How comfortable can middle age be for Cerner?
There are a significant number of applications and infrastructure vendors in the software space who have middling growth, significant profitability and fairly reasonable valuation. There are many reasons that animate the valuation concepts investors use to figure out a “fair’ price to pay for shares of companies that are still growing but are no longer in their hyper-growth phase. For example, the fintech world is populated, for the most part, with companies that have very stable but also very modest CAGRs that usually need acquisitions to be maintained. Profitability is high for these companies. They emphasize strong free cash flow generation and most of them seem to be able to continue to grow their margins. Investors have had a love affair with fintech companies the last several years now and hence their valuations are high – exalted is probably too strong a word to use and elevated is maybe too critical – but they are no bargain in terms of classic methodology-stability and predictability have trumped all.
Then there are companies like Aspen Tech that seemingly is in middle age and has the monkey on its back of selling to the oil and gas industry and yet has a lofty valuation at least using traditional metrics. The company was able to report a significant earnings beat when it published its earnings the other day and the shares spiked and they are now up 22% YTD and 22% over the past three months. Nothing against Aspen except its valuation and the fact that it has to compete in a space with many and varied alternatives and in an environment that is the opposite of benign, i.e. with the relatively low price of oil and gas, to say the least.
One really can’t write articles about Cerner and just compare its shares to those of its competitors such as the high fliers at athena or Epic which is its closest competitor but which is also a private concern that doesn’t report detailed numbers. Some years ago Cerner was a pioneer in the medical software space and was perceived as an exciting player that might one day take over the world. I wrote an article on the company almost six months ago with a theme that its recent stumbles, as they were perceived by some observers, would likely prove transitory and the lack of share price performance over the prior year afforded investors with a reasonable entry point into the shares. While the shares have appreciated dramatically since the time of my recommendation, appreciating by almost 35%, the company’s business has more or less plodded along.
Investors were displeased with Q1 results and felt quite differently in the wake of the Q2 earnings release. Frankly, it is my view that lots of the increase in the share price was driven by the fact that Cerner shares performed so poorly on a relative basis all through 2015 and into early 2016 partially because of controversies regarding growth and profitability brought on by the acquisition of Siemens Health Services which closed in early 2015. The acquisition of Siemens hobbled GAAP earnings in 2015 as was reasonable to anticipate – non GAAP earnings showed a stronger increase but on a pro-forma basis, revenues adding historical Siemens Health Systems revenues, contracted by about 1%. But of more importance to the share price underperformance was the difficulty the company had in forecasting its business and the fact that it had to frequently reset expectations. Middle aged software companies are supposed to hit forecasts in exchange for giving up hyper-growth and Cerner wasn’t really able to deliver its side of the bargain to investors during much of 2016. But while reported revenue numbers were inconsistent last year, some of that inconsistency ought to have been offset by the strong increase in bookings and backlog over the period and the win, as part of the Leidos Partnership, to replace the DOD health records for active service military and retirees. Cerner beat its largest single rival Epic in what was considered a significant upset at the time.
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Overall, given the growth in bookings and backlog, I had thought that headline growth numbers, excluding the impact of Siemens, would start to look stronger in 2016 and stronger than either guidance or consensus expectations. And so my relatively bold headline proclaiming that while Cerner was not seeing much reported revenue growth, it was necessary to look beyond the headlines to gauge the success of the company’s sales efforts.
Of course, Q1 didn’t quite work out quite that way. This time the culprit was long-term bookings, whose weak performance held the year over year change in that metric overall to nil, although many observers prefer to look at the change in shorter term bookings to reflect the “quality” of bookings activity. Overall revenues missed by about 1% and EPS was just in line. Investors chose to be unforgiving of those results and the shares traded in a tight range until the post Brexit rally.
The question now is having seen the valuation spike in the wake of a single decent quarter are there more such quarters in prospect and do the shares reflect a valuation that can produce positive alpha? And can middle age have much in the way of excitement for this company or will it plod along in some cyclical fashion as it gradually moves its business from on-prem to the cloud?
One of the problems with reaching middle age in the software world is that companies, unlike individuals, often find themselves with aggressive and seemingly implacable competitors. I guess that really isn’t that different than the way we humans choose to live. But competing with the likes of athenahealth and privately held Epic as well as Allscripts Health and McKesson is never going to be either simple or without pitfalls. Another problem for this company is that it is still offering both on-premise and hosted solutions that tend to muddy revenue comparisons more than a little.
