, solution is most importantly impacting the patient experience and recently respected doctors such as the Department of Health; Dr. Gillian Braunold has shared positive feedback about the benefits of Choose and Book with the British House of Commons. Choose and Book along with the flagship website NHS Choices is at the heart of the government’s push for enhanced patient choice.

We are pleased that this solution is becoming central to the NHS’s focus on high quality personalized care for patients. In addition to Choose and Book we continue to deliver results with our partner British Telecom in London. Royal Free Hamstead is now live with a version of Cerner’s 2007 release called LC1. Royal Free represents several firsts including connectivity to the national data spine, the use of Smart cards, and the integration to Choose and Book.

While there is still significant and ongoing work to be done there the opportunity to build momentum in the second half of the year is most promising. Indeed as the author of the NHS Informatics Review commented to the media last week, in London it’s starting to look very positive.

Finally in the southern cluster the agreement that Marc described earlier in the call allows us to continue to work with the live sites in that region to allow them to progress as the government transitions to a new local service provider or LSP. We are more committed then ever to seeing these trusts realize continued success in the near-term and of equal importance as they chart their IT strategies over time.

Jeff Townsend spent last week in England talking with government officials, working with our partners on several new initiatives, and interacting with key hospital trusts. Like my own visit in early July, Jeff’s view coming out of last week is that we remain very well positioned. We are committed to driving a demonstrable clinical benefit. We are focused on true value for the investments made and we believe suppliers who deliver on this objective will have the opportunity to play an active role in the program in the future.

Moving to our PowerWorks position practice business where we continue to make good progress. As I have mentioned in previous calls our biggest opportunity continues to be the leveraging of our large acute care base and ability to support both inpatient and outpatient environments on a unified architecture. On this front we continue to gain momentum with initiatives where acute care clients are offering PowerWorks to position in their respective communities.

Last quarter I announced the go-live of our first ambulatory surgery center using the PowerWorks solution. We are already building on this success as we recently signed another surgery center and a promising pipeline of additional opportunities continues to grow. In addition we signed a PowerWorks deal with our first ever critical access hospital this quarter and we expect to continue expanding the reach of the PowerWorks model to rural health, urgent care facilities and small specialty hospitals.

We are also gaining traction in our business office outsourcing solution as well. I’d also like to comment on a positive development for the overall physician practice market. We view the recent passage of the Medicare Bill into law as a positive. This measure delays a proposed 10.6% cut to Medicare physician payments and allows for 18 months of stable payments to the medical physician community.

Additionally the Bill will foster adoption of electronic prescribing by providing incentives for its use between 2009 and 2013 with penalties for not using it starting in 2012. Clearly this delay in reimbursement cuts helps physicians. We also then provide incentives for ePrescribe is an important positive statement. To align with ePrescribe incentives we have introduced a very low cost ePrescribe solution on a-per provider, per-month basis that can be purchased separate from our EMR.

This directly competes with the otherwise free ePrescribe offerings with the Cerner advantage of being connected and running in our PowerWorks EMR domain. This will allow clients to easily add other EMR components in the future as they become more comfortable with this new technology.

With that I’ll turn the call over the Jeff.

Jeff Townsend

Thanks Trace, today I’m going to make some brief comments on our CareAware platform and then turn it over for Q&A. In the second quarter we continued to advance our CareAware platform both from a capability standpoint and from a market awareness standpoint. The core principal around our CareAware platform is the premise that electronic medical records create a new digital medium for care delivery.

From there the entire delivery experience can be redesigned to include a contextual awareness of the entire experience well beyond the workflow represented on the screen. Our CareAware MDBus device connectivity solution allows medical devices to be connected to the EMR through a USB like plug-and-play connection. It is more then just connectivity as today these devices require a human interaction to adjust for the changing treatment or context of patient care.

Making the devices in the EMR aware of each other introduces a new paradigm in what’s possible. The level of client interest in this solution continues to exceed our expectations and in Q2 we signed several new clients and an expansion agreement with an existing client. We also continued to expand our library of device drivers completing another 100 new drivers which increased our library to over 250.

