Thesis
Cerner’s consistent backlog growth and their
commitment to providing customer-focused solutions helped them outperform a
high-growth industry that was propped up by government regulation. However, Cerner’s
window is closing as the healthcare IT industry matures. By 2017, many
healthcare providers will put the regulatory goals in their rearview mirrors, and
their sole focus will be on reducing costs. As a result, Cerner’s growth will
slow to a 5% CAGR in 2019 and beyond.
Drivers of Thesis
· Government
Regulation: Since the Health
Information Technology for Economic and Clinical Health Act (HITECH Act) of
2009, Cerner had an average annual revenue growth rate over 15%. We expect this
growth to slow as many providers meet the HITECH Act standards in 2017.
· Pricing Pressure
from Healthcare Providers: Cerner
focuses on providing solutions that make hospitals more efficient, and they
have benefited from the drive to reduce healthcare costs. However, the focus on
healthcare spending also increases pricing pressure from providers when they negotiate
contracts.
· Seeking Growth
Opportunities: Cerner is one of the only
companies expanding outside the United States. While the international market
has lower penetration, the demand for healthcare IT (HCIT) solutions is weaker
abroad. Cerner will also face headwinds as they negotiate the dynamic
healthcare systems in other countries.
Risks to Thesis
· Security
Breach within the Industry: A
security breach may lead to patient and doctor mistrust of digital systems, and
it would significantly change the valuation of companies across the industry.
· Department
of Defense Contract: The $11 billion
contract for the DoD’s HCIT system (expected announcement in July 2015) will
launch Cerner, or one of its competitors, ahead of the competition.5
Company Description
Cerner Corporation provides IT solutions
and integrated devices that help healthcare providers become more efficient and
improve patient outcomes. They also provide support, maintenance, revenue cycle
management, data analytics, and remote hosting services for their clients.
Cerner’s customer base is composed of large hospitals, pharmacies, small
physician practices, and ambulatory facilities.
Data
Source: Cerner 2014 10-K
Cerner’s business model starts with
their sales and negotiation of new bookings. Since 2010, new bookings grew at
an average rate of 19% per year to $4.3 billion in 2014. The new bookings
filter into Cerner’s current sales or their backlog. Cerner’s backlog grew at
an average of 20% over the past five years. At this point, the company’s backlog of $10.6
billion is over three times their 2014 sales levels.
Data
Source: Cerner Financial Statements
Cerner operates in three primary
business segments (discussed in detail below): Systems, Support and
Maintenance, and Services. On their income statement, however, support,
maintenance, and services are combined. In the two charts below, we see that
while systems sales account for 31% of total revenues, they contribute only 14%
of profits due to the lower margins in this segment.
Data Source: Cerner 2014 10-K
Data
Source: Cerner 2014 10-K
Systems
Sales
Systems sales include revenues from the
sale of licensed software, technology resale, software upgrades, installation
fees, transaction processing, and subscriptions. Software sales grew over 11%
from 2013 to 2014 to $946 million. This growth was driven primarily by strong
growth in software and subscriptions.2
Software sales will slow over the forecast period to a 3% long-term
rate. This is because we have passed the end of the first electronic medical
records (EMR) wave (highlighted in the graphic below.) As healthcare providers
enter the second wave, they become focused on improving their existing systems
and using them in more meaningful ways, and this will transition revenues to
Cerner’s services segment.
Source: 2015
Institutional Investors Conference3
Previously, Cerner broke down systems
sales into subcategories including: licensed software, technology resale, and
subscriptions/transactions, but they did not make this data available in their
2014 financial statement. When Cerner secures contracts for new software or
technology resale, their clients typically also enter into support and
maintenance contracts, which make up their next business segment.
Support
and Maintenance
As the name implies, support and
maintenance revenues consist of the reoccurring fees Cerner charges their
clients for software support and device maintenance. The company expects this
segment to continue growing as their customer base expands. I expect single
digit growth in this segment, slowing to 5% long-term growth as systems
revenues slow over the forecast period.
