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A Wide-Moat Healthcare IT Company for Your Watchlist

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Morningstar's Matt Coffina, who edits the StockInvestor newsletter, recently purchased Cerner; we're going to talk about what he likes about this company. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So let's talk a little about Cerner the business first, then we'll get into why you decided to buy it now. What does this company do? Why is important in the healthcare space? 

Coffina: Sure. Cerner is one of the leading healthcare information technology vendors, so 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. But Cerner's really a leader in this business. It's a business that's seen a tremendous amount of growth over the course of decades, and it's especially seeing growth right now as regulators have put in place some incentives to get hospitals to adopt and use electronic medical records.

Glaser: So this is a place where maybe the push to reduce costs ... they actually benefit from that? 

Coffina: I think that's the hope. Certainly healthcare has been a late adopter of information technology. It's a very complex field. It's an area where you'd think that having a lot of really good data and analysis tools would be helpful to holding down healthcare costs. I think it still remains to be seen whether that promise or that hype is really going to be lived up to. But it almost doesn't matter at this point because of the regulatory incentives and because this is how the industry is moving. Healthcare IT is becoming so deeply ingrained in every aspect of patient care. You go to the doctor nowadays, most of them have electronic medical records. They're looking at their computer half the time, entering your information, looking at your lab results, maybe looking at your images. And so it's become very deeply ingrained in the practice of healthcare and so I don't think there's really any turning back now. I don't think we're ever going to go back to paper records. And so you're going to see hospitals adopt more and more software modules and more and more technology and 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.

Glaser: So if we have these two big players, does that produce a good pricing power for Cerner, or do they compete against each other to the point where they're not able to get that nice pricing? 

Coffina: 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. Returns on capital are also very attractive. It's a business that's been built mostly organically. They just did a very large acquisition of Siemens Health Services. But besides the acquisition, it's mostly been a business that's been built organically and it's done very, very well for investors over many, many years. Having two major players, I would say the environment's not overly competitive. In particular it's not that price-sensitive. I wouldn't say that's the main source of competition. Certainly price matters, but hospitals are even more concerned that the vendor's going to be able to meet technologically relevant standards. That they're going to support this software over many, many years to come. Because the switching costs are so high, they want to make sure these solutions are going to continue to be technologically relevant five, 10, 20 years from now. They want to make sure the product's going to be implemented on time, and that they're going to be able to meet the standards that they've set for themselves. All of these factors play into it, and again, the companies have become very good businesses and really it's a two-horse race now between Cerner and Epic.

Glaser: So why did the valuation look attractive? Is there something weighing on the business that's bringing the shares down? 

Coffina: Cerner, at the time I bought it, was trading for about 23 times earnings. That's not screamingly cheap in an absolute sense, but it's very cheap relative to Cerner's history. A more common price/earnings multiple has been in the 30-50 range, so this is a stock that very rarely gets meaningfully cheap. And the reason the valuation's been under pressure lately is that revenue growth disappointed last year, and even more concerning than that is the fact that management repeatedly guided to certain revenue numbers and then failed to hit them. So that raised some concerns about management's ability to really understand the business and forecast growth. I've given Cerner a bit of a pass on this. First of all, because, again, the valuation's much cheaper than it's been historically. So I don't think investors are pricing in mid-teens kind of revenue growth or even higher that they've seen historically.

Besides that, I think there were a lot of unusual circumstances last year. They had some unusually complex contracts that took longer to implement than expected, they weren't able to recognize the revenue as quickly as they thought they'd be able to. Even though the bookings were still there, they couldn't recognize the revenue. They did the Siemens Health Services acquisition as I mentioned. A company that's not used to doing a lot of acquisitions over time, not used to integrating these large acquisitions, so I think that created some disruption in the short term. There were foreign exchange headwinds. They also had lower sales of third-party services and equipment and things like that. That third-party resale tends to be a lower-margin business for them and also less predictable. So there were a lot of factors going on last year that I think sort of excused management's missing on the revenue guidance. Just as importantly, the bookings were very strong last year so that, inevitably, is going to translate into revenue sooner rather than later. And then they also hit their earnings guidance. So with the strong bookings, hitting their earnings guidance, again, I'm willing to give them a little bit of a pass on the revenue guidance.

Glaser: So it sounds like this is a firm with good competitive advantages that you were able to pick up at a good price.

Coffina: Yeah. It's an excellent, excellent business in my view that's almost never available for even a reasonable price, and I think right now we're getting a chance to buy it at a reasonable price.

Glaser: Matt, thanks for your thoughts on Cerner today.

Coffina: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser, thanks for watching.