The second quarter also included good progress with RxStation, our medication dispensing units. RxStation has a strong differentiation in the marketplace because it is directly connected to the EMR turning what was once an island of information in an isolated workflow into a comprehensive workflow with a single source of truth. After our first implementation of RxStation production units in April we are now doing the second phase of implementation at that sight.

We also sold another new footprint in Q2 and have several more implementations scheduled in the coming months. Our pipeline remains strong and we believe we are well positioned for contributions from RxStation to accelerate after we complete implementations at our early doctor sites and create a strong reference base.

I mentioned last quarter that we planned to launch a unique marketing campaign for our CareAware suite of solutions including MD Bus, RxStation, myStation, and other solutions that collectively allow us to show a smart hospital room of the future and the complete redesign of the care experience. Because you have to see these solutions in context to understand them, we created the Cerner Smart Semi through a collaborative effort with Steelcase.

After starting in May the Smart Semi has already made more then 20 stops and we have 60 more scheduled in 2008 which represents an increase from our original schedule because of strong interest. We are averaging more than 100 clients at each stop including many C Suite executives from our clients and prospective clients.

In addition to the strong lead generation created by the Smart Semi we are seeing an add benefit of getting our clients reenergized about the potential for technology and their relationship with Cerner. In addition the media interest in the Smart Semi has been strong and many clients have used this as an opportunity to tell their story about using technology to improve patient care in their communities.

With that we’re ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Charles Rhyee – Oppenheimer

Charles Rhyee – Oppenheimer

You talked about the catch-up on the margin for the UK contract, can you go over that again and explain where—is it for the southern cluster or is it for the London cluster? I just wanted to get a better understanding what you meant and what we should expect.

Marc Naughton

It’s a good idea; prior to obviously the Fujitsu contract stopping the answer was the same to both. But relative to BT we continue to do our accounting work relative to ability estimate to get to the point where we can start recognizing margin. We continue to look to be on track to getting that done by the end of this year so we will begin be able to start taking margin at that time. As we’ve gone through the accounting its our expectation that there will be a certain catch-up so there’ll be a certain level of margin from the date the contract started to the date that we can begin recognizing margin that will catch-up margin to that point.

So there’ll be a one-time tranche of margin that would get recognized and then post that we would begin recognizing our margin on a monthly basis as we do the work just like under normal long-term contract accounting. That’s a little different then what our initial view was so we wanted to make sure people were aware of that. We haven’t quantified what that amount would be but we feel very good that relative to our path to 20% and the fact that we were looking in 2009 to having some of the margin from the UK helping us get there, that the go forward level of margin on the BT contract will be enough to support the 2009 view of the 20% margin.

Charles Rhyee – Oppenheimer

If I’m not mistaken the original assumption was that the margin that we were not recognizing under the cost recovery method from the start of the contract till the recognition point, that was going to be recognized ratably over the remainder of the contract.

Marc Naughton

Correct that was our original expectation as well and what we’ve discussed. As we’ve continued to go through the fairly complex accounting for these things, it is the guidance of our auditors that there will be some amount of catch-up. Once again we don’t, until we get that quantified we wanted to just preview that with investors. We don’t know if that will be a very large amount at all. Our expectation is its not going to be huge with respect to the entire contract.

But there will be some level of that and we wanted to preview that because the southern cluster and as we work through and a new prime is named and we contract under that new prime going forward actually this cut off will probably be fairly affective in that the prior period was under a revenue and expense approach, will get settled out as part of the Fujitsu settlement and then going forward as I indicated in my comments would think we would pretty quickly get to a margin recognition in that new contract in the south and then it’ll just be that margin on that new contract being recognized as costs are incurred over that period.

Operator

Your next question comes from the line of Bret Jones - Leerink Swann

Bret Jones - Leerink Swann

Just to make sure I understand with this southern region with the termination any profitability associated with the work that’s already been completed would have to be recognized right away?

