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CERNER CORP /MO/ - 10-K - 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 our results of operations and financial condition. 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). Our fiscal year ends on the Saturday closest to December 31. Fiscal years 2012, 2011 and 2010 each consisted of 52 weeks and ended on December 29, 2012, December 31, 2011 and January 1, 2011, respectively. All references to years in this MD&A represent fiscal years unless otherwise noted. 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 strategy centers on creating 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 10,000 facilities around the world, including more than 2,700 hospitals; 4,150 physician practices; 45,000 physicians; 550 ambulatory facilities, such as laboratories, ambulatory centers, behavioral health centers, cardiac facilities, radiology clinics and surgery centers; 800 home health facilities; 45 employer sites and 1,750 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 looking to replace their current supplier. We expect to drive growth through new initiatives 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, employer services, Cerner ITWorks services, Cerner RevWorks services, and solutions on our Healthe Intent platform. Finally, we believe there is significant opportunity for growth outside of the United States, with many non-U.S. markets focused on HCIT 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 20% 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 do by continuing to grow earnings and prudently managing capital expenditures. Results Overview The Company delivered strong levels of bookings, revenues, earnings and cash flows in 2012. New business bookings revenue in 2012, which reflects the value of executed contracts for software, hardware, professional services and managed services, was $3.1 billion, which is an increase of 15% compared to $2.7 billion in 2011. Our 2012 revenues increased 21% to $2.7 billion compared to $2.2 billion in 2011. The year-over-year increase in revenue reflects improved economic conditions, ongoing demand related to the HITECH Act, and increased contributions form new initiatives, such as device resale, Cerner ITWorks and Cerner RevWorks. Our 2012 net earnings increased 30% to $397.2 million compared to $306.6 million in 2011. Diluted earnings per share increased 28% to $2.26 compared to $1.76 in 2011. The 2012 and 2011 net earnings and diluted earnings per share reflect the impact of stock-based compensation expense. The effect of these expenses reduced the 2012 net earnings and diluted earnings per share by $23.5 million and $0.13, and the 2011 earnings and diluted earnings per share by $18.2 million and $0.11, respectively. The growth in net earnings and diluted earnings per share was driven primarily by strong revenue growth and continued progress with our margin expansion initiatives, including efficiencies in our implementation and operational 22-------------------------------------------------------------------------------- Table of Contents processes, leveraging R&D investments and controlling general and administrative expenses. Our full-year 2012 operating margin of 21.4% reflects an increase of 50 basis points compared to 2011, which was driven by strong margin expansion in our core business that was somewhat offset by record levels of lower-margin technology resale. We had cash collections of receivables of $2.7 billion in 2012 compared to $2.2 billion in 2011. Days sales outstanding was 74 days for the 2012 fourth quarter compared to 73 days for the 2012 third quarter and 83 days for the 2011 fourth quarter. Operating cash flows for 2012 were strong at $708.3 million compared to $546.3 million in 2011. Health Care Information Technology Market Outlook We have provided a detailed assessment of the health care information technology market under "Health Care and Health Care IT Industry" in Part I, Item 1 "Business." Results of Operations Fiscal Year 2012 Compared to Fiscal Year 2011 % of % of (In thousands) 2012 Revenue 2011 Revenue % Change Revenues System sales $ 902,799 34 % $ 706,714 32 % 28 % Support and maintenance 604,247 23 % 550,554 25 % 10 % Services 1,103,082 41 % 901,193 41 % 22 % Reimbursed travel 55,308 2 % 44,692 2 % 24 % Total revenues 2,665,436 100 % 2,203,153 100 % 21 % Costs of revenue Costs of revenue 608,197 23 % 441,672 20 % 38 % Total margin 2,057,239 77 % 1,761,481 80 % 17 % Operating expenses Sales and client service 1,020,640 38 % 869,962 39 % 17 % Software development 301,370 11 % 286,801 13 % 5 % General and administrative 163,567 6 % 144,920 7 % 13 % Total operating expenses 1,485,577 56 % 1,301,683 59 % 14 % Total costs and expenses 2,093,774 79 % 1,743,355 79 % 20 % Operating earnings 571,662 21 % 459,798 21 % 24 % Other income, net 16,046 9,896 Income taxes (190,476 ) (163,067 ) Net earnings $ 397,232 $ 306,627 30 % Revenues & Backlog Revenues increased 21% to $2.7 billion in 2012, as compared to $2.2 billion in 2011. • System sales, which include revenues from the sale of licensed software, software as a service, technology resale (hardware, devices, and sublicensed software), deployment period licensed software upgrade rights, installation fees, transaction processing and subscriptions, increased 28% to $902.8 million in 2012 from $706.7 million for the same period in 2011. The increase in system sales was driven by record levels of technology resale and solid growth in subscriptions and software. • Support and maintenance revenues increased 10% to $604.2 million in 2012 compared to $550.6 million during the same period in 2011. 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. 23-------------------------------------------------------------------------------- Table of Contents • Services revenue, which includes professional services, excluding installation, and managed services, increased 22% to $1.1 billion in 2012 from $0.9 billion for the same period in 2011. This increase was driven by growth in CernerWorks managed services as a result of continued demand for our hosting services and an increase in professional services due to increased implementation activities and growth in Cerner ITWorks services. Contract backlog, which reflects new business bookings that have not yet been recognized as revenue, increased 21% in 2012 when compared to 2011. This increase was driven by growth in new business bookings during the past four quarters, including continued strong levels of managed services and Cerner ITWorks services bookings that typically have longer contract terms. A summary of total backlog at the end of 2012 and 2011 follows: (In thousands) 2012 2011 Contract backlog $ 6,534,564 $ 5,401,427 Support and maintenance backlog 738,154 705,744 Total backlog $ 7,272,718 $ 6,107,171 Costs of Revenue Cost of revenues as a percentage of total revenues was 23% in 2012, compared to 20% in the same period of 2011. The higher cost of revenues as a percent of revenue was driven by a higher mix of technology resale, which carries a higher cost of revenue. 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 14% to $1.5 billion in 2012, compared with $1.3 billion in 2011. • Sales and client service expenses as a percent of total revenues were 38% in 2012, compared to 39% in the same period of 2011. These expenses increased 17% to $1.0 billion in 2012, from $0.9 billion in the same period of 2011. 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 decrease as a percent of revenue reflects ongoing efficiencies in our implementation and operational processes. 24-------------------------------------------------------------------------------- Table of Contents • Software development expenses as a percent of revenue were 11% in 2012, compared to 13% in 2011. Expenditures for software development reflect ongoing development and enhancement of the Cerner Millennium platform, including investments in the next evolution of Cerner Millennium, Millennium+, which leverages the cloud and enables greater mobility. The reduction as a percentage of revenue reflects our efforts to control spending relative to revenue growth. Because of the strong platform we have built, we are able to continue advancing our solutions and investing in new solutions without large increases in spending. Expense was also limited by a higher percentage of our software development investments being capitalized, which we expect to continue, as a higher percent of our development initiatives are focused on new functionality versus maintenance. A summary of our total software development expense in 2012 and 2011 is as follows: For the Years Ended (In thousands) 2012 2011 Software development costs $ 319,828 $ 290,645 Capitalized software costs (98,067 ) (81,417 )Capitalized costs related to share-based payments (2,122 ) (1,525 ) Amortization of capitalized software costs 81,731 79,098 Total software development expense $ 301,370 $ 286,801 • General and administrative expenses as a percent of total revenues were 6% in 2012, compared to 7% in 2011. These expenses increased 13% to $163.6 million in 2012, from $144.9 million for the same period in 2011. General and administrative expenses include salaries for corporate, financial and administrative staffs, utilities, communications expenses, professional fees, transaction gains or losses on foreign currency and expense for share-based payments. The increase in general and administrative expenses was primarily driven by an increase in corporate