Will a new headquarters building provide Cerner with a clean slate on which to grow?
Cerner started to move into its enormous new campus in South Kansas City a few weeks ago. It is surely one of the largest developments in the area since the Hall family built the Crown Center a few decades ago. This first phase of construction has erected space for 3,000 employees, but ultimately the campus, which will be built in phases through 2025, is expected to house 16,000 Cerner employees. The development has some innovative architectural flourishes sadly lacking in the Crown Center, at least according to the pictures I have seen. But, of course, it doesn’t come close to matching the glories of the Country Club Plaza. Seville reimagined in the American Midwest on the banks of the scenic Blue River. Its creator, J. C. Nichols, was a peerless developer – and never ran for political office.
The question is now that Cerner has secured its real estate future for decades, when the company will take some innovative steps to reignite its growth engine, something completely lacking in the past couple of years at this company, at least on an organic basis. What’s frustrating, at least to this author, is that the company is still struggling with growth a couple of years after what was supposed to be a transformative acquisition. And it is equally disheartening to see an absence of growth when market research analysts more or less unanimously have concluded that the space is still growing in the mid teens.
I think most investors at this point, especially in the wake of seeing a more than a year’s revenues invested in real estate, are looking for answers. The Q4 results weren’t so much regarded as good although the shares bounced a little. They were simply regarded as less bad. Bookings managed to grow, but were at the low end of the forecasted range. At the end of the day, the company saw a decline in GAAP earnings, both because of noticeable growth in sales and marketing expenses and an increase in general and administrative costs. Non-GAAP EPS did not decline because severance costs were excluded as one time and because there were fewer outstanding shares.
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The purpose of the article is to try to provide some answers, but it will inevitably leave some areas of ambiguity and doubt. This company is taking the steps to remain relevant in a world based on hosting and the cloud, and yet that still has not quite led to bookings growth.
Cerner’s shares hit a high of about $75 in August of 2015 and are actually down 20% since that time although they have recovered from the worst of their swoon in the early part of this year. It has often been said that corporate performance of technology vendors is inversely related to their real estate developments and that is certainly the case with this company. Simply put, and in the same way as has happened at its much smaller rival athenahealth (NASDAQ:ATHN) that I recently discussed, Cerner has a growth problem, and last year, it reported no growth in bookings although it was able to report an 8% growth in revenues and a 9% growth in non-GAAP earnings per share. The shares are perched at the moment about halfway between their 12-month high and low. The company, whatever else might be said, has grown a base of recurring revenues and it also now owns that vast campus in what had been the wasteland of South Kansas City.
The campus the company is building is a bold statement. It speaks to confidence about years of significant growth in the future. The company has published aspirational objectives of growth of around 10% and has said its internal goal is higher. Its goal should be if it doesn’t wish to become a chronic market share donor, a condition that while not fatal is deleterious to good corporate health. But in the short term, the company is still expecting very modest growth in bookings.
The company is forecasting that it will not see a terribly significant improvement/change in most operating result categories in 2017 when compared to the results of 2016. Revenue growth is supposed to remain at 8%. Margins are supposed to be flat to slightly up. EPS is expected to grow by 9%. Bookings growth is expected to be 3% in Q1, but may accelerate later in the year due to contribution from the company’s outsourcing service called ITWorks.
The company is well aware that it has developed a credibility issue with its stakeholder base including potential investors. Quoting from the prepared remarks made by the CFO during the course of the conference call:
“Our 2017 guidance reflects slightly lower ranges from what we provided based on our preliminary on our last call. These lower ranges reflect our desire to factor in as much of the unpredictable nature of our business as possible and to make our guidance attainable as we look to avoid having another year where we miss elements of our guidance.”
In sum, the company reduced its estimates related to current year bookings quite substantially. Current year bookings are now supposed to represent 18% of the current year forecast revenue of $5.2 billion compared to 21% of revenues that had previously been forecast. The CFO also spoke to a methodology for forecasting bookings growth that positions the company for a higher chance of an upside rather than a downside miss.
Generally speaking, the newly found conservatism has been well received by shareholders. While the day after the earnings release saw shares decline, since that point, they have bounced by 15% and have actually outperformed IGV which is just up 3% over that span. Investors are looking for reliable guidance more than some expression of aspirational thinking.
The chances of Cerner resuming its growth trajectory
It is hard to believe, but once upon a time, this company was one of the hyper-growth names that was a favorite speculative vehicle of the hedge fund community. The company was growing swiftly, margins were rising, and the idea that medical costs would be controlled by moving to Electronic Health Records was a well-established belief. The government adopted mandates regarding reimbursement that obliged healthcare providers to switch to the use of EHR in order to qualify for certain levels of reimbursement.
In that environment, Cerner in particular was considered one of the quintessential growth companies of the first year of this century. But results this decade have been anything but satisfying. While the shares are up by 63% in five years, GAAP EPS was about the same in 2016 as it was five years ago. In the prior five-year span, GAAP EPS had more than doubled. As a result, Cerner’s shares have lost ground to the IGV index over the period which has risen by almost 96%.
