INVESTMENT THESIS
Cerner Corp. (NGS: CERN) is BUY. The company performed well in the third quarter, meeting the consensus earnings estimate despite the continued impact of the COVID-19 pandemic. While the pandemic has led to slower sales, and delayed the deployment of certain electronic health records systems, management believes that the company’s sales opportunities will simply be spread out over a longer period, rather than lost altogether. In addition, the company continues to rein in costs and to identify new partnerships and acquisition opportunities. On the negative side, we note that Cerner used the services of SolarWind, which was recently subject to a major cyber attack, as recently as 2018; however, as of this writing, there is no indication that it has been impacted by the breach. Our revised target price of $88, raised from $77, assumes a projected 2021 P/E of 26, still below the industry average, and a potential return of 13% including the dividend.
RECENT DEVELOPMENTS
The company recently reported 3Q20 EPS that matched expectations for earnings, but missed on revenue. Adjusted EPS rose 9% to $0.72, at the midpoint of management’s guidance range of $0.70-$0.74 and in line with the consensus forecast. On a geographic basis, revenue fell 3% in the domestic segment to $1.23 billion, and 16% in the international segment to $138 million, primarily due to the divestiture of assets in Germany and Spain. The company reported bookings of $1.47 billion in 3Q20, up 10% sequentially. The total backlog was $13.01 billion, down 2% sequentially, primarily due to the impact of divestitures. For the first three quarters of the year, revenue fell 3% to $4.11 billion, while adjusted EPS rose 7% to $2.06.
On the 3Q earnings call, management provided fourth-quarter guidance. In 4Q20, it expects revenue of $1.365-$1.415 billion, representing a year-over-year decline of 2%-5%, though management noted that the midpoint represents roughly 1% growth after adjusting for divestitures. It expects 4Q adjusted diluted EPS of $0.76-$0.80, representing growth of 1%-7%. It also looks for fourth-quarter new business bookings of $1.55-$1.75 billion, representing a sequential improvement from 3Q20.
Cerner has relied in part on partnerships to drive growth. On September 10, the company announced a collaboration with a group of regional governments in Finland with the goal of delivering improved access to health and social services. On August 27, it also announced a collaboration with Amazon that allows consumers to easily measure and share health information with physicians and other healthcare providers. Through the collaboration, data from the Amazon’s Halo wearable device, which can measure body fat percentages, sleep and activity levels, and other functions, can be integrated directly into patients’ electronic health records. On July 16, the company announced an expanded relationship with Banner Health to implement a comprehensive suite of revenue cycle management solutions. The expanded partnership is designed to streamline and simplify the clinician and patient experience across Banner Health’s 28 hospitals and clinics in six states.
The company has also relied on acquisitions and investments into other organizations. On December 16, Cerner announced an agreement to acquire the health division of Kantar Group, a consulting company, for $375 million in cash, subject to adjustment. Through the acquisition, the company aims to use data to improve the safety, efficiency, and efficacy of clinical research. The acquisition is expected to close in 1H21 and is not expected to have a material impact on the company’s earnings in 2021. Earlier, on December 8, Cerner announced an investment in Elligo Health Research, an integrated research organization that enables clinical trials with nationwide community-based healthcare practices. Financial terms were not disclosed.
EARNINGS & GROWTH ANALYSIS
Over the past five years, Cerner has generated compound annual growth of 5.8% in revenue and 7.3% in adjusted EPS. Management is targeting long-term revenue growth of 5%-8% through 2024, implying revenue of $7.3-$8.4 billion by the end of the period using 2019 as a base year.
Cerner has seven business lines: Professional Services (35% of 3Q sales); Managed Services (23%); Support and Maintenance (19%); Licensed Software (13%); Subscriptions (7%); Technology Resale (3%); and Reimbursed Travel (0.3%). In 3Q, the fastest-growing businesses by revenue were Licensed Software, up 11% to $172 million; Managed Services, up 3% to $312 million; and Subscriptions, up 2% to $93 million. On the negative side, Reimbursed Travel fell 81% to $4.7 million; Technology Resale fell 33% to $47 million; Support and Maintenance fell 6% to $260 million; and Professional Services fell 5% to $480 million.
Cerner is focused on controlling costs. In the third quarter, the gross margin rose 200 basis points year-over-year to 83.1%, reflecting an improved revenue mix. The 3Q adjusted operating margin rose 230 basis points from 3Q19 and 200 basis points sequentially to 20.4%. Management noted that it is still targeting a full-year operating margin near 20.0%, which would represent expansion of 150 basis points.