personnel costs, as we have continued to increase such personnel to support our overall revenue growth. Non-Operating Items • Interest income increased to $16.5 million in 2012 from $15.2 million in 2011 due primarily to growth in investments. Interest expense decreased to $5.1 million in 2012 compared to $5.3 million in 2011 due primarily to payments on our long-term debt, offset by increased capital lease obligations. Other income in 2012 also includes a $4.5 million gain recognized on the disposition of one of our cost-method investments. • Our effective tax rate decreased to 32% in 2012 from 35% in 2011. This decrease was primarily due to an increase in net favorable permanent differences, along with a favorable adjustment to our unrecognized tax benefits, partially offset by the expiration of the research and development tax credit on December 31, 2011. We do not expect the favorable impact of permanent differences to be as significant in 2013. We also do not expect any significant favorable adjustments to our unrecognized tax benefits in 2013. Refer to Note (12) of the notes to consolidated financial statements for further information regarding our effective tax rate. In January 2013, the American Taxpayer Relief Act of 2012 (Act) became law. The Act reinstates the research and development tax credit retroactively from January 1, 2012 to December 31, 2013. In the first quarter of 2013, we will recognize the research and development tax credit related to 2012 as a favorable discrete item. Research and development tax credits generated in 2013 will be recognized pro-rata over that year as a component of the overall 2013 effective tax rate. 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 Argentina, Aruba, Australia, Austria, Canada, Cayman Islands, Chile, China (Hong Kong), Egypt, England, France, Germany, Guam, India, Ireland, Italy, Japan, Malaysia, Mexico, Morocco, Puerto Rico, Qatar, Saudi Arabia, Singapore, Spain, Sweden, Switzerland and the United Arab Emirates. 25-------------------------------------------------------------------------------- Table of Contents The following table presents a summary of the operating information for the years ended 2012 and 2011: (In thousands) 2012 % of Revenue 2011 % of Revenue % Change Domestic Segment Revenues $ 2,341,304 100% $ 1,894,454 100% 24% Costs of revenue 548,813 23% 387,466 20% 42% Operating expenses 506,249 22% 439,465 23% 15% Total costs and expenses 1,055,062 45% 826,931 44% 28% Domestic operating earnings 1,286,242 55% 1,067,523 56% 20% Global Segment Revenues 324,132 100% 308,699 100% 5% Costs of revenue 59,384 18% 54,206 18% 10% Operating expenses 131,580 41% 126,997 41% 4% Total costs and expenses 190,964 59% 181,203 59% 5% Global operating earnings 133,168 41% 127,496 41% 4% Other, net (847,748 ) (735,221 ) 15% Consolidated operating earnings $ 571,662 $ 459,798 24% Domestic Segment • Revenues increased 24% to $2.3 billion in 2012 from $1.9 billion in 2011. This increase was primarily driven by strong growth in technology resale and professional services. • Cost of revenues was 23% of revenues in 2012, compared to 20% of revenues in 2011. 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 increased 15% to $506.2 million in 2012 from $439.5 million in 2011, due primarily to growth in managed services and professional services expenses. Global Segment • Revenues increased 5% to $324.1 million in 2012 from $308.7 million in 2011. This increase was primarily driven by growth in technology resale and managed services, along with a higher level of support services. Growth in our Global Segment revenues has lagged our faster rate of revenue growth in our Domestic Segment due to the more significant impact of the economic downturn of the last several years on the non-U.S. countries in which we conduct operations. • Cost of revenues was 18% in 2012 and 2011, due to a similar mix of sales. • Operating expenses were at $131.6 million in 2012, compared to $127.0 million in 2011, primarily due to overall growth in our Global segment. 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 15% to $847.7 million in 2012 from $735.2 million in 2011. This increase was primarily due to growth in corporate and development personnel costs. 