As I tried to present a fundamental view of the company in terms of its major products and initiatives as well as it competitive positioning, I do not propose to reprise that analysis in the balance of this article. Not all that much has changed and the fact is that there were skeptics regarding the company’s outlook six months ago and not enough visible has changed to change the minds of doubters. I’m not going to spend any more time on either the history of the company or its shares but try just to look at Q2 results and the future of the company. Providing readers a specific recommendation is really a harder call now than was the case back in February both because of a 25% rally over the course of little over a month and the question of growth versus valuation. But as I suggested in the title, there are elements of the reported results that suggest operating improvements that are really not captured by the headline numbers to any particular extent.
Q2-When pretty good is more than just enough!
I’m a shareholder of Cerner. I have traded the name on and off for years and I always thought that at some point the company would benefit substantially from the growth of electronic health records. Indeed, it probably has to a greater or lesser extent, but never to the level I had always hoped would be the case. Supposedly EHR is to be a $23 billion market by 2020 – and Cerner which is involved in many parts of the healthcare IT landscape is expected to reach around $5 billion of revenues this year. So, it is hardly the behemoth of the EHR market although it is a major player in the space. After all, how could that trend and other overarching trends in healthcare not lift the largest public boat in the space? I keep hoping for faster growth and I have traded the shares accordingly although lately it has been harder and harder to trade around a position.
Cerner certainly didn’t start 2016 off in a promising fashion and the results for Q1 were considered to be disappointing. Revenues missed by $10 million – although that was primarily a function of the long-term secular decline in what are essentially pass-through hardware revenues. Bookings were flat, because of ongoing issues, not with getting business but because of the comparisons with an elevated period in the prior year for long-term bookings. It didn’t matter – the consensus was that Cerner had contracted a disease from one of the hospitals to which it sells.
Because of the Siemens merger and other factors, including an investor communications program that has been less than stellar, the shares eventually contracted 10% in the wake of the earnings release to a level where I thought that even the semblance of a “normal” quarter, i.e. one that met prior articulated management expectations would be enough to achieve a decent trade. By that point, the shares had declined 12% since the start of 2016 while the IGV-tech/software index had lost just 4% of its value.
Overall, I thought that expectations had been reduced to a level that seemed to be a lower bar than usual and that the company – or so management claimed – had plenty of visibility into its upcoming quarter. It seemed like a pretty good set-up.
And Q2 did turn out to be a pretty good quarter all things considered. But whether it was a quarter that was worth a share price spike of around 10% requires a deeper bit of inspection and some careful parsing about management commentary during its conference call.
Q2 results included headline revenues of $1.22 billion, barely ahead of the consensus. EPS was $.01, just marginally above the consensus as well. On the other hand, system sales were up 16% sequentially while maintenance and services revenues grew by 2.9% sequentially. The company maintained that it was gaining share in the EHR replacement market as users’ sunset legacy systems aged and replaced with Cerner solutions. It called out what it described as a significant replacement win at a hospital in Dubai.
It is impossible for this writer to substantiate claims regarding market share in particular healthcare IT segments and the fact is that Epic, not being a public company, publishes few if any whenever they have a success vis-a-vis Cerner. Further, there is no research that identifies healthcare IT market shares in general and certainly nothing specific in terms of identifying market share trends in the EHR space. The consensus of opinion appears to be that Epic is in first place and that both ATHN and CERN seem to be growing faster and that is about all market research has to offer on the subject.
The company’s Q3 revenue guidance was below the prior forecasts and the company lowered the top end of the range for full-year revenues. These decreases, which often are poorly received by investors, had to do with hardware revenues which have little or no margin and hence investors are no longer particularly concerned about those sales being less than previously forecast. Indeed, looking at current versus historical expectations, as far back as nine months ago, Cerner had forecast that it would achieve 2016 EPS of $2.30-$2.40 and it reconfirmed that estimate both in its earnings press release and on its conference call. In this world, predictability is seemingly as important as absolute growth and the return of Cerner to producing predictable results counts for a lot in evaluating the worth of the shares.
Bookings growth for Q2 quarter was 9%. Again, not a fantastic attainment, but probably good enough for what observers have been habituated to view as “normal” for this company. But while 9% might seem pedestrian, it masks some more favorable trends relating to the company’s shorter term bookings – the ones that lead to revenues over the next year. The forecast for bookings for Q3 is almost consistent with bookings in the prior year. Some of that is prudence and some of that is a very difficult year on year comparison. Cerner President Zane Burke mentioned that demand remains at levels from which double-digit increases in bookings can be expected as the norm going forward and that seems to be a reasonable expectation given the growth of Cerner’s space and its assertion that it is gaining market share.
It should be remembered that the prior year bookings reflected the multi-billion award that the company received as its part of the Leidos Partnership. So flat bookings in the absence of that specific award is a pretty fair achievement and its attainment would represent the product of a healthy pipeline coupled with a conversion rate that is consistent with results of the last several quarters.
