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CERNER CORP /MO/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following Management Discussion and Analysis (MD&A) is intended to help the reader understand the results of operations and financial condition of Cerner Corporation (Cerner, the Company, we, us or our). This MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (Notes) found above. Our second fiscal quarter ends on the Saturday closest to June 30. The 2014 and 2013 second quarters ended on June 28, 2014 and June 29, 2013, respectively. All references to years in this MD&A represent the respective three or six months ended on such dates, unless otherwise noted. Except for the historical information and discussions contained herein, statements contained in this quarterly report on Form 10-Q may constitute "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the Exchange Act). Forward-looking statements can often be identified by the use of forward-looking terminology, such as "could," "should," "will," "intended," "continue," "believe," "may," "expect," "hope," "anticipate," "goal," "forecast," "plan," "guidance" or "estimate" or the negative of these words, variations thereof or similar expressions. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including without limitation: the possibility of product-related liabilities; potential claims for system errors and warranties; the possibility of interruption at our data centers or client support facilities; our proprietary technology may be subject to claims for infringement or misappropriation of intellectual property rights of others, or may be infringed or misappropriated by others; risks associated with our non-U.S. operations; risks associated with our ability to effectively hedge exposure to fluctuations in foreign currency exchange rates; the potential for tax legislation initiatives that could adversely affect our tax position and/or challenges to our tax positions in the United States and non-U.S. countries; risks associated with our recruitment and retention of key personnel; risks related to our reliance on third party suppliers; risks inherent with business acquisitions and other combinations; the potential for losses resulting from asset impairment charges; risks associated with volatility and disruption resulting from global economic conditions; managing growth in the new markets in which we offer solutions, health care devices and services; changing political, economic, regulatory and judicial influences; government regulation; significant competition and market changes; variations in our quarterly operating results; potential inconsistencies in our sales forecasts compared to actual sales; volatility in the trading price of our common stock and the timing and volume of market activity; the authority of our Board of Directors to issue preferred stock and anti-takeover provisions contained in our corporate governance documents; material adverse resolution of legal proceedings; and, other risks, uncertainties and factors discussed elsewhere in this Form 10-Q, in our other filings with the Securities and Exchange Commission or in materials incorporated herein or therein by reference. Forward looking statements are not guarantees of future performance or results. The reader should not place undue reliance on forward-looking statements since the statements speak only as to the date they are made. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial condition or business over time. Management Overview Our revenues are primarily derived by selling, implementing and supporting software solutions, clinical content, hardware, devices and services that give health care providers secure access to clinical, administrative and financial data in real time, allowing them to improve quality, safety and efficiency in the delivery of health care. Our fundamental strategic focus is the creation of organic growth by investing in research and development (R&D) to create solutions and services for the health care industry. This strategy has driven strong growth over the long-term, as reflected in five- and ten-year compound annual revenue growth rates of 12% or more. This growth has also created an important strategic footprint in health care, with Cerner® solutions licensed by approximately 14,000 facilities around the world, including more than 3,000 hospitals; 4,900 physician practices; 60,000 physicians; 590 ambulatory facilities, such as laboratories, ambulatory centers, behavioral health centers, cardiac facilities, radiology clinics and surgery centers; 3,500 extended care facilities; 150 employer sites and 1,790 retail pharmacies. Selling additional solutions back into this client base is an important element of our future revenue growth. We are also focused on driving growth through market