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Quality Systems Inc (NASDAQ:QSII) is a healthcare IT company. The company operates in four divisions: QSI Dental, NextGen, Hospital Solutions, and Revenue Cycle Management (RCM) Services. The company was founded in 1974, and originally focused primarily on the Dental market. After year of phenomenal growth and acquisitions, the lion share of revenues and earnings now come from the NextGen subsidiary. NextGen provides employee health record (EHR) solutions as well as financial and HIE (health information exchange) solutions.

Magic Screen

The first criteria we check in our system is whether the company is a magic formula screen stock or not. Quality Systems is currently on the 50 over 1 billion magic formula screen. A few months ago the stock was also on the 50 over 50 million, but has recently run up a bit in price as the overall market has gone up.

Score: 1pt

Circle of Competence

With professional experience as an IT consultant, our circle of competence in the software industry is high. Healthcare knowledge is not particularly high, but from our investment perspective this industry and company is quite understandable.

Score: 1.5pts

Business Prospects

The healthcare IT industry is without question growing considerably and will continue to do so in the foreseeable future. The major drivers in the US are an aging baby boomer population, and the rapidly increasing costs of healthcare, which is now at 17.3% of GDP. This is growing at an unsustainable rate, where as in 2008 it was only ~16%. One of the main initiatives to reduce this cost is for increasing efficiencies using technology, and there is large support from the US government to push healthcare providers to further adopt modern technology. Even in 2012, the majority of hospitals and physicians still do not have access to HIE systems, a whopping 80% of hospitals and 97% of physicians. All players in this industry will benefit from these trends, and Quality Systems should be well positioned to continue growing in the long run.

The company experienced some short term difficulties in 2012 with earnings growth dropping off and some short term market softness, but we fully expect the overall growth trend to remain strong in the coming years.

Score: 1pt

Shareholder Friendly

The company has had a consistent dividend yield near for several years. At current prices the yield is a very respectable 3.7%.

In July 2012 2 insiders on the board bought 10,000 shares each, which is a clear sign that they felt the company was unduly punished with the recent decline in price from 24/share to 16/share. The company has since recovered and stabilized at 18.60/share.

Score: 1pt

Moat

One of the strengths of software companies in general that license software like Quality Systems is the inherent moat that is developed overtime as they build their product lines and brands. Switching costs for expensive IT products is large, and the recurring revenue base from license fees and maintenance costs significantly reduces the downside risk to a company like Quality Systems. 70% or more of revenue is recurring. The company has gross and operating margins which are greater than the industry average, which also indicates the proprietary nature of their software and the specialized products they produce. (Gross margin is 63% vs. industry average of 51%). Their are some larger competitors, e.g Allscripts (NASDAQ:MDRX) and McKesson (NYSE:MCK), but as the industry is growing rapidly enough there is significant room for several of these major players to develop a strong moat and competitive position around their flagship product(s).

Score: 1pt

Conservatively Financed

The company has zero debt and is flush with cash. The company has grown consistently over the last 10 years without using any debt.

Score: 1pt

Predictable Earnings

Earnings have grown at a strong consistent clip over the past 10 years. Growth of around 20% per year, with no down years, even through the great recession in 2008 - 2009.

Score: 1pt

Margin of Safety

To calculate whether the current price constitutes a sufficient margin of safety, we have performed a simple DCF. We believe that the value of a company should always be thought of in terms of how much the company can earn in profit now and in the future for its shareholders. We have used the following inputs:

  • Current Earnings: $1.28/share
  • 10 year growth of Earnings: 10%
  • Growth after 10 years: 0%
  • Discount rate: 6%
  • How confident are we in our earnings estimate? : 75% confident

This provides an intrinsic value of $35/share. At a current price of 18.64 at time of writing, there is an upside of 87%! This is a high margin of safety and one we believe that shows just how undervalued the company is currently. The current price is actually assuming a negative growth in earnings over the next 10 years. This seems highly unlikely, given the consistent growth in Healthcare IT spending for at least the coming 5 years. 12 analysts following the company have an average long term growth rate of 15%. The previous 10 years the company has consistently grown earnings at more than 20%. So given the growth prospects of this industry, and the relatively strong competitive position of Quality Systems, we feel very confident in the strong margin of safety present here. Near term difficulties in a slowdown in earnings, as well as managements retraction of their outlook for the remainder of the year have put some uncertainty on the stock which caused a large decrease in price in July (~25% drop). It has since stabilized and recovered more than 10%. We now feel this is an opportune time to buy in.

Score: 1pt

Total Score: 8.5pts.

Conclusion: Quality Systems is a "Buy".

In our 10 point system, we consider any company with a score of 8 or higher to be a buy.

Source: Quality Systems Is Still A Buy At Current Levels