26-------------------------------------------------------------------------------- Table of Contents Fiscal Year 2011 Compared to Fiscal Year 2010 % of % of (In thousands) 2011 Revenue 2010 Revenue % Change Revenues System sales $ 706,714 32 % $ 550,792 30 % 28 % Support and maintenance 550,554 25 % 517,494 28 % 6 % Services 901,193 41 % 749,483 40 % 20 % Reimbursed travel 44,692 2 % 32,453 2 % 38 % Total revenues 2,203,153 100 % 1,850,222 100 % 19 % Costs of revenue Costs of revenue 441,672 20 % 320,356 17 % 38 % Total margin 1,761,481 80 % 1,529,866 83 % 15 % Operating expenses Sales and client service 869,962 39 % 767,152 42 % 13 % Software development 286,801 13 % 272,851 15 % 5 % General and administrative 144,920 7 % 130,530 7 % 11 % Total operating expenses 1,301,683 59 % 1,170,533 64 % 11 % Total costs and expenses 1,743,355 79 % 1,490,889 81 % 17 % Operating earnings 459,798 21 % 359,333 19 % 28 % Other income, net 9,896 2,879 Income taxes (163,067 ) (124,940 ) Net earnings $ 306,627 $ 237,272 29 % Revenues & Backlog Revenues increased 19% to $2.2 billion in 2011, as compared to $1.9 billion in 2010. • System sales increased 28% to $706.7 million in 2011 from $550.8 million in 2010. The increase in system sales was driven by strong increases in licensed software, technology resale, and subscriptions. • Support and maintenance revenues increased 6% to $550.6 million in 2011 compared to $517.5 million in 2010. This increase was attributable to continued success at selling Cerner Millennium applications and implementing them at client sites. • Services revenue increased 20% to $901.2 million in 2011 compared to $749.5 million in 2010. This increase was driven by growth in CernerWorks managed services as a result of continued demand for our hosting services and an increase in professional services due to increased implementation activities and growth in Cerner ITWorks services. Contract backlog, which reflects new business bookings that have not yet been recognized as revenue, increased 26% in 2011 compared to 2010. This increase was driven by growth in new business bookings during 2011, including continued strong levels of managed services and Cerner ITWorks bookings that typically have longer contract terms. A summary of total backlog at the end of 2011 and 2010 follows: (In thousands) 2011 2010 Contract backlog $ 5,401,427 $ 4,285,267 Support and maintenance backlog 705,744 654,913 Total backlog $ 6,107,171 $ 4,940,180 27-------------------------------------------------------------------------------- Table of Contents Costs of Revenue Cost of revenues as a percentage of total revenues was 20% of total revenues in 2011, as compared to 17% of total revenues in 2010. 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, and a slightly higher level of third party consulting costs. Operating Expenses Total operating expenses increased 11% in 2011 to $1.3 billion as compared to $1.2 billion in 2010. • Sales and client service expenses as a percent of total revenues were 39% in 2011, as compared to 42% in 2010. These expenses increased 13% to $870.0 million in 2011, from $767.2 million in 2010. The increase in these expenses was primarily attributable to growth in the managed services business and a higher level of professional services expenses. The decrease as a percent of revenue reflected efficiencies in our implementation and operational processes. • Software development expenses as a percent of revenue were 13% in 2011, as compared to 15% in 2010. These expenses increased 5% in 2011 to $286.8 million, from $272.9 million in 2010. Expenditures for software development in 2011 reflected continued development and enhancement of the Cerner Millennium platform and software solutions and investments in new growth initiatives. Although these expenses increased in 2011, the reduction as a percent of revenue reflected our ongoing efforts to control spending relative to revenue growth. A summary of our total software development expense in 2011 and 2010 is as follows: For the Years Ended (In thousands) 2011 2010 Software development costs $ 290,645 $ 284,836 Capitalized software costs (81,417 ) (79,631 ) Capitalized costs related to share-based payments (1,525 ) (1,348 ) Amortization of capitalized software costs 79,098 68,994 Total software development expense $ 286,801 $ 272,851 • General and administrative expenses as a percent of total revenues were 7% in 2011 and 2010. These expenses increased 11% to $144.9 million in 2011 from $130.5 million in 2010. An increase in corporate personnel costs accounted for the majority of the overall increase in general and administrative expenses, as we increased personnel to support our overall revenue growth. Non-Operating Items • Interest income increased to $15.2 million in 2011 from $10.3 million in 2010 due primarily to growth in investments and related increase in investment returns. Interest expense decreased to $5.3 million in 2011 from $6.9 million in 2010 due to payment on our long-term debt. • Our effective tax rate was 35% in 2011, as compared to 34% in 2010. The increase was attributable to the mix of domestic and foreign earnings. 