Investment Thesis
The healthcare information technology (HCIT) industry grew
at a 9.3% CAGR since 2009, dragging healthcare providers into the 21st
century with the help of the Affordable Care Act. Healthcare providers will
take the driver’s seat as the benefit of digital systems increases their
demand. However, healthcare providers have also become more price sensitive
when negotiating HCIT contracts. Well-positioned companies (those who focus on
large hospital systems and interoperable solutions) will grow at a 6-12% CAGR
through 2017.
Drivers of Thesis
· The second
wave of demand: HCIT companies, whose
products go beyond medical records management, are in the best position to gain
market share in the future. The second wave of demand stems from healthcare
providers’ desire to reduce costs, and companies who can make them more
efficient will win their business.
· Hospital
mergers and the focus on interoperability: Large hospital systems need solutions that communicate throughout
their organization, and companies who provide interoperable systems will be in
high demand.
· Mergers and
acquisitions: As the industry
matures, market share will become more difficult to win, and established
industry leaders will increasingly target new entrants.
Risks to Thesis
· Changes in product
requirements: Changing government specifications
will significantly increase costs for HCIT companies as they rework products to
meet new requirements.
· Significant
security issues: Security breaches
could create patient mistrust of the system, reducing demand for HCIT solutions
and increasing costs for the industry.
Industry Description
The HCIT industry includes companies
specializing in software development, technology consulting, medical device
integration, records maintenance, and revenue cycle management. The industry
had revenues of $35 billion in 2013, low market share concentration, and it was
the beneficiary of increasing government regulation since 2004.3
Companies compete by selling software products and winning long-term service
contracts.
The HCIT industry is widely regarded as a growth
industry, which has benefited significantly from government regulation. Companies
who specialize in providing electronic medical record (EMR) services for
doctors and medical facilities saw the largest gains, as this was the goal set
out by legislators. While most of the growth has occurred in the United States
due to the transitioning health care system, opportunities also exists internationally.1
With many health care providers meeting the first
benchmark established by the HITECH Act, HCIT companies transitioned to meeting
the second benchmark, improving care by using EMRs established in Stage 1. This
transition will shift revenues from software sales to systems management and maintenance.
This is because healthcare providers have already adopted EMR software, and
HCIT companies will have to provide new services to generate secondary revenue
streams. For many companies, this secondary revenue stream is built in to their
contracts through maintenance and services. For others, secondary revenues will
come from the additional products they market to existing customers.
Companies compete in this industry in several ways.
First, some companies benefit from working with health care providers of a
specific size. For instance, Allscripts Healthcare Solutions Inc. (MDRX) made
gains in market share by working primarily with small and mid-sized medical practices.
In contrast, Epic Systems Corporation gained the largest market share by
focusing on large health care organizations and academic medical centers.
Companies also compete through their product offerings, where successful companies
tailor their software to the needs of clients.
HITECH Act
The key topic discussed throughout this report is
government regulation. This trend started with the American Recovery and
Reinvestment Act (ARRA) of 2009, specifically the provision titled the HITECH
Act. The federal government established this policy to promote the use of EMRs
in the United States’ health provider system. The ultimate goal was to create a
universal electronic health record (EHR) system. The universal EHR system would
enable health care providers to access a database of EMRs not only from their system,
but also from organizations across the country.
The HITECH Act is characterized by three stages, which
healthcare providers are required to meet. The chart below lists the
requirement timeline for healthcare providers based on when they initiated the
process. The numbers in the middle identify which stage a company should be in.
For instance, a provider who started the process in 2011 should be in Stage 3
by 2016.
Deadlines for Stage Attestation
Source: Centers for Medicare
and Medicaid Services
According to the Centers for Medicare and Medicaid
Services (CMS) Stage 1 involves adopting EMRs and using them in ways that positively
affect patient care.4 For attesting to Stage 1, providers can receive
Medicare incentives up to $43,720 spread over five years and Medicaid incentives
up to $63,750 spread over six years. Additionally, eligible providers who
choose not to participate face Medicare payment reductions of 1% per year (up
to a maximum of 5% annual adjustment) beginning in 2015. Many healthcare
providers initially focused on meeting Stage 1 goals, which represented the
first wave of industry demand. However, it is the second wave of demand that
will drive the HCIT industry forward.