Marc Naughton

Well the southern contract kind of just terminates and is kind of a separate contract that we will certainly be negotiating with Fujitsu and settlement on. We’ve taken revenue equal to expense so to date we have taken no profit there. Certainly as we go through our settlement discussions with Fujitsu we would look to be able to realize profit on that activity that we had. That would all be part of the settlement so rather then having a one-time margin occurrence as you convert from revenue equal expense to recognizing margin in that case you’ll have the Fujitsu settlement being the determinant of what margin would get recognized and that would be tied to the timeframe of the settlement occurring. And then you’ll have a separate contract which as I indicate we would expect to fairly quickly get to margin recognition. So in that case it’s actually going to be split between two contracts, one of which as part of the settlement will bring with it the potential for margin recognition in a relative lump sum but then there’ll be an ongoing for the second contracts which we would expect to see the margin occurring ratably. So we kind of will end up in the same impact for both contracts but they’ll get there through two different paths.

Bret Jones - Leerink Swann

On the financial system upgrade cycle that you kind of alluded to with revenue cycle an increase in interest and revenue cycle management, I believe at the HFMA Conference there was talk that there was supposed to be an expected new release of a financial system this fall, I was wondering if you could provide an update on that?

Mike Valentine

Relative to our revenue cycle solutions there were updates that were included in our 2007 release and we’ve implemented those updates in our install base. If that’s what you’re referring to it was essentially advancing the solution in the ProFit front as well as registration and scheduling.

Jeff Townsend

Most of the next big move forwards on revenue cycle will occur when we release the next iteration of Millennium 2007 which as I indicated in my comments will be early 2009. So what you may be referencing at the HFMA was more of our initial dates that we thought would be toward this fall, those will be now in the early 2009 which will be good for us because we’ll have the chance to review the code with our clients in our October Cerner Health Care Conference and that’ll give us some good insight as we go and finalize the code for release.

Bret Jones - Leerink Swann

The $8 million settlement for the third party software did that hit in the support and maintenance line for revenues?

Marc Naughton

The revenue would have come through on the client services line, its part of our managed services business so the revenue stream that it would have supported would be in the services line basically.

Operator

Your next question comes from the line of Anthony Vendetti - Maxim Group

Anthony Vendetti - Maxim Group

Do you have any sense for the timetable as to when the NHS will make a decision on this and if it is British Telecom that you’re working with them in London, is it your understanding that you would be the sub there?

Marc Naughton

Yes, obviously there’s hypothetical’s involved in your question and the discussions are ongoing. Certainly one of the scenarios that we talked about, it’s got to be one of the existing primes that take over. Should British Telecom be the prime that takes over given our implementations already in that region, it would be very logical for us to continue to expand in that region. There hasn’t been any timetable established by the government as far as when they expect to work through all this. I think they certainly want to get a resolution in the timing of coming up with the next year’s budget so we’d expect to make progress as we roll through the end of this year and into early next year. But I think there hasn’t been a timetable established. We’ll obviously provide updates as we learn more. The key for us is we have a transition agreement in place; we can effectively support those eight trusts that are up and running live in southern cluster today. But we certainly look forward to meeting some of the additional demand that we see in the south or people who have not yet gone live on Millennium.

Anthony Vendetti - Maxim Group

So the way you’re currently accounting for it, if you were to pick up the southern cluster and again would that just be upside to the way you’re currently accounting for it?

Marc Naughton

In essence the southern contract we had with Fujitsu is kind of now a historical document and it has related to it some receivables and a variety of payments that we believe we are due under the contract so that kind of stands alone. And to the extent we receive reimbursement in excess of what we have on our revenue equal cost level of receivables that would represent additional margin on that contract.