28 -------------------------------------------------------------------------------- Table of Contents Operations by Segment The following table presents a summary of our operating segment information for the years ended 2011 and 2010: (In thousands) 2011 % of Revenue 2010 % of Revenue % Change Domestic Segment Revenues $ 1,894,454 100% $ 1,562,563 100% 21% Costs of revenue 387,466 20% 272,385 17% 42% Operating expenses 439,465 23% 417,181 27% 5% Total costs and expenses 826,931 44% 689,566 44% 20% Domestic operating earnings 1,067,523 56% 872,997 56% 22% Global Segment Revenues 308,699 100% 287,659 100% 7% Costs of revenue 54,206 18% 47,971 17% 13% Operating expenses 126,997 41% 124,546 43% 2% Total costs and expenses 181,203 59% 172,517 60% 5% Global operating earnings 127,496 41% 115,142 40% 11% Other, net (735,221 ) (628,806 ) 17% Consolidated operating earnings $ 459,798 $ 359,333 28% Domestic Segment • Revenues increased 21% to $1.9 billion in 2011 from $1.6 billion in the same period in 2010. This increase was driven by growth across all business models, with particular strength in licensed software, technology resale, professional services and managed services. • Cost of revenues increased to 20% of revenues in 2011, compared to 17% in 2010. The higher cost of revenues as a percent of revenue was primarily driven by a higher mix of technology resale, which carries a high cost of revenue, and an increase in third party consulting costs. • Operating expenses increased 5% to $439.5 million in 2011, from $417.2 million in 2010, due primarily to growth in managed services and professional services expense. Global Segment • Revenues increased 7% to $308.7 million in 2011 from $287.7 million in 2010. Global revenues increased due to an increase in licensed software and managed services revenue, which was partially offset by a decrease in professional services and technology resale revenue. The global comparisons were also impacted by a change in certain contract accounting estimates during the first quarter of 2010. • Cost of revenues was 18% and 17% in 2011 and 2010, respectively. The higher cost of revenues in 2011 was primarily driven by an increase in third party professional services costs. • Operating expenses increased 2% to $127.0 million in 2011 from $124.5 million in 2010, which was primarily to support our revenue growth. Other, net These expenses increased 17% to $735.2 million in 2011 from $628.8 million in 2010. This increase was primarily due to increased costs in software development, increased corporate and development personnel costs, increased stock compensation costs, and growth in other professional services. 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 consist of money market funds and time deposits 29-------------------------------------------------------------------------------- Table of Contents with original maturities of less than 90 days, and short-term investments. At the end of 2012, we had cash and cash equivalents of $317.1 million and short-term investments of $719.7 million, as compared to cash and cash equivalents of $243.1 million and short-term investments of $531.6 million at the end of 2011. Approximately 15% of our aggregate cash, cash equivalents and short-term investments at December 29, 2012, were held outside of the United States. As part of our business strategy, we plan to indefinitely reinvest the earnings of our foreign operations; however, should the earnings of our 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 the end of 2012, we were in compliance with all debt covenants. As of the end of 2012, we had no outstanding borrowings under this agreement; however, we had $14.3 million of outstanding letters of credit, which reduced our available borrowing capacity to $85.7 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 2013. The following table summarizes our cash flows in 2012, 2011 and 2010: For the Years Ended (In thousands) 2012 2011 2010 Cash flows from operating activities $ 708,314 $ 546,294 $ 456,444 Cash flows from investing activities (701,631 ) (565,091 ) (520,896 ) Cash flows from financing activities 66,034 48,853 34,841 Effect of exchange rate changes on cash 1,257 (1,421 ) 2,399 Total change in cash and cash equivalents 73,974 28,635 (27,212 ) Cash and cash equivalents at beginning of period 243,146 214,511 241,723 Cash and cash equivalents at end of period $ 317,120 $ 243,146 $ 214,511 Free cash flow (non-GAAP) $ 424,696 $ 358,557 $ 273,154 Cash from Operating Activities For the Years Ended (In thousands) 2012 2011 2010 Cash collections from clients $ 2,714,315 $ 2,211,361 $ 1,900,145 Cash paid to employees and suppliers and other (1,840,682 ) (1,543,414 ) (1,315,077 ) Cash paid for interest (6,448 ) (5,786 ) (6,887 ) Cash paid for taxes, net of refund (158,871 ) (115,867 ) (121,737 ) Total cash from operations $ 708,314 $ 546,294 $ 456,444 Cash flow