While revenues have grown significantly over the past several years, most of the company’s growth has been inorganic. While that may be OK at some level, it is an issue when EPS and free cash flow haven’t grown at comparable rates as revenue.
Cerner these days has a very broad portfolio and it would be more than a bit tiresome to perform forensic surgery on the different areas of promise and pain. But somewhere in the sea of disappointment, there are islands of promise. The question for investors is whether those islands will become large enough to reignite the growth engine in a consistent fashion. Overall, and simply put, Cerner has a couple of quite successful solutions, and a bunch of solutions, which basically is its core that are essentially not growing very fast. That hasn’t changed and the challenge faced by the company is finding ways to change the proportion of its business coming from higher growth areas. Depending on how one calculates different growth rates, Cerner’s core business is mired in low- to mid-single-digit growth. Why that should be so is a discussion that would extend to some length, but the company clearly has a core set of legacy solutions that is growing at less than 5%/year. It is why the newer solutions thumb-nailed below are so important in evaluating this story. The core is not likely to grow faster than it is growing and the company has to find a way to wrest more revenue from its newer offerings.
A couple of years ago, Cerner acquired the healthcare IT business of Siemens. One of that company’s major solutions was Sorian. Initially, the Sorian product family was a boat anchor for Cerner as can be seen from the linked article from a major industry consultant in the space. It has finally started to become a contributor to growth. Much of the business for products like Sorian these days is replacement of legacy products and much of that replacement has to do with functionality and with the ability of new technology to drive revenue for hospital clients.
Cerner sells a set of solutions that it calls Population Health. To some of us who have interacted with the solution, it can be quite annoying, but various health organizations think that there is a benefit to be had in reminding us to eat healthy, to see the doctor, exercise and take our meds and get tested for all kinds of diseases/conditions. It is a solution set that has remained a growth driver for the company and it is currently on a new iteration that can produce some bookings growth benefits.
Like most other application software providers these days, Cerner has both a platform and analytics. These offerings are showing significant levels of growth. The company CEO said that “near term, we have a significant pipeline of opportunities to exceed the collective amount of business we’ve signed in the past several years.” I don’t have a crystal ball that is any clearer than that used by the management of this company. The opportunities ought to be there. I do not believe based on the data provided by industry consultants that this company has been a market share donor to its largest competitor, privately-held Epic. KLAS, the gold standard in evaluating vendors in healthcare IT, rates principal competitor Epic at a higher level than Cerner, but that has been the case for seven years without any visible change in market share between the two vendors.
KLAS says competition in the space is heating up – but it has also said that for seven years. The company appears to win its share and lose its share of potential engagements.
The CEO maintained that the results of Q4 and the company’s forward visibility aren’t being impacted by the potential replacement of Obamacare. The issue that frustrates any observer is that there must have been something that drove the results of the public companies in this space to such mediocre levels. If not Obamacare, then what? KLAS gives Cerner decent to leading marks in most of the categories on which it reports.
Cerner was not successful in winning major new ITWorks deals in 2016. And simply put the lack of success in this area was the key reason for the poor bookings performance of the company last year. It is a cornerstone of Cerner’s strategy, and it needs to get better for the shares to work in terms of meaningful positive alpha.
ITWorks is essentially a service in which Cerner outsources the IT function of its clients, usually chains of hospitals. The deals are large, and it is one of the business offerings that can move the needle on bookings. Years in which the company closes some of these transactions usually turn out to have strong bookings growth. The company was able to sell additional deals into its base and the bookings the company had achieved in 2016 translated into revenue growth last year.
Will Cerner achieve the results it is forecasting this year? Much of the answer will come from closing the deals that slipped. Why did the deals slip and why should they close this year? Some of it is sales execution and some of it in some way relates to the multitude of pressures faced by hospitals in trying to deal with too many mandates. Perversely, there was a “pause” in some of the newer mandates regarding healthcare IT, and this seemingly led to hospitals pulling back from signing long-term, very large outsourcing deals, regardless of the likely benefits to them of such transactions. It really isn’t knowable how the current political situation might impact that component of demand, and it is one of the reasons the company has chosen a path with such conservative guidance.
The company is doing what it can to enhance the visibility of value within its largest clients. I won’t try to analyze the company’s new Value Creation initiative, but it is an innovative way of getting hospitals to respond to available technologies. Part of the VC alignment is the creation of tailored business analytic solutions for hospitals. It seems likely that something like this will resonate within the user base.
I am not particularly concerned that the company will not be able to achieve its revenue forecast for this year given the high level of coverage from the backlog. But the company can’t indefinitely grow bookings at 3% and revenues at 9%. The company has a large backlog relative to current revenues, but investors are not going to be content to see revenue objectives achieved based on a declining backlog. For Cerner to work as a stock, it is going to have to do a better job in growing its bookings than has been the case for two years now. Overall, the strength or lack thereof in bookings is going to be reflected in valuation metrics.