Going forward if we are selected to continue in the south which we certainly think is a strong possibility we will have a brand new contract, we would just backlog this quarter to take out what was left of the Fujitsu contract. So basically it would be just like signing a new contract going forward and the difference being that rather than being revenue equals expense for a long period of time on that new contract we think we’ll be able to leverage our British Telecom work and get to margin recognition more quickly which will really make it more of a normal long-term contract for us. Depending on our work share if it increased, that booking could be significantly bigger then what we originally had in the southern region.

Operator

Your next question comes from the line of Ross Muken – Deutsche Bank

Ross Muken – Deutsche Bank

Regarding the PowerWorks push you’ve made recently, obviously its been a very competitive market for long-term and you are definitely able to differentiate yourself by the folks in the acute care, but can you talk about just when you go into a standalone doctor’s office what the sale cycle looks like and what the competitive dynamic looks like there?

Trace Devanny

We’ve been talking about our PowerWorks physician office strategy now for a number of quarters and as we’ve said from the very beginning we think that with a lot of the activities going on around the Medicare reimbursement, a lot of the activities around some of our competitors we like the fact that we have the ability to put on a single platform both ambulatory as well as acute care facilities. So we sell, obviously it’s very difficult to sell to a single practitioner or even two to three practitioners. We perfected I think in large case an ability to do that via the internet. So phone work and our ability to show our system without showing up has kept the costs down and allowed us to continue to make progress in that very important part of the market.

We also have an important strategy relative to working with our clients and that’s where I think our biggest opportunity lies and that’s with the advantage we bring of our large IDM clients that oftentimes represent huge market share in a given MSA. Setting up that hub capability to connect all physicians within that given market service area has really been a positive for our business as well. So we like that space, we continue to make it a very important part of our subscription model and fully expect to continue to lead in that space.

Operator

Your next question comes from the line of Richard Close – Jefferies & Company

Richard Close – Jefferies & Company

Just curious on the backlog you said you pulled $178 million out is that correct? And that’s Fujitsu?

Marc Naughton

Correct.

Richard Close – Jefferies & Company

On receivables I think you said 10% of receivables should we be looking at the net receivables number at 398?

Marc Naughton

Net receivables at 398, we basically said it’s from a concentration view that it’s over 10% of that number.

Richard Close – Jefferies & Company

Just to be clear in talking about those numbers I think you mentioned that you have received some payment from Fujitsu in terms of this transition discussions, is the 10% receivables less that payment that you received or is that payment been received after the end of the quarter?

Marc Naughton

The payment was received after the end of the quarter.

Richard Close – Jefferies & Company

So that 10% now is lower.

Marc Naughton

The number that we ended the quarter with is lower then it was when we ended the quarter. Keep in mind that a fair amount of that receivable qualifies as unbilled. So that’s real key element here, we’ve incurred costs, recognized revenue equal to expense and under the contract had gotten to a point where we could invoice it in a normal terms. So that’s part of the settlement discussions obviously is what are we entitled to relative to payments on a contracted kind of stopped in mid term before some of the payment stream would have been triggered relative to that work.

Richard Close – Jefferies & Company

With respect to the system sales you mentioned hardware went down but you also realized some software growth can you elaborate maybe on the percentage year-over-year decrease in hardware and maybe the percentage of growth in the software in the quarter?

Marc Naughton

We don’t breakout the elements on system sales between those two items; we do at the end of the year talk about our [inaudible] and our license software business. So you’ll get more view of that as we head out of the year and give you annualized numbers. But the number in Q2 2007 was an all time record for hardware so it was very, very large.

Richard Close – Jefferies & Company

I guess I’m more concerned on the software growth side of things if you feel comfortable with where the software number is maybe versus where it was in the first quarter, are we seeing year-over-year growth possibly accelerate in software?

Marc Naughton

I think when you look at Q1 and Q2 we had good software growth and it was just in our expectations because we do our forecast we actually are forecasting stronger software sales. As you all recall in 2007 we saw an impact of the new release of Millennium 2007 and that did take some of the focus off of buying new software relative to doing upgrade projects. The good thing is we’re getting the upgrades done now in about 90 to 100 days so that’s taking much less focus and we are seeing more interest not only in our installed base from a license perspective but from new clients.