from operations increased $162.0 million in 2012 compared to 2011 and $89.9 million in 2011 compared to 2010 due primarily to the increase in cash impacting earnings, along with cash provided by working capital changes. During 2012, 2011 and 2010, we received total client cash collections of $2.7 billion, $2.2 billion and $1.9 billion, respectively, of which 3%, 3% and 4%, respectively, were received from third party client financing arrangements and non-recourse payment assignments. Days sales outstanding was 74 days in the fourth quarter of 2012, 73 days in the third quarter of 2012 and 83 days in the fourth quarter of 2011. Revenues provided under support and maintenance agreements represent recurring cash flows. Support and maintenance revenues increased 10% in 2012 and 6% in 2011. We expect these revenues to continue to grow as the base of installed Cerner Millennium systems grows. Cash from Investing Activities 30-------------------------------------------------------------------------------- Table of Contents For the Years Ended (In thousands) 2012 2011 2010 Capital purchases $ (183,429 ) $ (104,795 ) $ (102,311 ) Capitalized software development costs (100,189 ) (82,942 ) (80,979 ) Purchases of investments, net of sales and maturities (354,603 ) (291,393 ) (312,340 ) Other, net (63,410 ) (85,961 ) (25,266 ) Total cash flows from investing activities $ (701,631 ) $ (565,091 ) $ (520,896 ) Cash flows from investing activities consist primarily of capital spending and our short-term investment activities. Capital spending consists of capitalized equipment purchases primarily to support growth in our CernerWorks managed services business, building and improvement purchases to support our facilities requirements and capitalized spending to support our ongoing software development initiatives. Capital spending is expected to increase in 2013, primarily due to capital purchases associated with new office space and spending related to software development initiatives; however, we still expect strong levels of free cash flow. Short-term investment activity consists of the investment of cash generated by our business in excess of what is necessary to fund operations. We expect to continue such short-term investment activity in 2013, as we expect strong levels of cash flow. During 2012, we completed our acquisition of Anasazi Software, Inc. for $40.5 million, net of cash acquired. During 2011, we completed our acquisitions of Resource Systems, Inc. and Clairvia, Inc. for approximately $28.1 million and $37.2 million, net of cash acquired, respectively. During 2010, we completed our acquisition of IMC Health Care, Inc. for approximately $14.5 million, net of cash acquired. We expect to continue seeking and completing strategic business acquisitions that are complementary to our business. Cash from Financing Activities For the Years Ended (In thousands) 2012 2011 2010 Repayment of long-term debt and capital lease obligations $ (17,083 ) $ (25,701 ) $ (27,625 ) Cash from option exercises (including excess tax benefits) 86,517 75,333 60,950 Other, net (3,400 ) (779 ) 1,516 Total cash flows from financing activities $ 66,034 $ 48,853 $ 34,841 Cash inflows from stock option exercises are dependent on a number of factors, including the price of our common stock, grant activity under our stock option and equity plans, and overall market volatility. We expect cash inflows from stock option exercises to continue in 2013 based on the number of exercisable options at the end of 2012 and our current stock price. Free Cash Flow For the Years Ended (In thousands) 2012 2011 2010 Cash flows from operating activities (GAAP) $ 708,314 $ 546,294 $ 456,444 Capital purchases (183,429 ) (104,795 ) (102,311 ) Capitalized software development costs (100,189 ) (82,942 ) (80,979 ) Free cash flow (non-GAAP) $ 424,696 $ 358,557 $ 273,154 Free cash flow increased $66.1 million from 2011 to 2012 and $85.4 million from 2010 to 2011, which we believe reflects continued strength in our earnings. Free cash flow is a non-GAAP financial measure used by management along with GAAP results to analyze our earnings quality and overall cash generation of the business. The presentation of free cash flow is not meant to be considered in isolation, nor as a substitute for, or superior to, GAAP results and investors should be aware that non-GAAP measures have inherent limitations and should be read only in conjunction with our consolidated financial statements prepared in accordance with GAAP. Free cash flow may also be different from similar non-GAAP financial measures used by other companies and may not be comparable to similarly titled captions of other companies due to potential inconsistencies in the method of calculation. We believe free cash flow