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Health Care IT Industry Leader Is Trading at a Discount

Investment thesis

Cerner Corp. (NASDAQ:CERN) is an internet technology company benefiting from the digitization of the health care industry. Revenue and earnings growth as well as the implementation of its first-ever dividend resulted in a 28.6% gain in 2019.

Even on the back of such a strong performance, shares are still trading with an upside potential of 7% based on the intrinsic value per share calculated using a discounted cash flow model. The total return for investors will be much higher as the company continues to repurchase shares and distribute dividends.


Company overview

Cerner is a health care IT service provider with an installed base of more than 27,500 facilities around the world, according to its latest filings with the Securities and Exchange Commission. The company provides electronic health records, ambulatory services and analytics software.

The company's products and services can be categorized into five sections. Under these categories, Cerner provides a wide variety of software solutions that address the entire business value chain of a health care service provider.

Population health management

Clinical solutions

Open platforms

Revenue cycle management

Services and technology

Analytics

Ambulatory

Cerner connectivity hub

Billing, claims and contract management

Adoption coaching

Customer relationship management

Laboratory

Cerner health information exchange

Case management

Application services

Patient engagement

Critical Care

Reference lab network

Enterprise document management

Consulting services

Performance improvement

Nursing

Health information management and coding

Hosting and monitoring

Registries and scorecards

Oncology

Patient access

IT management and alignment

Wellness solutions and services

Pediatrics

Practice management

Record retrieval



Source: Company filings.

The company currently provides its software services to 2,593 hospitals and medical centers around the world and is a leader in this space.

Source: KLAS Research.

Cerner has a strong economic moat

While Cerner is the leader of the global health care IT services market, Epic, a private company, is its closest rival. Apart from these two major players, however, the market is fragmented, so there are no significant threats to Cerner's operations. The sheer size of the company is too much for small-scale players to deal with.

Source: Owler.

There are two economic moats helping Cerner stay ahead of the competition:

  1. Customer switching costs.
  2. The brand name.



Switching costs are high due to the time and effort required to transition from one software provider to another, discouraging health care service providers from switching from Cerner's solutions and look for alternative options.

There is also the risk of training employees on the new software platform to get the best out of it. Simply put, the costs of changing a software service provider in the health care industry are higher than the benefits. Therefore, changes often do not happen, unless the software provider fails to live up to the expected standards. The high proportion of recurring revenue (80% in 2018) suggests Cerner is doing an excellent job of retaining its customers, which makes it difficult for competitors to gain market share.

There is a risk of data loss as well when software service providers are being changed. For health care companies, the risk is too high to bear as losing essential patient data could lead to a significant loss in business and credibility.

The brand value of Cerner, which is an intangible asset, helps the company build on its strong moat. The company has been in operation since 1980 and has a high brand value in the health care IT sector. This is evident in the number of large-scale companies working with the company. For example, filings with the SEC list Ascension Health, Tenet Healthcare (NYSE:THC), Universal Health Services (NYSE:UHS) and Trinity Health, some of the largest health care service providers in the U.S., as Cerner's clients.

Another indication of Cerner's brand value is the wide recognition of its software products across the globe. Cerner operates in 35 countries currently and is the leader of the healthcare IT market in most of these countries.

Source: Data from HIMSS Analytics.

Cerner's economic moat is strong, which is an indication the company can stay ahead of the competition and remain profitable for many years to come.

Industry outlook

Deloitte projects the global health care industry will grow at a compounded annual rate of 5.4% through 2022. Three factors are driving the expected growth of this industry:

  1. The growth of the aging population.
  2. Higher allocation for health care costs by developing nations.
  3. Clinical and technological advances.



On the back of this projected growth for the industry, Deloitte expects the health care IT segment to grow at a compounded annual rate of 15.9% through 2021. This will benefit Cerner as it is one of the leading providers of health care technology services.

The industry is expected to become technology-centric within the next five years. Many high-tech aspects are being incorporated into the business operations by health care services companies. The graphic below illustrates the digital innovations driving the industry.

Source: Deloitte.

Soo Romanoff, the Morningstar analyst covering Cerner, predicts the industry will transform from a fee-for-service model to a fee-per-value model within the next five years. Such a transformation will further highlight the importance of IT service providers as advanced technologies could increase the value component for customers.

The highest growth in health care sector revenue will be reported outside the U.S. For instance, Krane Shares projects health care spending in emerging markets will increase to 24.4% as a percentage of gross domestic product by 2040, in comparison to just 9.8% in developed markets.

As such, the macroeconomic outlook for Cerner is favorable for at least the next five years.

Starboard's involvement

Starboard Value is a New York-based investment advisor that focuses on acquiring significant stakes in undervalued companies and pushing management for change in order to unlock hidden value.

Currently, Starboard owns 3 million shares of Cerner, which translates to 0.92% of the total shares outstanding. In April, the company announced the following changes to its business structure based on its agreement with Starboard investors.