Our client development team which is focused only on new business is actually, has been building a pipeline for awhile and they’re now starting to execute on that. That coupled with some of the view that we have for software on the global side is making the last half of the year look pretty attractive from a pipeline perspective in software.

Richard Close – Jefferies & Company

Just to be clear, you said you had about $2.4 million in amortization expense higher then you were expecting, correct?

Marc Naughton

That is correct.

Operator

Your next question comes from the line of Atif Rahim – JP Morgan

Atif Rahim – JP Morgan

Could you just remind us how much had been booked for the Fujitsu contract when you initiated this contract and how much revenue has been recognized to date and then also if you could provide information how much you feel you’re entitled to at this time in terms of what could be the profit that comes in.

Marc Naughton

For most of those things we really can’t comment a lot especially on the last part as far as what we expect. We certainly feel very comfortable that the amounts that are on the balance sheet which are in essence equal to our expenses, are fully recoverable and we have not taken any reserve against that number. So we’re very comfortable in that amount. We wouldn’t want to presuppose what the settlement will be. We’ll certainly aggressively pursue our rights under the contract to be fairly paid for all the work that we did.

Atif Rahim – JP Morgan

On the rationale for excluding this software settlement related to the remote hosting business the $3 million that’s excluded for this quarter, I’m just wondering why that’s been excluded from sales and client services and then going forward the $15 million is going to be amortized is that also going to be excluded from your non-GAAP results as you report them or will that be included within the non-GAAP results?

Marc Naughton

Let me clarify that, the key for relative to that item was the difficulty with that was that the supplier of that software did not have a pricing methodology for people that had a hosting agreement so we spent a lot of time negotiating that and [has been] settled in Q2 for $8 million. As we went back and looked at the facts surrounding that settlement it looked like we could have potentially in hindsight accrued $5 million of that in Q1 and that would have all been hitting in any period from 2001 forward. So there was no material impact on any one period of that amount if you’d accrued $5 million Q1 and taken it backward, so it was alright to go ahead and recognize that $5 million impact in the initial view of what that could have been in Q2.

In Q2 when we did finally settle it after we filed the 10-Q which is kind of the cut off timeframe of whether something could have hit Q1, the settlement was $8 million rather then $5 million. So in Q2 you have what is in essence a change in estimate and under the accounting rule that change in estimate hits the period in which the estimate changed so that’s fully a Q3 number still relating to a settlement so that’s why it’s a unique item. Going forward we will take the expense related to the $50 million of software we’re going to be buying and certainly for all the additional software we’ll buy as we continue to see huge growth in that business. But that will all just be normal expense. The only reason that that $8 million is broken out is because it relates to prior period and everything else is future will obviously be included as a normal operating expense so we wouldn’t adjust it out.

Atif Rahim – JP Morgan

I was curious about the PowerWorks ERX module that you have, could you give us any idea on the pricing there? Not just for the EMR but the specific ePrescription that you talked about.

Trace Devanny

For the PowerWorks ePrescribe its $25.00 per month per provider.

Operator

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

Sean Wieland - Piper Jaffray

On the UK and Fujitsu help me understand what the process is of achieving a settlement with Fujitsu and the timing of this?

Marc Naughton

Remember we’re a sub so currently connecting for health and Fujitsu are working together on settling out their contract. They have a contractual relationship and so they’ve got to go through that work. We are certainly looking to push our timeline as quickly as we possibly can. The reality is it probably occurs sometime after they get their work done relative to settling out their contract. So current course and speed that occur first and then they’ll be able to focus their efforts on us getting ours settled.

To the extent we can accelerate that, we would but that will take a period of time and it will the time that it takes. Given the facts that’s fine, our key focus is being able to more forward and to be able to address the market that we see in the south and the transition agreement does help us do that relative to the existing clients and then we certainly look forward to the government also as they work to exit Fujitsu naming the new prime so we can get that really begin, getting them back on path similar to what we are doing in London.