share expansion by strategically aligning with health care providers that have not yet selected a supplier and by displacing competitors in health care settings that are open to replacing their current supplier. We expect to drive growth through solutions and services that reflect our ongoing ability to innovate and expand our reach into health care. Examples of these include our CareAware® health care device architecture and devices, Cerner ITWorksSM services, revenue cycle solutions and services, and population health solutions and services. Finally, we believe there is 15-------------------------------------------------------------------------------- Table of Contents significant opportunity for growth outside of the United States, with many non-U.S. markets focused on health care information technology as part of their strategy to improve the quality and lower the cost of health care. Beyond our strategy for driving revenue growth, we are also focused on earnings growth. Similar to our history of growing revenue, our net earnings have increased at compound annual rates of more than 16% over the most recent five- and ten-year periods. We expect to drive continued earnings growth through ongoing revenue growth coupled with margin expansion, which we expect to achieve through efficiencies in our implementation and operational processes and by leveraging R&D investments and controlling general and administrative expenses. We are also focused on continuing to deliver strong levels of cash flow, which we expect to accomplish by continuing to grow earnings and prudently managing capital expenditures. Results Overview The Company delivered strong levels of bookings, revenues, earnings and operating cash flows in the second quarter of 2014. New business bookings revenue, which reflects the value of executed contracts for software, hardware, professional services and managed services, was $1.1 billion in the second quarter of 2014, which was an increase of 15% compared to $935.0 million in the second quarter of 2013. Revenues for the second quarter of 2014 increased 20% to $851.8 million compared to $707.6 million in the second quarter of 2013. The year-over-year increase in revenue reflects ongoing demand for Cerner's core solutions and services driven by the HITECH Act and other regulatory requirements, and increased contributions from Cerner ITWorks and Cerner revenue cycle solutions and services. Second quarter 2014 net earnings increased 14% to $129.0 million compared to $112.9 million in the second quarter of 2013. Diluted earnings per share increased 16% to $0.37 compared to $0.32 in the second quarter of 2013. The growth in net earnings and diluted earnings per share was driven by strong growth in services and higher margin components of system sales. Second quarter 2014 and 2013 net earnings and diluted earnings per share reflect the impact of stock-based compensation expense. The effect of these expenses reduced the second quarter 2014 net earnings and diluted earnings per share by $9.9 million and $0.03, respectively, and the second quarter 2013 net earnings and diluted earnings per share by $6.7 million and $0.02, respectively. We had cash collections of receivables of $843.9 million in the second quarter of 2014 compared to $718.7 million in the second quarter of 2013. Days sales outstanding was 66 days for the first and second quarters of 2014 compared to 68 days for the second quarter of 2013. Operating cash flows for the second quarter of 2014 were $248.3 million compared to $176.5 million in the second quarter of 2013. 16-------------------------------------------------------------------------------- Table of Contents Results of Operations Three Months Ended June 28, 2014 Compared to Three Months Ended June 29, 2013 The following table presents a summary of the operating information for the second quarters of 2014 and 2013: % of % of (In thousands) 2014 Revenue 2013 Revenue % Change Revenues System sales $ 234,563 28 % $ 200,503 28 % 17 % Support and maintenance 175,274 21 % 164,559 23 % 7 % Services 412,893 48 % 322,088 46 % 28 % Reimbursed travel 29,032 3 % 20,411 3 % 42 % Total revenues 851,762 100 % 707,561 100 % 20 % Costs of revenue Costs of revenue 162,369 19 % 125,800 18 % 29 % Total margin 689,393 81 % 581,761 82 % 19 % Operating expenses Sales and client service 343,234 40 % 281,192 40 % 22 % Software development 97,326 11 % 82,282 12 % 18 % General and administrative 57,200 7 % 51,831 7 % 10 % Total operating expenses 497,760 58 % 415,305 59 % 20 % Total costs and expenses 660,129 78 % 541,105 76 % 22 % Operating earnings 191,633 22 % 166,456 24 % 15 % Other income, net 2,737 2,733 Income taxes (65,337 ) (56,282 ) Net earnings $ 129,033 $ 112,907 14 % Revenues & Backlog Revenues increased 20% to $851.8 million in the second quarter of 2014, as