Stages 2 and 3 represent the second wave of demand,
and it is characterized by the focus on interoperable systems. Stage 2 meaningful
use involves increasing the amount of digitally available data and using secure
electronic communication between doctors, labs, and pharmacies. Healthcare
providers have until 2016 to meet Stage 2 requirements. The transition to Stage
2 will result in software sales below those recognized during Stage 1. As a
result, companies will need to sell new products to their customers. Cerner is
a company who has made this transition. Their revenue cycle management product is
offsetting slowing software sales, and it generates reoccurring revenues,
unlike the software sales in Stage 1.
Stage 3 meaningful use is focused on
improving “quality, safety, and efficiency through decision-support tools and
patient self-management tools.”5 The deadline for early adopters to attest
to Stage 3 is 2017. Companies who invested early in patient-friendly products
will benefit most from Stage 3. Companies who have a proven track record in
data security will also benefit from the transition to Stage 3.
Transition to Stage 2
Data source: Wells Fargo
Equity Report15
As of December 2014, almost 89% of hospitals and 63%
of physicians attested to Stage 1 meaningful use requirements, 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.)
The push to meet Stage 2, and eventually Stage 3, will
benefit the HCIT industry because it puts pressure on providers to adopt new
technologies. Stage 2 involves installing interoperable programs, which connect
hospitals to improve communication of EMRs. Stage 3 will also benefit HCIT
companies, because it requires providers to communicate medical information
with patients through secure methods. One example of this is eClinicalWorks’
Patient Portal, which gives patients access to their medical records and a
means to communicate with their doctors.6 As providers attest to Stage
3 requirements in 2017, expect the maturing industry grow 5-6% annually.
Companies who provide interoperable systems will see
the strongest growth through 2017. However, only companies who can effectively
sell their business efficiency products will see above average growth beyond
2017.
Consolidation of Healthcare Providers
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 [hospital]
mergers.”13 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 2013.14 These mergers are a
result of the increased efficiency of large hospital systems. This is important
in the post-Affordable Care Act environment, where there is strong pressure to
reduce healthcare costs. While the industry is still largely fragmented, the
increased consolidation will create more and larger contracts for HCIT
companies. Additionally, companies who hold contracts with the purchasing
healthcare provider increase their market share because of a merger.
Ultimately, this trend will lead to more consolidation in the HCIT industry.
SaaS and Cloud Computing Focus
SaaS models involve providing clients with software
solutions through a subscription system. Software is made available online, and
updates are conducted through the cloud. SaaS is projected to account for 30%
of industry revenue in 2014.1 The resulting effect of SaaS on HCIT
companies is a decline in revenues from maintenance services. Since providers
are able to update their own software through the cloud, their demand for a
HCIT company’s support will decline. On the other hand, maintaining a cloud is
an expensive endeavor, and the spending in cloud-based solutions is expected to
grow at a compound annual growth rate (CAGR) of 20.5% from 2012 to 2017.3
The benefits of an SaaS and cloud system are widely recognized by healthcare
providers, and the decline in software revenues from SaaS models will be offset
by service revenues from cloud maintenance.
Markets and Competition
Data Source: Company
Financials
The 2009 HITECH Act opened the field of competition in
the healthcare technology industry. As healthcare providers work to meet the
stage goals, they depend heavily on HCIT companies to provide solutions that
meet government requirement, make their businesses more efficient, and improve
their patient outcomes.
In this market, companies vie for contracts through
price, effectiveness of services, support, maintenance of systems, and the ability
to tailor solutions to their client’s needs. While some companies benefit from
working with large or merging healthcare providers, as discussed above, others
are able to grow by working with small to mid-sized providers. In doing so,
they provide more tailored solutions for their clients.
In general, the market concentration is low. While
some companies hold a large share of a specific client type, few are able to
provide solutions that meet the needs of all client segments.1
Investing in research and development (R&D) and skilled programmers is very
important in the industry. This enables HCIT companies to meet a client’s
specific need and provide new, differentiated software solutions. However, this
also has a significant impact on their cost structures, so a fine balance must
be achieved in this regard.
