Description

Certain statements contained herein reflect the opinion of the author as of the date written. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Thesis:

One of the main reasons I wrote-up Cerner Corporation (“Cerner; Nasdaq: CERN) is because it has never been posted on VIC. While I believe it is not the most attractive stock at the current valuation (~22x 2019E EPS ex. net cash), it is a recession resistant business with long-term, above average, secular growth. I believe the downside is protected by the recurring revenue (nearly 2/3 of the business) maintenance stream of earnings. The level of upside in the stock over the long-term will largely be determined by how successful Cerner is in growing its international business (currently with approximately 25% market share) over time.[1]

Business Description:

Cerner is one of the two largest standalone healthcare IT companies in the world and is a leading provider of electronic health record (EHR) systems. Cerner’s core product, Millennium, helps physicians access an individual’s health records at the point of care, which streamlines administrative functions, reduces costs, and enhances patient safety.

The Company licenses its Millennium solution to hospitals on a per-bed basis. In addition to the one-time license sale, Cerner also earns revenue from maintenance and support contracts that typically last five years.[2]

Due to the quality of its Millennium EHR product and long implementation times (nine to eighteen months), Cerner’s customer churn rate is less than 1%.[3] Low turnover among customers enables Cerner to cross-sell adjacent products into its installed base. Examples of adjacent services include revenue cycle management, clinical IT management, and population health solutions.

Cerner has systems in more than 27,000 facilities worldwide, including hospitals, physician practices, laboratories, ambulatory centers, behavioral centers, cardiac facilities, surgery centers, extended care facilities, and retail pharmacies.

High Quality Business:

Strong Competitive Position: Cerner is a top two player with in the U.S. with 28% of total hospital beds.[4]

Low Customer Churn: Cerner retains nearly all of its customers because the systems that it provides are mission critical with high implementation costs and long implementation timelines. The duration of maintenance contracts (~5 years) further circumvents switching. At contract expiry, it would be expensive for a hospital to retrain its employees on another operating system.

Strong Recurring Revenue: 62% of Cerner’s revenue is recurring (Support, Managed Services, Subscriptions, Works, SaaS) in nature while another 26% of revenue is highly visible (Professional Services). The 12% of revenue that is not recurring comes from new license sales and tech-resale.[5]

Defensive Investment Characteristics: with the exception of 2008 when the Company’s EBITDA declined 1% YoY, Cerner has grown EBITDA sequentially every year since 2004.[6] Cerner’s share price outperformed the S&P 500 index by double digits during the GFC.

Attractive Growth Profile: Cerner’s management team believes the Company can grow revenue by 7%-11% through 2025. Domestic growth is boosted by the Company’s recent Veteran Affairs contract win (worth approximately $10B over the next 10 years), cross-selling existing services, and developing new population health services. Cerner also has many opportunities to grow its installed base outside of the United States where penetration rates for EHR systems are significantly lower. Cerner is the largest player internationally with 25% market share. By comparison, the Company’s largest U.S. competitor, Epic (35% market share in U.S.), has only 1% international share.[7] The chart below helps frame Cerner’s long-term growth opportunity:[8]

Margin Improvement Opportunity: Cerner’s Adj. EBIT margin has fallen sequentially in each of the last five years as the Company has invested more in its services businesses, which carry lower contribution margins. All of the margin contraction from 2013-2017 has come from higher Sales and Client Service expenses related to the build out of the services businesses. Cerner’s operating margin is likely to contract once again this year due to further investment. However, beginning in 2019, management believes that it will be able to expand adjusted EBIT margins by 50bps-100bps as service and non-cash expenses moderate as a percentage of revenue.

Relative Valuation Moderately Attractive: In my view, Cerner has better long-term growth prospects and is a higher quality business than most companies in the S&P 500. Yet, despite this, Cerner’s 2019E free cash flow yield (~4%) is only moderately more expensive than the broader index.

Sustainably High ROCE Business: CERN sports a 14% unlevered after-tax ROCE and an excellent balance sheet (net cash position).[9]

Business Drivers:

Cerner’s business is driven by healthcare IT spending, which is affected by the health of the overall economy as well as regulatory changes. Some of Cerner’s largest opportunities are discussed below:

Population Health: Population Health is Cerner’s largest organic growth opportunity at an estimated $10B-$20B over the next 8-10 years.[10] The goal is to use the data stored in the electronic health records to help organizations predict what will happen within their population in order to drive better outcomes at a lower cost. Management believes that Population Health could make up 20% of the Company’s revenue mix by 2025 vs. ~5% today.[11]

Cross-selling: RevWorks, ITWorks, and Population Health remain significant opportunities.