  • The board of directors to be refreshed with four new directors, two of which were appointed by Starboard.
  • The establishment of a finance and strategy committee to oversee the company's operational efficiency.
  • A target operating profit margin of 20% for the fourth quarter of 2019.
  • Authorization of an additional share repurchase program of $1.2 billion on top of the existing authorization to repurchase $1 billion worth of shares.
  • A proposal to declare a quarterly dividend.



These developments are positive for investors. Starboard's initial strategy is to distribute wealth to shareholders. This will have two effects on the value of Cerner's stock.

First, repurchasing shares will improve earnings per share and sales per share. As a result, valuation multiples will make the stock look cheap.

Second, the total return to shareholders will increase as wealth is distributed through buybacks and dividends.

The company purchased 8.7 million shares in the second quarter and has $883 million remaining in the authorized plan.

Starboard's involvement is positive for the company's future as well. A declining operating profit margin is an issue Cerner has dealt with in recent years.

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Cerner, in collaboration with Starboard, has implemented 165 strategies to improve margins, which was confirmed by management in the second-quarter earnings conference call. These initiatives are expected to lift the operating margin in the fourth quarter to 20% and further improve it to 22.5% in 2020.

Cerner declared its first-ever quarterly dividend in May

Cerner declared a quarterly dividend of 18 cents per share in May, which marked the establishment of a regular dividend policy. The company's commitment to rewarding shareholders boosted the appeal of the stock among long-term value investors.

Growth opportunities

As a result of Starboard's involvement in the company, Cerner is working to improve operating margins by selectively taking on more profitable projects. During the earnings call, management confirmed that a particular emphasis on the nature of business contracts would be implemented to determine the long-term profitability before bringing on new clients or providing software services.

Analysts at NPI Financial believe health care companies are willing to pay for high-end core software systems so they can provide a more customized, personalized and seamless experience for their patients. This presents a growth opportunity for Cerner.

A survey conducted by SelectHub revealed the average life of an enterprise resources planning system is between five and 10 years. Morningstar estimates the average life of a health care ERP system is around 12 years. From this perspective, Cerner's revenue is sustainable in the long term. Also, as per the management, the company is looking to provide a seamless service to its existing customers to ensure they stick with the company's products.

Another growth area for Cerner is its operations outside the U.S. As highlighted in the industry analysis segment, international health care spending will grow exponentially through 2040. The company's presence in 35 countries is a good indication of the growth opportunities that will open up in the future.

In addition to these opportunities, Cerner plans to become the most respected and reliant resource for curated health data. Therefore, the long-term plan is to create a distribution platform to monetize this data. Management provided a detailed outlook for this strategy in during the recent earnings call.

Valuation

A discounted cash flow model was used to calculate the intrinsic value of Cerner. The table below illustrates the revenue growth assumptions for the next five fiscal years.

Fiscal year

Revenue (millions)

Implied growth rate

2019

$5,704

6.6%

2020

$6,121

7%

2021

$6,4562

7%

2022

$7,008

6.8%

2023

$7,463

6.5%



Source: Author's assumptions based on industry growth projections and analyst estimates from Refinitiv Eikon.

The operating margin is expected to improve as a result the initiatives Cerner has taken over the last six months. The earnings before interest, taxes, depreciation and amortization margin is projected to grow from 22.5% in 2018 to 33% in 2023. This improvement is a direct result of operating margin expansion.

Below are the other critical assumptions used in the discounted cash flow model.

  • Capital expenditures as a percentage of revenue: 7.88%
  • Working capital as a percentage of revenue: 11.6%
  • Depreciation and amortization as a percentage of revenue: 7.9%
  • Cost of capital of 9%.
  • A revenue multiple of 3.6 to calculate the terminal value.



With these assumptions, the intrinsic value per share comes to $73.31, which represents an upside of 7% from the current market price of $68.46.

The intrinsic value is highly sensitive to the revenue multiple used to calculate the terminal value.

Revenue multiple

Intrinsic value per share

Upside/downside

3.1

$64.11

-6.3%

3.6

$73.31

7%

4.1

$82.87

21%



Source: Author's estimates and calculations.

The risk-reward profile is attractive for Cerner, and the revenue growth rates used in the model are conservative. The health care IT sector might grow at a much higher rate if global economic growth continues to gain momentum.

Risks

The changing regulatory environment for the health care sector is the primary risk of investing in Cerner. The company needs to implement the requested changes quickly in order to comply with such regulations and avoid being the subject of hefty fines. Key customers could be lost if it does not adopt these changes efficiently.

Another risk is the reliance on growth outside of developed markets. If a global economic recession occurs within the next five years, growth in emerging markets will come to an end. This might prompt health care companies to cut back on capital expenditures.

Conclusion

Cerner shares are undervalued. The market pushed the stock higher in 2019, but the company's continued growth will support even higher share prices in the future. The macroeconomic outlook is favorable, Cerner's economic moat is strong and there are initiatives to improve the operational efficiency of the company. Share repurchases and dividends will provide an additional stream of income to investors.

Disclosure: I am long Cerner and plan to buy more shares in the next couple of weeks.

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This article first appeared on GuruFocus.