Cerner Corp. (CERN, Financial) is a gem with a short-term margin expansion opportunity at a reasonable valuation. I am waiting to see if management delivers what they promise or for the stock to drop below $60.
The company is a leader in the health care IT industry, which has years of growth ahead. That being said, Cerner has room to improve in regard to efficiency. The new management, under pressure from Starboard Value, is focusing on improving operations in the short term. The valuation is reasonable, especially if management can deliver the operating efficiency as promised.
Details
I have previosly discussed that anything to slow the growth of health care spending, without jeopardizing quality of care, is worth investing in. U.S. health care spending already accounts for 18% of gross domestic product, the highest of all developed countries. The Center of Medicare and Medicaid predicts health care spending will grow at an annual rate of 5.5% and will account for 20% of GDP by 2026. This trend is clearly not sustainable.
Meanwhile, the productivity of the health care industry is unsatisfactory. It is easy to imagine that many things can be done to improve productivity and cut costs by applying advanced technologies and analytical tools.
Cerner is the largest global health care IT company. It is number two in the United States, just behind privately-owned Epic. Cerner’s core software renders patients’ electronic health records easily accessible and shareable by physicians, hospitals and other health care providers.
Source: KLAS Enterprises.
Cerner, with 26% of the market share in the $280 billion health care IT industry, helps to slow the growth of U.S. health care spending. For example, Cerner helped MU Healthcare reduce its blood transfusion rate by 13.3%. This could potentially translate to $1.3 billion annual savings for all of its clients.
Cerner also helped Genesis, a hospital of 642 beds, realize $710,000 in savings in the first six months of using its program by reducing the length of stay for patients on antimicrobial drugs, reducing in-hospital acquired infections and delivering better formulary management. A full implementation of the program on all of Cerner’s clients could result in total annual saving savings of $585 million.
Cerner targets a 6% to 9% compounded annual growth rate for revenue over the next five years. In 2018, 90% of its revenue is recurring or highly visible. Aroung 40% of software revenue is software as a service, while 85% of the revenue in the forward year is locked through contracts in the $15 billion backlog (about three years of revenue).
But Cerner’s stock has not been performing well for the last three years, even with decent revenue growth.
What is the problem?
The issue lies in the decline of Cerner’s margin and earnings. The company's adjusted operating margin has declined from the mid-20s over the last three years to 15% in the first six months of 2019. The company has frequently missed earnings estimates since 2016.
I cannot pinpoint why the margin has deteriorated so much. During the fourth-quarter 2014 earnings call, management said that as a result of the acquisition of Siemens Health Care Services, which it acquired for $1.3 billion in 2015, the adjusted operating margin was expected to be in the low 20s, down from the mid-20s in 2014. But they also expected the margin to return to the mid-20s by 2017. In fact, the operating margin in 2015 was fairly decent at close to 25%. Therefore, I think the adjusted operating margin in the mid-20s is where the margin is supposed to be for the business. But the margin declined three and a half years in a row. Management discussions cited various reasons, but I am not convinced they are correct. The gross margin has been very stable at 83% to 84%, so the deteriorating margins do not seem to be due to a shift in mix.
Has Cerner become too unproductive? The biggest cost line item on the income statement, spending in sales and client services, increased from 42% in 2015 to 46% in 2018. In addition, not only does Cerner have the lowest revenue per employee among its competitors (some of which are much smaller in scale), but also this measure declined significantly over the last five years as the number of employees went up 32% but revenue increased only 21%.
I have several ideas as to why productivity has decreased. First, the company may have been preparing for growth after scoring a major contract with the Department of Veterans Affairs in 2018.
Second, the company may have run loose when it was in a period of leadership transition. Cerner’s founder and CEO, Neal Patterson, a tough manager regarded as one of the visionaries of the industry, had a recurrence of skin cancer in mid-2016 and passed away in 2017. Co-founder and Vice Chairman Clifford Illig took over as interim CEO before the company hired Brett Shafter at the beginning of 2018.