compared to $707.6 million in the second quarter of 2013. • System sales, which include revenues from the sale of licensed software (including perpetual license sales and software as a service), technology resale (hardware, devices, and sublicensed software), deployment period licensed software upgrade rights, installation fees, transaction processing and subscriptions, increased 17% to $234.6 million in the second quarter of 2014 from $200.5 million for the same period in 2013. The increase in system sales was primarily driven by strong growth in software and technology resale of $15.5 million and $11.6 million, respectively. • Support and maintenance revenues increased 7% to $175.3 million in the second quarter of 2014 compared to $164.6 million during the same period in 2013. This increase was attributable to continued success at selling Cerner Millennium® applications and implementing them at client sites. We expect that support and maintenance revenues will continue to grow as the base of installed Cerner Millennium systems grows. • Services revenue, which includes professional services, excluding installation, and managed services, increased 28% to $412.9 million in the second quarter of 2014 from $322.1 million for the same period in 2013. This increase was driven by growth in CernerWorksSM managed services of $17.7 million as a result of continued demand for our hosting services and a $73.1 million increase in professional services due to growth in implementation and consulting activities. 17-------------------------------------------------------------------------------- Table of Contents Contract backlog, which reflects new business bookings that have not yet been recognized as revenue, increased 23% in the second quarter of 2014 when compared to the same period in 2013. This increase was driven by growth in new business bookings during the past four quarters, including continued strong levels of managed services, Cerner ITWorks, and Cerner revenue cycle services bookings that typically have longer contract terms. A summary of our total backlog follows: (In thousands) June 28, 2014 June 29, 2013 Contract backlog $ 8,880,099 $ 7,244,030 Support and maintenance backlog 806,642 756,858 Total backlog $ 9,686,741 $ 8,000,888 Costs of Revenue Cost of revenues as a percentage of total revenues was 19% in the second quarter of 2014, compared to 18% in the same period of 2013. The higher cost of revenues as a percent of revenue was driven by a higher amount of third party resources being utilized for support and services related to a significant amount of systems going live during the quarter. Cost of revenues includes the cost of reimbursed travel expense, sales commissions, third party consulting services and subscription content and computer hardware, devices and sublicensed software purchased from manufacturers for delivery to clients. It also includes the cost of hardware maintenance and sublicensed software support subcontracted to the manufacturers. Such costs, as a percent of revenues, typically have varied as the mix of revenue (software, hardware, devices, maintenance, support, services and reimbursed travel) carrying different margin rates changes from period to period. Cost of revenues does not include the costs of our client service personnel who are responsible for delivering our service offerings. Such costs are included in sales and client service expense. Operating Expenses Total operating expenses increased 20% to $497.8 million in the second quarter of 2014, compared with $415.3 million in the second quarter of 2013. • Sales and client service expenses as a percent of total revenues were 40% in the second quarters of 2014 and 2013. These expenses increased 22% to $343.2 million in the second quarter of 2014, from $281.2 million in the same period of 2013. Sales and client service expenses include salaries of sales and client service personnel, depreciation and other expenses associated with our CernerWorks managed service business, communications expenses, unreimbursed travel expenses, expense for share-based payments, sales and marketing salaries and trade show and advertising costs. The increase was driven by strong services growth. • Software development expenses as a percent of revenue were 11% in the second quarter of 2014, compared to 12% in the same period of 2013. Expenditures for software development reflect ongoing development and enhancement of the Cerner Millennium and Healthe Intent platforms, with a focus on supporting key initiatives to enhance physician experience, revenue cycle and population health solutions. A summary of our total software development expense in the second quarters of 2014 and 2013 is as follows: Three Months Ended (In thousands) 2014 2013 Software development costs $ 114,511 $ 102,561 Capitalized software