Sean Wieland - Piper Jaffray

Do you expect to get a settlement with Fuji by the end of the year?

Marc Naughton

I’m not going to make any estimate of timing. When we know more we’ll let you but it’s still very early in the process so I’m not looking for anything near-term to happen but as soon as we get a better view we’ll let you all know but at this point we don’t really have any sense of when it will be completed.

Sean Wieland - Piper Jaffray

How many ProFit customers are you at now?

Trace Devanny

We have 33 live sites and we sold two more, I think our total is probably in the near 50 range.

Operator

Your next question comes from the line of Sandy Draper - Raymond James

Sandy Draper - Raymond James

On the software development costs, obviously the amortization went up but the total spending was down, is that more of a function, sequentially, is that a function, was there any abnormally high spending in the first quarter or what caused the total R&D or gross R&D number to come down sequentially by about $5 million?

Marc Naughton

What you’ll see in Q1 if you look back at 2007 Q1 to Q2 it’s just the payroll taxes. It stopped hitting, Q1 is fully taxed, Q2 is not so much so you’re going to naturally see kind of a $3 million or so decrease. I think that’s what you would have seen last year in the Q1 to Q2. Historically that’s what you’ll see. Probably the difference, the other million or so difference in the delta that you’re talking about would be related to just having a little bit lower headcount in the US, a little bit more in India. And then in Q2 we hire a lot of those people off campus in the US so to the extent that positions open up in Q2 we’ll save them open until we hire the person in from campus on Q3. So that could be $1 million, $1.2 million which will get you pretty much your difference.

Sandy Draper - Raymond James

So then you would expect the gross R&D number to build back up a little over the next two quarters?

Marc Naughton

It should be, we continue to work in India and put more resources there so to the extent that we are successful in doing more of that it will not build up as much but my expectation in Q3 it will probably be fairly similar to what you saw in 2007.

Operator

Your next question comes from the line of Steve Halper - Thomas Weisel Partners

Steve Halper - Thomas Weisel Partners

On ProFit it’s a product that you’ve been working on for a very long time, so what changed to account for this renewed momentum in the product. Do you think you’ve finally got it right?

Mike Valentine

I think a couple of things, in the comments I made earlier the, we see in our client base, the desire to have a solid clinical foundation prior to prioritization to dollars going towards the revenue cycle front. So specifically in our client base there’s really two types, the ones that make the decision and go with a big bang and do revenue cycle and clinical together and the ones that are deploying the clinicals first, getting a solid foundation there and then moving forward. And what I really see in front of us now is 170 plus clients in our client base that haven’t made a recent decision or an upgrade and are a great target opportunity for us.

So I just think the condition of the marketplace is evolving and our clients are maturing on the clinical front to the point where they would feel comfortable with approaching the revenue cycle side. At the same time I think we’ve advanced our solution over the years and the biggest things are really around our reporting and just the core workflow in the back office that have made I think the difference in clients being ready to move forward with the ProFit solution in our base. And I think that experience is going to get us lift outside of our base in a standalone market but we still don’t see a huge buying behavior in the standalone revenue cycle space but we expect it’s going to come at some time so we want to be ready for it.

Steve Halper - Thomas Weisel Partners

Regarding the accounting for the BT contract, you’re going through your accounting process that you need to do in order to recognize margin maybe by the end of this year but definitely in 2009, can you summarize what needs to happen there from an accounting perspective?

Marc Naughton

Really the key thing we’re working on is ability to estimate and going through and getting the detailed records and being able to show over cross periods of time what we estimated items would take relative to effort and time what they ended up appropriately taking and that’s done at very detailed levels. So we made a lot of progress as we were exiting Q2 and in the last 45 to 60 days so we actually, I’m more bullish on our ability to be looking at something the end of 2008 and have it in place by the start 2009.