Cash flow for the quarter was a strong $255 million with free cash flow of $57 million. Overall, operating cash flow more than doubled year on year. The company is building a new campus in its Kansas City HQ which is causing an elevated level of capital expenditures. The campus is ultimately to cost $4.5 billion and will not be totally completed until 2025 but it is being built in phases and has the potential to eat into free cash flow. Stock based comp represented about 10% of non-GAAP earnings last quarter down from 11% the prior year. It represented a more significant component of free cash flow which was constrained by the high level of capex that is being required to build the new campus.
This company capitalizes a relative significant level of software development costs and that sum is included in the calculation of free cash flow. Overall, the amortization of software development costs was $80 million last quarter compared to GAAP software development spending of $135 million. It is an unusual practice to see software capitalization used as part of the calculation of free cash flow as free cash flow is a non-GAAP measure and it depresses that metric compared to the practice of most other IT vendors. The company has been using most of its free cash flow to repurchase shares although it will need a new share repurchase authorization in the near future to continue to do so. Overall, outstanding shares have decreased by more than 2% over the past year and I think it would be reasonable to anticipate comparable trends in the near future when forecasting EPS.
I was initially not all that certain as to why the shares rallied upon release of the numbers. The quarter itself was fine, but I didn’t find a takeaway that seemed to be worth an 11% share price appreciation in the week after the release of Q2 earnings. One analyst from what is a second tier firm raised his rating from hold to buy – primarily because of his belief that the quality of the bookings was improving while another analyst raised his price target. I will take a more detailed look at why expectations seem to be what they are and then try to relate all of that to valuation in the last section before wrapping up.
Q2 – pretty good, but the rest of the year?
As mentioned earlier, Cerner’s outlook for the balance of the year is essentially consistent with its earlier views with the single exception of modestly trimming revenue expectations because it expects to sell a lesser amount of low margin hardware. So what has changed that has made investors more sanguine about the outlook and more willing to bid the shares higher in the wake of the call?
Two things really. The first of more importance, at least to me, then the second. Simply put, it appears now as though Cerner is talking about being able to drive both revenues and earnings a bit higher than the consensus forecast is for 2017. Cerner expects low double-digit growth in revenues, and that compares to a 10% forecast for revenue growth that is the current published consensus for analyst expectations. The CFO, Marc Naughton, forecast that at that kind of revenue growth attainment, operating margins would improve 50-100 bps. If it happens that way, then EPS would be able to reach $2.80-$2.90 depending on the exact trajectory for weighted average shares. That is noticeably higher than the current consensus of forecast of $2.69 published on First Call. So far, as mentioned above, there has been one estimate increase for this year in the past week and no estimate increases that were reported in the last week for 2017 EPS forecasts. There have been more widespread estimate increases for both this year and next year going further back in time but the published consensus has been where it currently is for at least the last quarter and likely further back than that.
In addition to what looks to be a more optimistic 2017 forecast than that embedded in guidance, the details of the guidance for the balance of this year also show some positive trends not discussed in articles looking just at the headline presentations. Taking a look at the specific Q3 expectations and backing them out from the full year forecast suggests a significant business acceleration in Q4, again compared to prior thinking. Cerner is a company that constructs very detailed forecasts and is careful about what it broadcasts in terms of forecasts so I would put some credence in its expectations of a higher level of growth in Q4 than had heretofore been expected. The CEO, Marc Naughton, said, “So I think we’re – once again, we don’t talk about bookings outside of the oncoming quarter, but we’re very comfortable that for the full year, we expect to grow bookings and so obviously to do that, we’d expect to have a pretty decent Q4.” That is typical Midwestern understatement, I would guess, and so some analysts, observers and other stakeholders have figured that the company’s business is performing better than the headlines might suggest. And that is or could be a factor in the share price strength, at least so far as I can tell. Yes, the spike in the share price does really represent an appropriate reaction both to the numbers themselves but especially to the specifics that are animating the numbers.
The CFO and the president said on several occasions that Cerner’s pipeline was at record levels. The President, Zane Burke, when asked about pipeline conversion, said, “we’re not seeing any variance in our conversion rate as we progress through the stages of the pipeline. But from a macro perspective, the trend lines have stayed the same on the conversion time.”
A significant issue for this company going back to the time of its acquisition of Siemens Health Services has related to the “win” rates of the acquired base as those deals come up for renewal. Cerner said at the time of the acquisition that it anticipated that some of its newly acquired users would defect to the competition and there has been much discussion among investors and analysts as to how retention has been proceeding. According to Cerner’s president, the company is ahead of percentage renewal expectations for smaller customers and at or slightly higher than its expectations for larger customers. That is, perhaps, a reason for the company suggesting that it sees low double-digit revenue increases as likely for 2017.
