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Stock Strategist

Growing Healthcare IT Demand Benefits Cerner

Although revenue issues continue, we think the shares are undervalued.

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Although  Cerner's (CERN) fourth-quarter results met our expectations, we've lowered our fair value estimate to $63 per share from $69. The management team once again missed its own revenue guidance, and we believe the firm is experiencing increasing pressure in its operating environment. Considering these latest developments, we now believe top-line growth will moderate slightly faster than we initially expected. Additionally, we believe competition from current and new healthcare information technology players has accelerated, given the growing need of providers to build in new reimbursement infrastructure and the prime opportunity this presents to the entire healthcare IT market. As a result, we believe Cerner will see greater sales and research and development expenses over the medium term than we initially expected. These modeling adjustments lead to a reduction in our explicit forecast revenue growth and operating margin expansion assumptions. Nevertheless, the stock trades below our reduced fair value estimate, presenting investors with an opportunity to acquire shares of a solid healthcare firm at a material discount.

We are highly disappointed that management has missed its own revenue guidance over the past several quarters. We believe management's missteps have built in an increased level of uncertainty for the firm. We will watch closely how this trend develops over the coming quarters and expect the missed guidance pattern to reverse over the course of 2016. We believe this issue points to a shift among Cerner's customer base as hospitals and medical service providers are now demanding greater value from their healthcare IT vendors. Additionally, we believe new entrants like UnitedHealth and traditional rivals such as Epic Systems have increased their sales efforts and are now willing to accept less advantageous payment terms. The confluence of these factors has caused Cerner to experience a delay in revenue growth and margin expansion.

While these headwinds are concerning, we believe demand for healthcare IT services will still steadily increase over the coming decades as providers are forced to become more efficient. These recent developments are near-term headwinds for Cerner, but we think they are more timing-based issues and less of a fundamental shift in the positive secular tailwinds for the sector. From our perspective, the outlook remains fairly robust for Cerner as the U.S. healthcare market will still need to become increasingly more efficient.

Key Player in Healthcare IT
The outlook for the healthcare IT sector is solid, with the combination of Affordable Care Act regulation and changing reimbursement structures motivating providers (hospitals, physician offices, diagnostic centers, and integrated provider networks) to either revamp or build new IT infrastructure. With a highly trusted brand, leading software products, and high customer switching costs, Cerner has a wide economic moat, in our opinion. The integrated and essential nature of its offerings makes the firm a key player in the healthcare IT market and should allow it to produce economic profits over a significant period.

Strong customer switching costs are the bedrock of Cerner's major competitive advantages. Long product implementation periods (18-24 months), highly integrated/customized software packages, and service contracts that last years lock major provider clients into the firm's grasp. Boosting the long-term demand for Cerner's services are several factors, including the increasing complexity of Medicare reporting, strong growth of value-based payer reimbursement schemes, and electronic medical records regulatory compliance. The combination of these factors solidifies the firm's long-term economic profitability.

What differentiates Cerner from its competitors is a strategy of developing and building its product portfolio in-house. Many large healthcare IT servicers have acquired varying software manufacturers, which creates less continuity in their product lineups. This dynamic can give Cerner a material advantage when competing for new business as its products are relatively more integrated and seamless.

While the need for EMR services will be a pillar of future industry growth, we believe predictive analytics and patient population management will also play major roles in driving healthcare IT demand as providers are increasingly required to produce more value for their services. As a leader in developing analytical products, Cerner is well positioned to benefit from this secular growth trend.

Product Performance Must Be Nearly Flawless
The major risk facing Cerner is a disastrous malfunction of its software that could literally cause life-and-death scenarios for its clients. The critical nature of the firm's products in intense medical environments means that the performance of its software has to be close to flawless. Any little disruption to a client's IT infrastructure as a result of a development misstep would be a major issue for Cerner and a major risk for equityholders. We also believe competition is likely to increase from well-capitalized rivals. We could plausibly see a scenario where competition increases materially for the healthcare IT industry, causing pricing and market share headwinds for Cerner.

Chief among the near-term issues for Cerner are two main variables. Major managed-care organization consolidation and its potential negative effect on future reimbursement rates have built in a significant level of operating uncertainty for providers. We believe this has led them to hold back on large-scale IT projects (or parts of them) in order to get more clarity around the MCO consolidation dynamic.

There has also been some confusion about the meaningful use EMR provision the government is using for Medicare and Medicaid reimbursement rates. We believe this has materially slowed demand for Cerner’s EMR services and products.

These factors do provide near-term headwinds for Cerner, but we would highlight them as short term. We believe the outlook remains robust for Cerner as the new fundamental dynamics of the U.S. healthcare market will motivate most providers to become more efficient, with up-to-date healthcare IT playing a key role in that process.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.