costs (41,225 ) (42,793 )Capitalized costs related to share-based payments (897 ) (780 ) Amortization of capitalized software costs 24,937 23,294 Total software development expense $ 97,326 $ 82,282 • General and administrative expenses as a percent of total revenues were 7% in the second quarters of 2014 and 2013. These expenses increased 10% to $57.2 million in 2014, from $51.8 million for the same period in 2013. General and administrative expenses include salaries for corporate, financial and administrative staffs, utilities, communications expenses, professional fees, depreciation and amortization, transaction gains or losses on foreign currency and expense for share-based payments. The increase in general and administrative expenses was primarily 18-------------------------------------------------------------------------------- Table of Contents driven by a $4.4 million increase in corporate personnel costs, as we have continued to increase such personnel to support our overall revenue growth. Non-Operating Items • Other income was $2.7 million in the second quarters of 2014 and 2013. • Our effective tax rate was 33.6% for the second quarter of 2014 and 33.3% for the second quarter of 2013. This increase is due to the expiration of the research and development tax credit in 2014. Refer to Note (6) of the notes to the condensed consolidated financial statements. Operations by Segment We have two operating segments: Domestic and Global. The Domestic segment includes revenue contributions and expenditures associated with business activity in the United States. The Global segment includes revenue contributions and expenditures linked to business activity in Aruba, Australia, Austria, Brazil, Canada, Cayman Islands, Chile, Egypt, England, France, Germany, Guam, India, Ireland, Israel, Malaysia, Mexico, Qatar, Saudi Arabia, Singapore, Spain, Switzerland and the United Arab Emirates. The following table presents a summary of the operating information for the second quarters of 2014 and 2013: (In thousands) 2014 % of Revenue 2013 % of Revenue % Change Domestic Segment Revenues $ 766,763 100% $ 618,991 100% 24% Costs of revenue 147,776 19% 113,099 18% 31% Operating expenses 165,653 22% 143,111 23% 16% Total costs and expenses 313,429 41% 256,210 41% 22% Domestic operating earnings 453,334 59% 362,781 59% 25% Global Segment Revenues 84,999 100% 88,570 100% (4)% Costs of revenue 14,593 17% 12,701 14% 15% Operating expenses 34,962 41% 24,977 28% 40% Total costs and expenses 49,555 58% 37,678 43% 32% Global operating earnings 35,444 42% 50,892 57% (30)% Other, net (297,145 ) (247,217 ) 20% Consolidated operating earnings $ 191,633 $ 166,456 15% Domestic Segment • Revenues increased 24% to $766.8 million in the second quarter of 2014 from $619.0 million in the same period of 2013. This increase was driven by strong growth across most of our business. • Cost of revenues was 19% of revenues in the second quarter of 2014, compared to 18% of revenues in the same period of 2013. The higher cost of revenues as a percent of revenue was driven by a higher amount of third party resources being utilized for support and services related to a significant amount of systems going live during the quarter. • Operating expenses increased 16% to $165.7 million in the second quarter of 2014 from $143.1 million in the same period of 2013, due primarily to growth in professional services expenses. Global Segment 19-------------------------------------------------------------------------------- Table of Contents • Revenues decreased 4% to $85.0 million in the second quarter of 2014 from $88.6 million in the same period of 2013. This decrease was primarily driven by a decline in software revenue of $7.4 million, offset by growth in technology resale of $2.3 million. • Cost of revenues was 17% in the second quarter of 2014 and 14% in the same period of 2013. The higher cost of revenues as a percent of revenue was primarily driven by a higher mix of technology resale, which carries a higher cost of revenue. • Operating expenses were $35.0 million in the second quarter of 2014, compared to $25.0 million in the same period of 2013, primarily due to an increase in bad debt expense. Other, net Operating results not attributed to an operating segment include expenses, such as centralized professional services costs, software development, marketing, general and administrative, stock-based compensation, depreciation, and amortization. These expenses increased 20% to $297.1 million in the second quarter of 2014 from $247.2 million in the same period of 2013. This increase was primarily due to an increase in corporate and development personnel costs, as we have increased such personnel to support our overall revenue growth and development initiatives. Six Months Ended June 28, 2014 Compared to Six Months