is important to enable investors to better understand 31-------------------------------------------------------------------------------- Table of Contents and evaluate our ongoing operating results and allows for greater transparency in the review of our overall financial, operational and economic performance, because free cash flow takes into account the capital expenditures necessary to operate our business. Contractual Obligations, Commitments and Off Balance Sheet Arrangements The following table represents a summary of our contractual obligations and commercial commitments at the end of 2012, except short-term purchase order commitments arising in the ordinary course of business. Payments Due by Period 2018 and (In thousands) 2013 2014 2015 2016 2017 thereafter Total Balance sheet obligations(a): Long-term debt obligations $ 24,765 $ 15,015 $ 15,015 $ - $ - $ - $ 54,795 Interest on long-term debt obligations 2,808 1,664 832 - - - 5,304 Capital lease obligations 34,817 32,860 32,025 30,214 11,428 - 141,344 Interest on capital lease obligations 3,900 2,855 1,767 589 94 - 9,205 Other obligations(b): Operating lease obligations 24,943 22,843 16,803 12,210 11,911 40,133 128,843 Purchase obligations 39,654 33,052 12,721 2,594 2,184 4,000 94,205 Total $ 130,887 $ 108,289 $ 79,163 $ 45,607 $ 25,617 $ 44,133 $ 433,696 (a) At the end of 2012, liabilities for unrecognized tax benefits were $2.2 million. (b) At the end of 2012, we had certain obligations related to the construction of office space in Kansas City, Kansas. Refer to Note (16) of the notes to consolidated financial statements for information regarding the construction. We have no off balance sheet arrangements as defined in Regulation S-K. The effects of inflation on our business during 2012, 2011 and 2010 were insignificant. Recent Accounting Pronouncements Refer to Note (1) of the notes to consolidated financial statements for information regarding recently adopted accounting pronouncements. Critical Accounting Policies We believe that there are several accounting policies that are critical to understanding our historical and future performance, as these policies affect the reported amount of revenue and other significant areas involving our judgments and estimates. These significant accounting policies relate to revenue recognition, software development, potential impairments of goodwill, and income taxes. These policies and our procedures related to these policies are described in detail below and under specific areas within this MD&A. In addition, Note (1) to the consolidated financial statements expands upon discussion of our accounting policies. Revenue Recognition We recognize revenue within our multiple element arrangements, including software and software-related services, using the residual method. Key factors in our revenue recognition model are our assessments that installation services are essential to the functionality of our software, whereas implementation services are not, and the length of time it takes for us to achieve the delivery and installation milestones for our licensed software. If our business model were to change such that implementation services are deemed to be essential to the functionality of our software, the period of time over which our licensed software revenue would be recognized would lengthen. We generally recognize revenue from the sale of our licensed software over two key milestones, delivery and installation, based on percentages that reflect the underlying effort from planning to installation. Generally, both milestones are achieved in the quarter the contracts are executed. If the period of time to achieve our delivery and installation milestones for our licensed software were to lengthen, our milestones would be adjusted and the timing of revenue recognition for our licensed software could materially change. 32-------------------------------------------------------------------------------- Table of Contents We also recognize revenue for certain projects using the percentage of completion method. Our revenue recognition is dependent upon our ability to reliably estimate the direct labor hours to complete a project which generally can span several years. We utilize our historical project experience and detailed planning process as a basis for our future estimates to complete current projects. Significant delays in completion of the projects, unforeseen cost increases or penalties could result in significant reductions to revenue and margins on these contracts. The actual project results can be significantly different from the estimated results. When adjustments are identified near or at the end of a project, the full impact of the change in estimate is recognized in that period. This can result in a