Industry Consolidation & Preference for a Single Software Vendor: Cerner and Epic have been gaining market share over the last seven years. Together, these two companies have ~63% market share (on a per beds basis) in the United States.[12]

Department of Veteran Affairs Contract: per the contract, which was signed on May 17, 2018, Cerner will build a new health record system for the Department of Veteran Affairs. The contract is worth approximately $10B over ten years and will be funded incrementally over time. Revenue is expected to ramp in three to five years.

International Growth: EHR penetration levels are significantly lower outside of the United States. Cerner has offices in over 30 different countries but generates only 11% of its overall revenue internationally. Cerner has 25% international market share vs. Epic, which as 1% international market share.

Industry Analysis:

Market Share:[13] Cerner is the second largest EHR provider by market share in the United States. Cerner has 25% market share by total hospitals served and 28.5% market share by total hospital beds. The Company’s largest competitor, Epic, has 26% market share by total hospitals served and 35% market share by total hospital beds. While both companies have been share gainers over the last seven years, Epic has gained considerably more share. Cerner has gained ~150pts of market share over the last seven years whereas Epic has gained ~1300pts of market share. Epic has captured market share faster by focusing on the non-profit hospital market[14] and through stronger replacement wins.[15] These market share gains have come at the expense of MEDITECH (16% share), CPSI (11% share) and Allscripts (8% share).

Growing Industry: the EHR market is $28B and is forecast to grow to $36.6B by 2021.[16] Cerner provides software and services that should help providers reduce the complexity of their operations and therefore reduce costs. However, Cerner’s clients are no longer being incentivized by the HITECH Act, which was signed into law in February 2009 with the aim of cutting down the cost of sharing healthcare information between doctors, hospitals, and other healthcare entities. This encouraged health records to be stored electronically as opposed to paper. Hospitals had to be in compliance by the end of 2015. Therefore, at this point, adopting additional add-on EHR solutions is more of a discretionary expense for healthcare providers.

Industry Participants Are Consolidating Their IT: by using fewer IT suppliers, providers can spend less time integrating disparate systems and more time delivering better clinical outcomes. Approximately 30% of all hospitals in the United States rely on EHR systems that are no longer supported by their vendor.[17] These hospitals will need to buy new licenses, and Cerner should be well positioned to take share. MEDITECH is most at risk of losing market share since 53% of these hospitals use its EHR system. Cerner (11%), CPSI (9%), and “other” (27%) are also somewhat at risk. Cerner’s exposure is due mostly to its acquisition of Siemens Health Services in 2015. Hospital consolidation should benefit Cerner because larger hospitals prefer to have standardized systems.

Switching Costs Are High: Cerner provides highly customized software and locks customers into long-term maintenance and support contracts. Initial implementation costs are high. The Company spends ~12% of its revenue on R&D to keep its product portfolio up to date. Cerner has an extremely strong reputation within the industry.

Risks:

Reduced IT Spending: management noted on the 1Q 2018 call that large hospitals seem reluctant to spend on discretionary IT at the moment. Many hospitals are facing pricing headwinds and cost inflation.   

Software Malfunction: A software malfunction could, I believe, significantly damage Cerner’s reputation if it results in a faulty clinical decision and/or patient injury.

Share Losses: Approximately 13% of the Company’s existing customer base is using software that is no longer supported by Cerner. If Cerner is unable to retain these clients as they upgrade their software, the Company may not be able to meet its financial targets.

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is not indicative of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.

[1] Source: Citi

[2] Source: BAML

[3] Source: Cerner Investor Relations Call, 9/18/18

[4] Source: BAML

[5] Source: Cerner Investor Day, 3/7/18

[6] Source: Capital IQ

[7] Source: Citi

[8] Source: Cerner Investor Day Presentation, 3/7/18

[9] Source: 10-K

[10] Source: BAML

[11] Source: Cerner Investor Day, 3/7/18

[12] Source: BAML

[13] Source: BAML

[14] Non-profit customers are less price sensitive than for-profit customers are. Epic charges 1.5x-2.0x as much as Cerner. However, Cerner still gets annual price increases on new contracts of 2%-3%+.

[15] When a hospital replaces an EHR system with another system (as opposed from going from paper to EHR).

[16] Source: Citi

[17] Source: BAML

Catalyst

Potential international growth acceleration.