Ended June 29, 2013 The following table presents a summary of the operating information for the first six months of 2014 and 2013: % of % of (In thousands) 2014 Revenue 2013 Revenue % Change Revenues System sales $ 441,250 27 % $ 399,405 29 % 10 % Support and maintenance 350,204 21 % 325,516 23 % 8 % Services 795,392 49 % 627,687 45 % 27 % Reimbursed travel 49,677 3 % 34,982 3 % 42 % Total revenues 1,636,523 100 % 1,387,590 100 % 18 % Costs of revenue Costs of revenue 291,468 18 % 253,029 18 % 15 % Total margin 1,345,055 82 % 1,134,561 82 % 19 % Operating expenses Sales and client service 674,135 41 % 548,548 40 % 23 % Software development 188,871 12 % 163,345 12 % 16 % General and administrative 112,413 7 % 99,643 7 % 13 % Total operating expenses 975,419 60 % 811,536 58 % 20 % Total costs and expenses 1,266,887 77 % 1,064,565 77 % 19 % Operating earnings 369,636 23 % 323,025 23 % 14 % Other income, net 5,727 5,777 Income taxes (126,804 ) (105,855 ) Net earnings $ 248,559 $ 222,947 11 % Revenues & Backlog Revenues increased 18% to $1.6 billion in the first six months of 2014, as compared to $1.4 billion in the first six months of 2013. • System sales increased 10% to $441.3 million in the first six months of 2014 from $399.4 million for the same period in 2013. The increase in system sales was primarily driven by strong growth in software of $37.4 million, which was partially offset by an $8.3 million decline in technology resale. 20-------------------------------------------------------------------------------- Table of Contents • Support and maintenance revenues increased 8% to $350.2 million in the first six months of 2014 compared to $325.5 million during the same period in 2013. This increase was attributable to continued success at selling Cerner Millennium applications and implementing them at client sites. We expect that support and maintenance revenues will continue to grow as the base of installed Cerner Millennium systems grows. • Services revenue increased 27% to $795.4 million in the first six months of 2014 from $627.7 million for the same period in 2013. This increase was driven by growth in CernerWorks managed services of $29.6 million as a result of continued demand for our hosting services and a $138.1 million increase in professional services due to growth in implementation and consulting activities. Costs of Revenue Cost of revenues as a percentage of total revenues was 18% in the first six months of 2014 and 2013. Operating Expenses Total operating expenses increased 20% to $975.4 million in the first six months of 2014, compared with $811.5 million in the same period of 2013. • Sales and client service expenses as a percent of total revenues were 41% in the first six months of 2014, compared to 40% in the same period of 2013. These expenses increased 23% to $674.1 million in the first six months of 2014, from $548.5 million in the same period of 2013. The increase as a percent of revenue reflects a higher mix of services during the period that was driven by strong services growth and the decline in technology resale revenue. • Software development expenses as a percent of revenue were 12% in the first six months of 2014 and 2013. Expenditures for software development reflect ongoing development and enhancement of the Cerner Millennium and Healthe Intent platforms, with a focus on supporting key initiatives to enhance physician experience, revenue cycle and population health solutions. A summary of our total software development expense in the first six months of 2014 and 2013 is as follows: Six Months Ended (In thousands) 2014 2013 Software development costs $ 225,499 $ 195,942 Capitalized software costs (85,209 ) (76,613 ) Capitalized costs related to share-based payments (1,457 ) (1,294 ) Amortization of capitalized software costs 50,038 45,310 Total software development expense $ 188,871 $ 163,345 • General and administrative expenses as a percent of total revenues were 7% in the first six months of 2014 and 2013. These expenses increased 13% to $112.4 million in 2014, from $99.6 million for the same period in 2013. The increase in general and administrative expenses was primarily driven by a $7.1 million increase in corporate personnel costs, as we have continued to increase such personnel to support our overall revenue growth. Non-Operating Items • Other income was $5.7 million in the first six months of 2014 and $5.8 million in the same period of 2013. • Our effective tax rate was 33.8% for the first six months of 2014 and 32.2% for the first six months of 2013. This increase is primarily a result of the favorable discrete item recorded in the first quarter of 2013 for the retroactive extension of the 2012 research and development credit and the expiration of the same credit at the end of 2013. Refer to Note (6) of the notes to condensed consolidated financial statements. 