Finally, as with many growing industries, the
competition level is very high. As shown in the discussion of recent contract
moves, the type of competition HCIT companies face is mostly within the industry.
The availability of substitutes gives clients bargaining power, and the poor
performance of an HCIT company’s software or support could lead to the shift of
an important contract.
Data Source: FactSet
Epic Systems Corporation
Epic is a privately owned company, headquartered in
Verona, WI, who specializes in mid to large hospitals and integrated healthcare
organizations. As such, the company focuses on providing enterprise-wide
solutions for their clients. Epic leads its competitors with 97% of hospitals
attesting to Stage 2 and is second in physician attestation at 26%.15
Epic is well-positioned in the industry with an estimated 22% of market share.1
In 2014, Epic made significant gains by winning new contracts at the expense of
their competitors including McKesson, Cerner, and Allscripts. Epic focuses on
many of the key industry drivers listed above. Specifically, they provide
interoperable solutions and have a strong hold on the large hospital market. Epic
has the best opportunity to increase their market share and they pose the
largest threat to the industry’s publically traded companies.
Data Source: FactSet
McKesson Technology Solutions (MCK)
McKesson, located in San Francisco, CA, operates in
two major segments. The first, McKesson Distribution Systems, focuses on the
distribution of pharmaceuticals for biotech and pharmaceutical companies. The
second segment, McKesson Technology Solutions, “delivers enterprise-wide
clinical, patient care, financial, supply chain, strategic management software
solutions, as well as connectivity, outsourcing and other services, including
remote hosting and managed services, to healthcare organization.”16
Their 2014 annual revenues were $137.6 billion, with $3.18 billion coming from
the McKesson Technology Solutions segment. They also reported an operating
margin of 1.2% and R&D expenses of $456 million in 2014.16
Finally, McKesson has a higher portion of debt compared to their peers, which
will put them at a disadvantage if they wish to increase their market share
through debt-financed acquisitions. McKesson’s market share will not increase
significantly, and I do not see them as a positive investment opportunity in
this industry. Their strengths and efficiencies lie in their distribution
business segment, which is a significantly different business model from the
typical HCIT company.
Cerner Corporation (CERN)
Cerner, headquartered in Kansas City, MO, provides
HCIT solutions to healthcare providers of all sizes, including hospitals,
ambulatory facilities, and small physician practices. The company provides
cloud-based systems and statistical algorithms aimed at improving patient
outcomes. They also provide software that improves billing cycle management,
helping hospitals collect payments more effectively. Cerner’s 2014 revenues
were $3.4 billion and operating margins were 22.4%.17 They
accomplished this high margin due to their popular brand name, successful
performance with large hospital systems, and comparatively large-scale
operation. While Cerner is able to compete for major contracts within the
United States, it has also seen significant growth in the United Kingdom,
Middle East, and Australia. Cerner is the best-positioned publically traded
company in the HCIT industry because they also focus on many of the drivers we
identified. Cerner’s low debt level enables them to finance any future
acquisitions with debt, even though previous deals were financed with cash.
Cerner may be stuck at the number two position, because of our positive outlook
for Epic, the current industry leader.
Data Source: Company
Financials
CareFusion Corp (CFN)
CareFusion, located in San Diego, CA, focused on
“areas of medical management, infection prevention, operating room
effectiveness, respiratory care, and surveillance and analytics.”18
CareFusion operates in a slightly different environment than Epic, Cerner, and
McKesson by providing products that improve efficiency and medical performance,
where their competitors look to provide enterprise-wide EMR solutions.
CareFusion has a market share of 11% and revenues of $3.84 billion, and their
operating margins are about 18%.18 While CareFusion presents an appealing
opportunity for growth based on their niche offering, the trends towards an
enterprise-wide HCIT solution give their competitors a better long-term
strategy. As hospitals merge, they will force their smaller components to adopt
their HCIT system. We believe that this could decrease CareFusion’s market
share while strengthening their competitors’.
