The Moat Stays Strong, Even if the Listing Is Gone

Cerner lost its place on a wide moat list but still retains its moat and has good odds for delivering double-digit growth through the next decade

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Oct 21, 2016
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In mid-September, Cerner Corp. (CERN, Financial) was removed from a prestigious list: The Morningstar Wide Moat Focus IndexSM.

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The Index is made up of two components.Ă‚ Morningstar describes them this way:

“Companies must have an economic moat rating of wide (meaning we think they have advantages that will fend off competitors for at least 20 years), and their shares must be among those trading at the steepest discount to their fair value estimates in our coverage universe. (Our fair value estimates are determined through independent research by the Morningstar Equity Research team.)”

Does Cerner’s removal from the list suggest the company has slipped in some important way? Not really, because it lost its place due to the second criterion: being at a very steep discount to fair value estimates. It continued to hold its moat rating, according to Morningstar.

As seen above, that wide-moat rating suggests the company should be able to fend off competitors for at least 20 years.

Cerner has a place on another list, the Undervalued Predictable list at GuruFocus.

Below is an exploration of Cerner’s strengths and weaknesses.

History

1979: The company is founded by Neal Patterson, Clifford Illi and Paul Gorup, who had worked at the management information systems consulting division of Arthur Anderson in Kansas City, Missouri. Their goal is to develop laboratory information systems.

1980: Cerner is incorporated and continues to work on product development.

1984: The first application is released: the PathNet laboratory information system.

1985: The company begins to define what will become its Health Network Architecture, an envisioned end-to-end system that will provide access across the continuum of a patient's care.

1991: It acquires Intellimetrics Instrument Corporation of Massachusetts and introduces Open Clinical Foundation (OCF).

2015: It acquires Siemens Health Services, the health information technology business of Germany’s Siemens AG.

(History based on information at FundingUniverse and Wikipedia.)

Cerner is a high tech company with more than 35 years in its chosen field that has grown through organic development and acquisitions.

Cerner’s business

The company describes itself this way (unless otherwise noted, the information here comes from its 10-K for 2015):

“Cerner is a leading supplier of health care information technology (HCIT)."

“Our mission is to contribute to the improvement of health care delivery and the health of communities."

“We offer a wide range of intelligent solutions and services that support the clinical, financial and operational needs of organizations of all sizes."

“We have systems in more than 20,000 facilities worldwide, including hospitals, physician practices, laboratories, ambulatory centers, behavioral health centers, cardiac facilities, radiology clinics, surgery centers, extended care facilities, retail pharmacies and employer sites.”

Solutions are built on two platforms:

  • Cerner Millennium architecture.
  • HealtheIntentĂ‚ cloud-based platform.

Cerner holds more than 300 patents and several hundred more applications. It spends heavily on research and development -- about $685 million in fiscal 2015 -- and at the end of the year had some 5,900 employees working in R&D.

The company sums up its business model in this graphic from the Investment Community Meeting HIMSS Las Vegas:

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With installations in more than 20,000 facilities, Cerner Corp. has a very wide footprint and intellectual property to help protect its stature in its industry.

Revenue

The company had revenue of $4.43 billion in fiscal 2015, which came from three main sources, as shown in this excerpt from its 10-K:

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Domestic (U.S.) operations also accounted for almost 90% of that revenue.

GuruFocus notes, “During the past three years, the average Revenue per Share Growth Rate was 18.5% per year. During the past five years, the average Revenue per Share Growth Rate was 17.3% per year.”

Cerner has grown its revenue aggressively, with revenue per share in the high double digits over the past three and five years. While the Siemens acquisition may change the proportions in this and future years, the company gets most of its revenue from domestic operations.

Competition

Cerner says in its 10-K for 2015 that the market is intensely competitive, with competition from other full-suite providers, as well as companies that focus on only part of the market.

Named competitors in the full-suite category are: Allscripts Healthcare Solutions Inc. (NASDAQ:MDRX), Computer Programs and Systems Inc. (NASDAQ:CPSI), Epic Systems Corp., GE Healthcare Technologies (NYSE:GE), Healthland Inc., McKesson Corp. (NYSE:MCK), MEDHOST Inc. and Medical Information Technology Inc.

Turning to the firms that offer some services and products, named competitors are Clinovations Inc., Dell Inc. (NYSE:DVMT), Encore Health Resources LLC, IBM Corp. (NYSE:IBM), Impact Advisors, S&P Consultants, The Advisory Board Company and Xerox Corp. Ltd. (NYSE:XRX)

Cerner’s moat

While Cerner has called its market intensely competitive, Matt Cofina of Morningstar says:

“. . . their core product is electronic health records that they sell, especially to large hospital systems. There are a number of companies that do this, but it's really evolved into a two-horse race, especially in the large hospital market, between Cerner and Epic systems, which, unfortunately, is a privately held company so we can't invest in it.”

“. . . Cerner, because it's an early mover in the space and really capturing a lot of the incremental client wins, is going to be very well positioned to benefit from that growth over the course of the coming decades.”