Our estimate is slightly above the midpoint of management’s guidance range and implies growth of 6% this year. We expect growth to accelerate in 2021 and are reiterating our EPS forecast of $3.33, implying growth of about 17% from our 2020 estimate.
FINANCIAL STRENGTH & DIVIDEND
Total debt was $1.34 billion, up from $1.17 billion at the end of 2019, and accounted for 23% of total capital, up from 21% but below the peer average of 32%. We view average levels as 50%-55%. Operating cash flow of $382 million was up 9% from 3Q19, while free cash flow of $237 million was up 36%.
Cerner has a share repurchase program, which it has not used since March 2020 due to the pandemic. As of September 30, 2020, the company had $1.03 remaining on its repurchase authorization.
Management has not yet provided a timeline for resuming buybacks. Cerner pays a quarterly dividend.
On December 11, 2020, the company announced a 22% increase in its quarterly dividend to $0.22 per share, beginning with the January 12, 2021 payment. The annualized payout of $0.88 implies a projected yield of about 1.2%.
MANAGEMENT & RISKS
Brent Shafer has served as the company’s chairman and CEO since February 1, 2018. Mr. Shafer had previously served as CEO of Philips North America. Marc Naughton is the company’s current CFO, though he will step down in 2021. Mr. Naughton joined the company in 1992, rising to the role of CFO in 1995.
Investors in CERN shares face risks. Cerner operates in a highly competitive industry, and client wins and losses may impact its financial performance. In addition, healthcare IT is changing rapidly, and new technology may put Cerner at a disadvantage. Furthermore, cybersecurity risks have grown, with the U.S. healthcare companies observing data breaches at a rate of more than one per day. Cerner has highlighted cybersecurity expertise as one of its competitive strengths, though it has been a client of SolarWinds, which was recently the victim of a major hacking attack; however, there is no evidence that the hackers targeted Cerner as part of this attack.
Cerner’s customers are highly regulated by the federal government and the states, and the company’s IT systems must comply with a range of regulations. EMR and IT systems are being held to increasingly strict reporting and compliance standards.
The company also faces risks related to the coronavirus, including the uncertainty about impact of the flu season on the pandemic. It also faces the risk that some clients may become insolvent, although management believes the likeliest outcome is industry consolidation. Such consolidation could provide opportunities for Cerner’s HealtheIntent platform, which can help client companies to integrate acquisitions.
The company has major contracts with government agencies that can be difficult to manage. With regard to the company’s 10-year contract with the Department of Defense, Cerner has made progress advancing the program despite the challenges presented by the pandemic. In September, the DoD and the Leidos Partnership for Defense Health deployed MHS GENESIS to 10 additional sites, bringing the total number of DoD sites to 18. Additionally, the U.S. Coast Guard had successful ‘go-lives’ of MHS GENESIS at four sites
Regarding the company’s contract with the Veteran’s Association, on October 26, Cerner announced the successful first deployment of a modern EHR at a VA medical center in Spokane, Washington, marking the first time that three federal departments were using the same EHR system. The new system was initially set to go live at the first VA sites in March 2020, but the the Department of Veterans Affairs decided to pause its rollout to focus resources on caring for veterans with the coronavirus. Earlier in October, the DoD, VA, and USCG joined the CommonWell Health Alliance, adding more than 15,000 additional private sector providers to the Joint Health Information Exchange, which was launched in April.
COMPANY DESCRIPTION
Based in Kansas City, Missouri, Cerner provides a range of information software products, professional services, and medical device integration and remote hosting services for healthcare providers at more than 27,500 facilities worldwide.
VALUATION
The stock initially fell about 34% by mid-March after achieving an all-time high in February 2020, but has since recovered by about 50%. While it is still below its prepandemic, all-time-high of $80.90, it appears to have broken out from a sideways trading pattern that extended through most of the recent recovery. Looking ahead, we expect the stock to continue its gradual advance as investors recognize the company’s ability to grow earnings despite the pandemic.
On the fundamentals, CERN trades at 23-times our 2021 EPS estimate, below the five-year average of 25 and the average of 30 for a healthcare services peer group that includes ATHN, MDRX, and MDSO. It is also trading at a price/sales ratio of 4, below the peer average of 6. Our revised target price of $88 assumes a projected 2021 P/E of 26, still below the industry average, and a potential return of about 13% including the dividend.
On December 28, BUY-rated CERN closed at $78.05, down $0.36.
Source: Argus