material impact on our results for a single reporting period. Software Development Costs Costs incurred internally in creating computer software solutions and enhancements to those solutions are expensed until completion of a detailed program design, which is when we determine that technological feasibility has been established. Thereafter, all software development costs are capitalized until such time as the software solutions and enhancements are available for general release, and the capitalized costs subsequently are reported at the lower of amortized cost or net realizable value. Net realizable value is computed as the estimated gross future revenues from each software solution less the amount of estimated future costs of completing and disposing of that product. Because the development of projected net future revenues related to our software solutions used in our net realizable value computation is based on estimates, a significant reduction in our future revenues could impact the recovery of our capitalized software development costs. We historically have not experienced significant inaccuracies in computing the net realizable value of our software solutions and the difference between the net realizable value and the unamortized cost has grown over the past three years. We expect this trend to continue in the future. If we missed our estimates of net future revenues by 10%, the amount of our capitalized software development costs would not be impaired. Capitalized costs are amortized based on current and expected net future revenue for each software solution with minimum annual amortization equal to the straight-line amortization over the estimated economic life of the software solution. We are amortizing capitalized costs over five years. The five-year period over which capitalized software development costs are amortized is an estimate based upon our forecast of a reasonable useful life for the capitalized costs. Historically, use of our software programs by our clients has exceeded five years and is capable of being used a decade or more. We expect that major software information systems companies, large information technology consulting service providers and systems integrators and others specializing in the health care industry may offer competitive products or services. The pace of change in the HCIT market is rapid and there are frequent new product introductions, product enhancements and evolving industry standards and requirements. As a result, the capitalized software solutions may become less valuable or obsolete and could be subject to impairment. Goodwill Goodwill is not amortized but is evaluated for impairment annually or whenever there is an impairment indicator. All goodwill is assigned to a reporting unit, where it is subject to an annual impairment assessment. We assess goodwill for impairment in the second quarter of each fiscal year and evaluate impairment indicators at each quarter end. We assessed our goodwill for impairment in the second quarters of 2012 and 2011 and concluded that goodwill was not impaired. The 2012 assessment consisted of a qualitative analysis in accordance with new guidance effective in 2012. The 2011 assessment consisted of a quantitative analysis, in which the fair values of each of our reporting units exceeded their carrying amounts by a significant margin. We used a discounted cash flow analysis utilizing Level 3 inputs, to determine the fair value of the reporting units in 2011. Goodwill amounted to $247.6 million and $211.8 million at the end of 2012 and 2011, respectively. If future anticipated cash flows from our reporting units that recognized goodwill do not materialize as expected, our goodwill could be impaired, which could result in significant charges to earnings. Income Taxes We make a number of assumptions and estimates in determining the appropriate amount of expense to record for income taxes. These assumptions and estimates consider the taxing jurisdictions in which we operate as well as current tax regulations. Accruals are established for estimates of tax effects for certain transactions, business structures and future projected profitability of our businesses based on our interpretation of existing facts and circumstances. If these assumptions and estimates were to change as a result of new evidence or changes in circumstances, the change in estimate could result in a material adjustment to the consolidated financial statements. We have discussed the development and selection of these critical accounting estimates with the Audit Committee of our 33-------------------------------------------------------------------------------- Table of Contents Board of Directors and the Audit Committee has reviewed our disclosure contained herein. |