Cerner is doing its best to transition users to various kinds of payment plans that are essentially ratable in nature. One pricing template that is considered strategic by Cerner is what is called “PMPM” which is per member per month. The company has not done a particularly effective job in terms of educating its stakeholders about the specific impacts of the cloud on either revenue growth or profitability. It is unfortunate for observers such as this writer and for other stakeholders to have to guess at both the size and the trajectory of the switch to the cloud, but it is almost certainly one of the factors that can and has led to a dis-juncture between the percentage growth of bookings in some quarters compared to the percentage growth in revenues. The new payment options such as PMPM are just nascent for Cerner, and thus the impact in terms of percentages impact on reported headline numbers is at its highest and will be proportionately significant until there is a far different mix between new customers using a ratable model and users renewing who have been on that model.
Overall, Q2 for Cerner was not one of those quarters in which investors and observers marvel at the upside and start speculating about sugarplum fairies – or maybe about getting a bottle of Penfold’s Grange for Christmas. No caviar dreams in the headlines. But there were elements that suggest the company is coming back nicely from its digestion process of Siemens Health Systems and that it is getting its share or perhaps getting a little more than its share of the growing IT healthcare marketplace.
Valuation
Cerner shares are not particularly cheap. They have rarely been cheap as there has been a certain aura about being the leading public vendor in the healthcare IT space. The shares were obviously cheaper when I first wrote about the company than they are today although as mentioned above, part of that reflects that published expectations haven’t caught up to the specifics of the company’s forecast. But for the record, EV/S based on current year revenues would be about 4.5X, a middling number for a company with a low, but consistent double-digit revenue growth rate. The P/E is high at 28X the current consensus estimates for 2016. Using my own set of expectations for 2017 EPS, the P/E is a much less elevated 23X. Given the trends in valuation in the market as a whole over the past few months, these are not off the wall valuations.
As mentioned earlier, the company is seeing free cash flow sink significantly this year, primarily due to the construction of its major new campus/headquarters which is being paid for out of cash flow. The CFO said that company expectations are for “solid” free cash flow for the balance of the year although capex for continued spending on the company’s campus will remain elevated. I suppose that probably means cash flow will be consistent with Q1 which was quite strong. If that works out, then free cash flow for the year could be in the range of $500 million. That still produces a free cash flow yield of less than 2.5%. No one is likely to buy Cerner shares because they constitute a great bargain in terms of their free cash flow yield. Free cash flow is likely to expand significantly in 2017 because the current phase of the campus will have been completed. So, it is possible that a free cash flow yield based on 2017 projections would probably exceed 4%.
Overall, the case for investors to buy Cerner shares at current levels is predicated on the likelihood that the company will be increasing earnings expectations above the consensus in 2017, that some metrics for bookings and perhaps operations in general will show an acceleration in Q4 and that the free cash flow yield and other classical valuation metrics are at reasonable levels given longer term growth expectations for revenues and earnings. A very decent GARP story and that is probably what constitutes a comfortable middle age.
Summing Up!
- Cerner reported the results for its fiscal Q2 about 10 days ago. The results were consistent with prior expectations and the guidance was also consistent but the shares spiked 10% regardless.
- There were some significant trends below the headlines that caught the attention of some investors. These included comments that suggest that the consensus forecast for 2017 is too low and will have to be significantly increased.
- The company maintains that its results are being driven by noticeable market share gains although I cannot validate that claim from any independent source.
- The company’s bookings are showing signs of life once one looks below the surface of the recent Siemens acquisition and the massive contract award from the DOD last summer.
- Like many older software companies, Cerner has begun to sell more of its solutions on ratable contracts. The company has yet to disclose the impact that this is having on reported numbers although it is likely to be significant at the margin.
- The company’s free cash flow numbers are being constrained by the construction of a massive new headquarters facility the company is building. The constraint will be less next year than this year but the campus will not be completed until 2025 so there will be other years in which capex is elevated.
- There are many trends that favor the growth of the healthcare IT space such as the transition to electronic health records and the increasing automation of many clinical processes. Cerner, compared to many other IT companies in less favored fields, is operating with the wind at its back most of the time.
- The company is returning most of its free cash flow to investors in the form of share buybacks which is reducing outstanding shares by about 2%-3%/year and is an important component in EPS growth forecasts.
- At these levels, Cerner shares cannot be recommended for a short-term trade. And it is difficult although not quite impossible to imagine that the company might be the subject of a mega-consolidation transaction – if the size of the LinkedIn transaction was doable, than it would be possible for some of the larger IT vendors to buy this company although I rate that as a highly unlikely consummation.
But for longer term investors who want predictable, double-digit earnings growth in a favored space in the IT firmament, Cerner shares represent reasonable value and positions can be initiated with the thought of using any market weakness or share price pullback to acquire more shares.
Date: August 15, 2016