21 -------------------------------------------------------------------------------- Table of Contents Operations by Segment The following table presents a summary of the operating information for the first six months of 2014 and 2013: (In thousands) 2014 % of Revenue 2013 % of Revenue % Change Domestic Segment Revenues $ 1,464,467 100% $ 1,195,630 100% 22% Costs of revenue 263,121 18% 219,796 18% 20% Operating expenses 326,719 22% 290,867 24% 12% Total costs and expenses 589,840 40% 510,663 43% 16% Domestic operating earnings 874,627 60% 684,967 57% 28% Global Segment Revenues 172,056 100% 191,960 100% (10)% Costs of revenue 28,347 16% 33,233 17% (15)% Operating expenses 68,304 40% 50,607 26% 35% Total costs and expenses 96,651 56% 83,840 44% 15% Global operating earnings 75,405 44% 108,120 56% (30)% Other, net (580,396 ) (470,062 ) 23% Consolidated operating earnings $ 369,636 $ 323,025 14% Domestic Segment • Revenues increased 22% to $1.5 billion in the first six months of 2014 from $1.2 billion in the first six months of 2013. This increase was driven by growth across most of our business, with the exception of technology resale, which was flat. • Cost of revenues was 18% of revenues in the first six months of 2014 and 2013. • Operating expenses increased 12% to $326.7 million in the first six months of 2014 from $290.9 million in the same period of 2013, due primarily to growth in professional services expenses. Global Segment • Revenues decreased 10% to $172.1 million in the first six months of 2014 from $192.0 million in the same period of 2013. This decrease was primarily driven by declines in software and technology resale revenues of $13.6 million and $6.6 million, respectively. • Cost of revenues was 16% of revenues in the first six months of 2014 and 17% in the same period of 2013, due primarily to a lower mix of technology resale. • Operating expenses were at $68.3 million in the first six months of 2014, compared to $50.6 million in the same period of 2013, primarily due to an increase in bad debt expense. Other, net These expenses increased 23% to $580.4 million in the first six months of 2014 from $470.1 million in the same period of 2013. This increase was primarily due to growth in corporate and development personnel costs, as we have increased such personnel to support our overall revenue growth and development initiatives. Liquidity and Capital Resources Our liquidity is influenced by many factors, including the amount and timing of our revenues, our cash collections from our clients and the amount we invest in software development, acquisitions and capital expenditures. Our principal sources of liquidity are our cash, cash equivalents, which primarily consist of money market funds and time deposits with original maturities of less than 90 days, and short-term investments. At June 28, 2014, we had cash and cash 22-------------------------------------------------------------------------------- Table of Contents equivalents of $315.3 million and short-term investments of $673.5 million, as compared to cash and cash equivalents of $202.4 million and short-term investments of $677.0 million at December 28, 2013. The non-U.S. subsidiaries for which we have elected to indefinitely reinvest earnings outside of the U.S. held approximately 17% of our aggregate cash, cash equivalents and short-term investments at June 28, 2014. As part of our current business strategy, we plan to indefinitely reinvest the earnings of these foreign operations; however, should the earnings of these foreign operations be repatriated, we would accrue and pay tax on such earnings, which may be material. Additionally, we maintain a $100.0 million multi-year revolving credit facility, which expires in February 2017. The facility provides an unsecured revolving line of credit for working capital purposes, along with a letter of credit facility. Interest is payable at a rate based on prime, LIBOR, or the U.S. federal funds rate, plus a spread that varies depending on the leverage ratios maintained. The agreement provides certain restrictions on our ability to borrow, incur liens, sell assets and pay dividends and contains certain cash flow and liquidity covenants. As of June 28, 2014, we were in compliance with all debt covenants. As of June 28, 2014, we had no outstanding borrowings under this agreement; however, we had $16.6 million of outstanding letters of credit, which reduced our available borrowing capacity to $83.4 million. We believe that our present cash position, together with cash generated from operations, short-term investments and, if necessary, our available line of credit, will be sufficient to meet anticipated cash requirements during 2014. The following table summarizes our cash flows in the first six months of 2014 and 2013: |