The void in leadership may have contributed to the bloated cost base. If my guesses are mostly correct, then neither of the two are structural problems. The margin problem could be remedied fairly quickly with 6% to 9% top-line growth.
Why is the stock a buy?
First of all, health care IT is a sizable market and helps solve one of the toughest problems faced by the United States. Each of the growth categories within the industry is a decent size and have good growth potential. As the second-largest player in the EHR market, Cerner already has access to valuable patient data on its platform. It is well positioned to capture the growth in analytics and artificial intelligence, telehealth and population health management, three of the high-growth areas with a combined $100 billion market opportunity. Cerner’s current revenue of $5 billion as one of the leaders in the industry is pale in comparison.
Second, the company also has a scale advantage. Epic and Cerner are the two leaders in EHR accounts for about 50% market share. There are still many other smaller players, but as health records become increasingly connected, the companies with the largest scale and best access to data can provide the best services and analytics to clients. Cerner is one of the top two with that scale. Being the second-largest EHR network provides the company with an important platform for future growth and a deep moat that is easier to defend.
Third, short-term growth is visible. Cerner has two things to ensure growth over the next several years.
One is the contract with the VA. Cerner was selected in 2018 to replace the agency's existing EHR system with one based on the EHR deployed across the Department of Defense's health system, which was built by Cerner. The VA manages one of the largest health systems in the world with more than 18 million people. This project will allow patient data to be shared between the VA, Department of Defense and community providers through a secure system. This contract is expected to contribute to Cerner's growth for several years to come.
Second, Cerner has promised investors it will improve the adjusted operating margin from the current (and lowest in company history) margin of 18% in 2018 to 20% by the end of 2019 and 22.5% in 2020.
While the CEO didn’t deliver the first year, the board is likely to push changes through.
In the first quarter of the year, Starboard Value accumulated 1.2% of Cerner’s shares. Using its influence, the firm was able to add four directors to Cerner’s board, boost its stock buyback program from $1.2 billion to $1.5 billion and initiate a quarterly dividend of 18 cents per share. Subsequently, the company announced its aims to improve the adjusted operating margin. We will count on Starboard to continuously push for changes if the company’s performance is unsatisfactory.
Valuation
Compared to the very few publicly listed health care IT companies, which are small and have low profitability, Cerner seems fairly valued. But compared to some of the leading IT companies in other sectors, the company looks very attractive, especially if we can trust its margin expansion story.
With mid-to-high single-digit top-line growth and good profitability, Cerner appears quite pleasing for the long term. The question is whether I will be able to achieve a 15% annual return for the next two years.
The price is currently around $66. The margin is supposed to be expanded and normalized in 2021.
Based on a price-earnings ratio of 20 in 2021, a purchase price $55 gives me a good margin of safety to achieve a 15% return for the next two years. I think 20 times earnings is attractive for a company that can consistently enjoy 6% to 9% top-line growth for a long time.
If I am willing to be more aggressive and use 25 times earnings in 2021, a purchase price of $65 gives me a good margin of safety to achieve a 15% return for the next two years.
The consensus has built in a certain level of margin recovery. The next step is to see the company deliver, which it has not (currently) done to my satisfaction. The most recent quarter showed the operating margin was still 18%, though management did confirm it expects a 20% margin at year-end.
I do not have enough confidence that management can deliver a 22.5% margin for 2020. At its current price, the risk of Cerner stock is balanced to me. I will be more aggressive if the share price gets below $60, everything else being equal. Alternatively, I will need to see management demonstrate the ability to deliver what they have promised.
What keeps me up at night
Execution, execution, execution. The CEO has been in place for over a year and we saw margins drop and several quarters of disappointing earnings. Management became more focused on margins after Starboard bought into the stock, but there are still several things bothering me.
First, I don’t understand why the margin dropped that much in the first place. Second, why did an outside activist investor have to tell management the margin is a problem that needs to be fixed? Third, I would like the presentations and conference calls to have more numbers and facts rather than wordy marketing and promotions.
Disclosure: No positions.
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