Services
Cerner’s services business segment
consists of contracts that are generally over five years in length. This
segment includes products under the Millennium and HealtheIntent (cloud-based)
platforms. Products in the services segment include RevWorks, a revenue cycle
management tool, and ITWorks, a product which helps hospitals improve their
internal IT systems. The services segment grew over 20% in each of the past
four years due to the success of the two products listed above. These products
also represent Cerner’s best growth opportunity. As providers meet HITECH Act
goals, Cerner is able to offer their service products to help hospitals reduce
costs and become more efficient. Cerner will see double-digit growth of 17% and
15% in the next two years, slowing to 6% annual growth long term.
Industry Trends:
Transition
to Stage 2
As of December 2014, almost 89% of
hospitals 63% of physicians attested to Stage 1 meaningful use requirements
under the HITECH Act, signaling an industry shift to Stage 2. The December 2014
data also reported that 55% of required hospitals and 8% of physicians met
Stage 2 requirements (physicians have until March 2015 to meet Stage 2.)6
The push to meet Stage 2, and eventually
Stage 3, will result in slow new software sales as providers look to improve
their existing systems. Stage 2 involves installing interoperable programs,
which connect hospitals to improve communication of electronic medical records
(EMR.) Stage 3 requires providers to communicate medical information with
patients through secure methods.7 Cerner is in a good position because
of their focus on interoperability and communication of data across
enterprises. This is reflected in their double-digit revenue growth in 2015 and
2016. However, as providers meet the final goals of the HITECH Act in 2017, Cermer
will see growth between 6.5% and 6.0% in 2017 and 2018, finally reaching their long-term
growth rate of 5% in 2019.
Consolidation
of Healthcare Providers and Increasing Pricing Pressure
According to IBISWorld, “Healthcare
reform will likely lower industry prices and enforce reimbursement models that
create powerful incentives for hospitals to form large systems of care… As a
result of these changes, reform is expected to increase both the number and
size of industry mergers.”1 In 2014, there were 95 hospital mergers,
which represents a 44% increase since 2010. This is in addition to the 105
deals reported in 2012 and 98 reported in 2013.2 While the industry
is still largely fragmented, increasing consolidation will create fewer but
larger contracts for the HCIT industry. Cerner will face tough competition to
win these contracts, and they will have to negotiate via price. This pricing
pressure will also come from providers who want to reduce their costs because
of the Affordable Care Act.
Catalysts for Growth
The main growth factor for Cerner is the
HITECH Act and the focus on reducing healthcare costs. The incentives and
penalties from the HITECH Act will continue to drive investment in IT solutions.
Cerner will derive profits from their support, maintenance, and services
business segments when new software sales slow, but the drive to reduce
healthcare costs is a double-edged sword. While it created the HCIT industry,
it also forces companies to provide IT solutions at a low cost to providers.
Cerner’s recent acquisition of Siemens
Healthcare IT business segment is another important growth driver. The addition
will generate EPS growth of over 40% in 2015. However, EPS growth will return
to single digits in the following years. Gaining market share in this industry is
a very difficult task, because the high cost of switching prevents many hospitals
from changing their HCIT companies. This acquisition has the benefit of
significantly increasing Cerner’s market share in a very competitive
environment.
Investment Positives
• Cerner’s strengths lie in their
ability to win contracts and sell new products to existing customers, which is reflected
in their double digit bookings and backlog growth.8
• The growing demand for interoperable
systems will drive Cerner in the near term, as this is an area of competitive
advantage for them.
• Cerner’s large cash reserves and low
debt levels put them in a good position to gain market share through
acquisitions. Past acquisitions focused on growing their core business, which
enabled Cerner to integrate additional assets quickly.
Investment Negatives
• The HCIT industry will see limited
growth opportunities after providers meet the HITECH Act standards. Cerner hopes
that exploring overseas markets early will pay off in this regard. However,
they will face significant headwinds in lower demand and diverse healthcare
environments.
• My relative valuation models indicate
that Cerner’s near-term growth is built into their current price. They have a
higher P/E multiple in 2016 and higher PEG ratios in 2015 and 2016 relative to
their peers.
• As healthcare providers face pressure
to reduce patient costs, they will apply pricing pressure during contract
negotiations.
Valuation
Sales
Growth
I projected sales growth according to the
figures in the table below.