“Cerner is a very nicely profitable business--very robust operating margins. Margins tend to trend up over time; it's a naturally scalable business. Once you've built the software, you can spread it to more and more clients without that many incremental costs.”

Cofina’s comments point to three critical advantages possessed by Cerner: effectively it is one of only two companies competing for electronic health records in large hospitals, it has early-mover status and it has economies of scale.

Growth

According to its Investment Community Meeting HIMSS Las Vegas presentation, Cerner expects to grow on two fronts. First, it has set the goal of achieving double-digit growth through 2025:

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It also plans to materially grow its margins:

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Comments: Assuming the company can deliver on both of those goals, growth will be both robust and profitable for the next decade.

Other

Cerner Corp. is incorporated in Delaware, and headquartered in Kansas City, Missouri.

It had approximately 22,000 employees at the end of 2015.

Neal Patterson, age 66, is the chairman and CEO. As noted, he is one of the founders of the company.

Marc G. Naughton, age 60, is chief financial officer and executive vice president. He joined the company in 1992 as manager of taxes, and in 1995 was named chief financial officer.

The 2015 fiscal year ended on Jan. 2, 2016.

Information on company officers from Reuters.com.

Ownership

Ten investment gurus followed by GuruFocus hold positions in Cerner Corp. The Vanguard Health Care Fund (Trades, Portfolio) is the biggest, with 16,949,730 shares. The second and third largest holdings belong to Frank Sands (Trades, Portfolio) and Manning & Napier Advisors Inc.

Otherwise, there is a very heavy concentration of institutional ownership, with a modest showing by shorts and insiders.

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Almost all of this company is owned by institutional shareholders, mainly pension funds and mutual funds. The degree of ownership by shorts and insiders seems reasonable.

CERN by the Numbers

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The company reports in its 10-K that it bought back, but did not retire, 4.1 million shares in fiscal 2015.

The current share price is roughly half way between the 52-week high and low, the price-earnings (P/E) ratio is above 30, and the return on equity (ROE) is above 16%. The company pays no dividend and does not effectively buy back shares.

Financial Strength

GuruFocus’ ranking system gives Cerner good, but not great, marks for both financial strength and profitability & growth:

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Looking down the Financial Strength column, the eye-catcher is the red icon for its Cash to Debt ratio, the red indicating the company is not doing as well now as it has in the past. So, let’s look at a five-year chart of its long-term debt:

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Now, let’s add on cash and cash equivalents (the red line):

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What changed the direction of these lines? The acquisition of Siemens Health Services, with a $1.39 billion cash price tag. It is an accretive acquisition, and the company reports in its 10-K that it booked revenue of $930 million for the 11 remaining months of fiscal 2015.

Here’s how EBITDA looked, to the end of 2015:

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And free cash flow:

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Cerner’s financial profile changed dramatically in 2014-15 as it bought out Siemens Health Services, its first major acquisition in recent years.

Valuation

First, Cerner is a high-predictability company, with a 4.5- (out of 5) Star rating. GuruFocus back testing has found average annual gains of 4.5-Star companies to be 10.6%. And, there is only a 10% chance a 4.5-Star company will be in a loss position if held for 10 years.

As to valuations, GuruFocus advises, “Cerner Corp is more suitable for Earning Power Based valuation methods. This includes 1) Median P/S Value 2) Peter Lynch Fair Value. The Median P/S Value of Cerner Corp for today is 58.89. The Peter Lynch Fair Value of Cerner Corp for today is 27.53.” At the time of this assessment, the share price was $58.89, the same price as the Median P/S Valuation.

The Discounted Cash Flow calculator produces a lower valuation:

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Note that the DCF calculator uses a discount rate of 19.6% for the first 10 years, and a 4% annual return for the second 10 years.

Finally, Benjamin Clark submitted CERN to the ModernGraham valuation test, and reported this result on Aug. 9.

“As for a valuation, the company appears to be fairly valued after growing its EPSmg from 87 cents in 2012 to an estimated $1.71 for 2016. This level of demonstrated earnings growth supports the market's implied estimate of 13.86% annual earnings growth over the next seven to 10 years. As a result, the ModernGraham valuation model, based on the Graham value investing formula, returns an estimate of intrinsic value within a margin of safety relative to the price.”

Comments: Did the acquisition of Siemens Health Services add to Cerner’s valuation? Apparently so, judging by the median P/S valuation and the ModernGraham valuation. The purchase did pull down its cash flow metrics and increased its debt, but earnings should continue to justify the purchase.

Conclusion

Cerner Corp. should be on the short list(s) of investors looking for double-digit earnings growth at a fair price. Since it does not pay a dividend, it will not suit income investors.

We began by noting that Cerner no longer has a place on Morningstar’s Wide Moat list. And, that it lost its place because, “. . . their shares must be among those trading at the steepest discount to their fair value estimates . . . ” Since that change, in mid-September, the share price has again slipped down, so perhaps it again deserves a place on the list (although the list is only updated every six months).

Since the moat remains intact, we might add that the odds of that double-digit earnings growth continuing are quite good, and prospects for its owners look bright as well.

Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the foreseeable future.

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