Steve Halper - Thomas Weisel Partners

So is the goal really is to accurately estimate the undelivered elements of so this way you could recognize the profit on the stuff that you’ve delivered?

Marc Naughton

It’s really more related to the ability to estimate the time for any element of the contract. The implementation, any of the R&D work we’re doing, any of the development work, so it’s more broad then just specifically focused on those. That’s why its not something you can in a weekend and get done, you’ve got a lot of work to do, a lot of interviews to do, a lot of tracking, a lot of timesheets to review. Once again it’s a process, the good news is we’re kind of focused on what we need to get accomplished because this is a very complex area and there was a variety of things that we actually had to get through to make sure that getting this answer kind of completes the task. And so we I believe at this point are at that point and should be able to complete the work by the end of the year.

Steve Halper - Thomas Weisel Partners

So there are dollars being used here in terms of this component in order to be able to be in that position to capture the margin because your alternative is just to let it go and an indefinite amount of time before you could recognize the margin if you don’t go through the process is that the right way to look at it?

Marc Naughton

Well yes, software accounting has a variety of flavors, the first view we had of some of these UK projects when we were initially bidding on them was we were going to get to take all of the revenue on the last day of the contract. Fortunately the accounting evolved to get to the point of we could at least do revenue equal expense. And so now we’re looking to continue to meet the requirements under 81-1 and the related software provisions that now let us get into what really for almost the rest of the world is a fairly normalized recognize a margin on every hour that you worked to provide to on this project based on a large bucket of estimated hours.

Operator

Your final question comes from the line of Dushan Batrovic – Cannacord Adams

Dushan Batrovic – Cannacord Adams

On the whole credit crunch issue, you mentioned that you weren’t seeing much of an impact there, could you go through just a little bit more detail as to how your customers are responding to the auction rate securities, are they refinancing, how are they going through the whole process because from a macro standpoint there does seem to be something happening there.

Mike Valentine

I would say that they aggressively dealt with it as it hits their radar and as it affects them directly so there’s been a lot of activity starting in Q3, Q4 of last year on this front. So it’s not like it hasn’t been on their radar and consuming cycles. What I would say is that they by and large having continued to manipulate their way through this maneuver their way through this, to the extent that it hasn’t had a dramatic negative effect on our business. So I think they’re doing an effective job of doing it and I think what you’re seeing is that our initiatives represent priorities in their strategies as operational entities and so that we continue even though there are some effects from the ARS fall out that they continue to prioritize us as a strategic investment in the grand scheme of things. So we haven’t seen a huge negative impact from it. But again it continues to be on their radar.

Marc Naughton

I think we saw a fair amount of our clients actually go refinance their bonds and so many of them are either through that process or have the process in place to change it from the ARS to some type of a variable floating rate bonds. For the most part that’s what I’m seeing when I talk to CFOs. That’s one of the reasons it doesn’t seem to be having an impact on our businesses, they just see it as something they’ve got to do. They don’t expect their net interest rate to fill up a whole lot other then just normal current rates.

Dushan Batrovic – Cannacord Adams

Is it safe to say that the issue is behind us then?

Marc Naughton

We indicated it wasn’t a Q1 issue and it didn’t come up in Q2. We are keeping an eye out to make sure, but it feels like we’ve weathered that storm.

Trace Devanny

A final comment, as you can tell from our remarks today we are pleased with our strong results in the quarter specifically around bookings, earnings, and cash flow. We continue to believe that Cerner’s breadth and depth and scalability of solutions are unmatched in this industry. We’re particularly pleased that even in these challenging economic times health care providers, our clients are viewing their IT investments as strategic and are making them a high priority as Marc just mentioned, not only here in the United States but around the world. Let me make sure that you all know that we’re looking forward to seeing you at the Annual Cerner Health Conference coming up here October 5 through 8 in Kansas City, certainly this year’s conference will be the biggest and best ever. So look forward to hopefully hosting you there. Thanks for joining us today and have a good rest of the day.

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