Costs and Margins
If the company’s bookings growth initiatives falter, will margins support a rising EPS expectation. I think the one word answer is NO! The company is forecasting flattish margins this year. In the past, Cerner has had aspirations of growing margins on a steady basis. Some of that has to do with the increasing level of amortization as new solutions are released which causes recorded research and development to rise. Cerner is a relatively older software company and capitalizes on software development. It is a concept that can make sense in theory, but like many such concepts, it has often been abused and often has unintended consequences. For Cerner, it will have a negative impact on margins this year although the pressures will abate during 2018.
There are as well some other smaller headwinds that will be a drag on margins this year. The company is moving more of its revenues to SaaS, and while over the long term that is almost surely a positive margin driver, up front, it is going to weigh on gross margins. The most interesting headwind relates to the bookings potential for ITWorks and RevWorks. If the company is successful in booking large deals this year, the impact again perversely will be negative on margins. That is because the initial revenues from those products are services which have a low or possibly no margin at all. Eventually the outsourcing deals lead to lots of Cerner software sales, but since there were no major new bookings last year, there will be no software sales from that source this year, and the company is expecting to close some larger new contracts this year. It has essentially modeled the margin impact of those potential new deals and ignored the magnitude of those new deals in its bookings forecast.
It is something that provides a level of confidence that the current forecast is meant as a floor and not meant as an attempt to model the most likely scenario. That should be carefully considered when looking at the company’s valuation metrics.
Valuation: GARP or growth
One of the longer running debates regarding this company’s shares is whether they should remain in the growth sweepstakes category. Almost every conference call features some dialogue about whether the company can or should be able to achieve double-digit growth. The company aspires to do so and is focused on that – the results. Well, the last two years haven’t produced much of an argument in favor of a double-digit target.
The question seems to be a function as to whether it will be able to grow in double digits or not and the company is on the cusp.
Cerner currently has 340 million shares outstanding. At current market prices, its shares have a market capitalization of $20.2 billion. The company’s average share count continues to contract and likely will do so for the future. The company has a zero net cash position, in part a reflection of its real-estate activities. In any event, at an enterprise value of $20.2 billion and revenue expectations for the current year of $5.2 billion at the mid-point, the EV/S to 3.8 X. From my perspective, whether or not Cerner can grow revenues at double-digit rates, its valuation is in the GARP as opposed to growth range already. Double-digit growth, should it happen, would be lagniappe in terms of share price valuation.
The company is forecasting non-GAAP EPS to be $2.50 at the mid-point and that results in a P/E of a bit less than 24X. In the current market, Cerner’s P/E is far from an outlier, and in the software world, it might even be described as moderate. EPS is growing, and stock-based comp, at less than 2% of revenues and 7% of reported non-GAAP earnings, is significantly lower than other companies in the software space.
Last year, Cerner generated operating cash flow of $1.16 billion. Most of the cash flow was used in the company’s building program, and the total increase in plant and property was $753 million, which left free cash flow of just a bit over $400 million. The company says it is targeting an increase in free cash flow of greater than $100 million next year due to smaller expenses on the campus and also because of higher non-cash charges for amortization of capitalized software.
I think free cash generation should grow at a swifter cadence than forecast since net income alone is forecast to grow $50 million or so. But even at $600 million, my own guess, the company’s free cash flow yield is only 3%. CERN will not generate significant free cash flow until investments on its campus start to materially abate, which may be the case, depending on growth expectations for the company in 2018.
Cerner’s valuation makes the shares a reasonable risk/reward play. As pointed out earlier, there isn’t a huge risk in this forecast, and all the risks there are would be toward the upside. It seems likely that Cerner is in a position in which it most likely beats the current forecast and that is certainly true for the just closed quarter in which it has forecast closing no large deals.
I’m the last writer to proclaim that I have some crystal ball about some of the things on which I write. There is much that says that Cerner ought to be doing better than it has done the past two years. And it ought to be doing better without needing to take market share in any meaningful way. My own experiences with hospitals and medical practices is that they are woefully underinvested in almost all kinds of information technology. For those of us who need to use medical services in a large metropolitan hospital, the lack of IT in terms of a patient experience is almost comical if it weren’t so serious. Some of the group practices are even worse.
But whether or not Cerner is going to get its flagship offerings such as ITWorks accepted by more of its potential customers is something that I really have no way of objectively evaluating. If I were a hospital administrator, I would jump at outsourcing IT and rebadging all of that staff – that is obviously an opinion not shared by many potential customers.
I do not currently own Cerner’s shares, although I would like to if I see any signs that the company has made progress in addressing its growth issues. But there are investors who will be attracted to the relatively low risk of these shares given the level of current or potential growth. At current valuations, it will have an appeal to investors looking for some growth and less risk. I’m personally looking for more growth. And I will be interested to see if CERN’s campus actually gets fully constructed to house all of the associates the company will need if it can resume growth.
Date: April 14, 2017