Data Source: FactSet
Catalysts for Growth
The main growth factor in the HCIT industry is the
HITECH Act and the increased focus on reducing healthcare costs. The incentives
and penalties will continue to drive investment into IT solutions. When new
software or system sale growth slows, HCIT companies will be need to transition
to a maintenance based model.
The other important growth catalyst is the trend
towards reducing healthcare costs, while improving patient care. With the use
of data analytics, increased communication among providers and patients, and
ability to remotely diagnose and treat patients, the HCIT industry will help
achieve both of these goals.
Investment Positives
·
The HCIT industry
will continue to benefit from an increased awareness of healthcare costs in the
United States. As pressure is applied to healthcare providers to become more
efficient, they will seek HCIT companies to help improve their business model.
·
The
implementation of new IT solutions will generate immediate and long-term
revenues for HCIT companies. As they transition from installing new systems to
improving and maintaining those systems, they will continue to generate
profits.
Investment Negatives
·
As important as
the HITECH Act was in spurring a growth opportunity in the HCIT industry, a
change in legislation could significantly affect the industry. A change in the
incentive/penalty policy would reduce the demand for some healthcare providers,
changing the outlook for industry.
·
Cloud storage is
widely regarded as a more secure storage system than the previous, paper copy
system used in hospitals. However, the threat of a data breach is very real; any
significant events in this regard would cause Americans to reexamine the
industry.
Valuation
In the coming years there will be transition in the
industry towards system improvement and maintenance. I expect current growth
rates of 6-12% to continue until 2017, when many healthcare providers will meet
Stage 3 requirements. Beyond 2017, growth rates to slow to around 6%.
Companies who focus on large hospital systems,
interoperable products, and improving additional revenue streams are best
positioned to take advantage of industry trends. Companies like Epic and Cerner
will increase their market share as hospitals merge and look to reduce costs. Epic
and Cerner will grow closer to 12% per year through 2017, but even they will be
subject to increasing pricing pressure and declining demand in the long-term. In
2018 and beyond, Epic and Cerner will slow to 6% annual growth
.
References
1.
“Electronic
Medical Record Systems in the US” IBISWorld. 2014.
2.
NCHS Data Brief,
2013:
3.
Barr, James.
“Healthcare IT Systems Market Leaders” Faulkner Information Services. 2015.
4.
Centers for
Medicare and Medicaid Services: http://www.cms.gov/Regulations-and-Guidance/Legislation/EHRIncentivePrograms/index.html
5.
The Office of the
National Coordinator for Health Information Technology:
6.
Keston, Geoff.
“Electronic Medical Records: Trends” Faulkner Information Services. 2013.
7.
Wayne, Alex;
Webb, Alex. “Cerner to Buy Siemens Health Data Business for $1.3 Billion”
Bloomberg. 06 August 2014.
8.
Herper, Matthew.
“Cerner to buy Siemens Health IT for $1.3 Billion” Forbes. 05 August 2014.
9.
Mead, Charles;
Rana, Anurag. “Cognizant’s TriZetto M&A Feeds Fastest-Growing Health-Care
Unit” Bloomberg. 15 September 2014.
10.
Boulton, Guy. “Mayo
Clinic picks Epic Systems for Electronic health records” Milwaukee Journal
Sentinel. 21 January 2015.
11.
Armour,
Stephanie. “Accenture Wins New HealthCare.gov Contract” The Wall Street
Journal. 29 December 2014.
12.
“Health IT Law
& Industry Rep.: Elsewhere in the News” Bloomberg. 15 January 2015.
13.
IBISWorld –
Hospitals in the US, 2015.
14.
Hirst, Ellen
Jean. “Hospital mergers continued to create larger systems in 2014” Chicago
Tribune. 10 February 2015.
15.
“Epic and Athena
distance themselves in stage 2” Wells Fargo Equity Research. 03 February 2015.
16.
McKesson
Technology Solutions 2014 10-K report.
17.
Company press
release, 10 February 2015:
18.
CareFusion Corp
2013 10-K report.
19.
“Total health
expenditure” IBISWorld. 2014.
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