System sales drive Cerner’s overall
revenue growth, because the other segments build on Cerner’s existing base. System
sales had a five-year annual growth rate of 14%, but this number may be an
overstatement due to abnormally strong years in 2010 and 2014. In 2013, Cerner
saw system sales growth of -6.1%, but they recovered to achieve 11.6% growth in
2014. Sales will grow at 5% in 2015 and slow during the forecast period,
because of healthcare providers’ progress in meeting HITECH Act standards.
Support and maintenance sales grew at an
average of 8% per year over the past five years, and this trend will continue
in 2015. As systems sales slow, support and maintenance sales will follow suit.
The services segment grew at over 20%
annually in each of the last four years.8 This is a result of
Cerner’s focus on interoperability and enterprise-wide solutions. Products like
RevWorks focus on improving hospitals beyond the requirements of the HITECH
Act. I expect continued success in this area in the near term, but they will
suffer from decreasing investments from healthcare providers in 2017 and beyond.
To combat this, Cerner must convince cost-sensitive hospitals that investing in
products like RevWorks is worth the optional expense.
Additional
Sales from Siemens Acquisition
Cerner expects that their purchase of
Siemens Health Services will add approximately $1.2 billion in annual revenues
in 2015.8 Using this figure, total revenue growth is over 40% in
2015. As the only projection available at the time of this report, it is
included it in my model. A sensitivity analysis of this projection shows that
if Cerner overestimated Siemens’ contribution, the target price will fall
further below the current price. An addition of $950 million from Siemens would
adjust our DCF price to $73, and the DCF price is $69 at a low estimate of $700
million.
Continuing
Value Growth
I projected the continuing value growth
to be 5%, and Cerner will reach this growth rate in 2019 because of the
industry trends discussed above. Sensitivity analysis highlights the importance
of this rate. At a growth rate of 5.1%, the DCF price is over $80, and at 4.90%,
the resulting DCF price is $75.
EPS
Estimates
The table below shows a comparison of my
EPS estimates to consensus estimates. With the exception of 2015, consensus EPS
estimates are above mine. This is because consensus revenue estimates grow
faster and reach a higher level in 2019. The consensus 2019 total revenue
estimate is $7.56 billion, which is higher than my estimate of $6.50 billion. Considering
that the HCIT market is around $35 billion, the resulting market share
calculation leads me to believe that my estimate is more realistic. Consensus
estimates suggest that Cerner is able to capture almost 22% of the market by
2019, where mine have a more conservative estimate of 18.5%. While both suggest
that Cerner will increase their market share in a very competitive industry, it
will be difficult for Cerner to increase their market share from 10% in 2014 to
22% in 2019 without another large acquisition or large contract win.
EPS vs. Consensus
Source:
FactSet3
Valuation
Model Results
The model results in a target price of $77.82,
which is the most accurate model projection. This is primarily because of the difficulties
applying the other models described below. The DCF price is above the current
consensus price of $73.193 for a variety of reasons including
differences in cost of debt, beta, and WACC.
The dividend discount model produces a
target price of $40.08, but this is less reliable because Cerner does not pay a
dividend.
Lastly, the relative valuation models
suggest Cerner is overvalued to varying degrees. The variance stems from
differences in size, profitability, and risk when compared to industry peers.
Cerner’s broad customer focus also makes it difficult to compare them with
others, because many of their competitors focus on niche areas of the
healthcare industry or healthcare providers of a certain size. The best peer
comparison would be Epic Systems, because they have a very similar strategy to
Cerner. However, Epic is a privately held company.
For the reasons listed above, the DCF
model results were used to generate the target price range. Through sensitivity
analysis of key variables, I arrived at the target price range of $73 to $81.
References
1.
IBISWorld –
Hospitals in the US, 2015.
2.
Hirst, Ellen
Jean. “Hospital mergers continued to create larger systems in 2014” Chicago
Tribune. 10 February 2015.
3.
FactSet
4.
Bloomberg
5.
“Health IT Law
& Industry Rep.: Elsewhere in the News” Bloomberg. 15 January 2015.
6.
“Epic and Athena
distance themselves in stage 2” Wells Fargo Equity Research. 03 February 2015.
7.
Keston, Geoff.
“Electronic Medical Records: Trends” Faulkner Information Services. 2013.
8.
Cerner 10-K
report.
