Thursday, April 13, 2006

The Bull Case for Cerner

Medical errors are unfortunately still running rampant in America, so the need for clinical/administrative data automation in the health care industry is greater than ever.

According to IDC, hospital-related IT spending is expected to rise considerably within the next 3-5 years as health care providers look to implement safety metrics across the board. The Center for Information Technology Leadership (CITL) says the health-care system could save more than $100 billion annually if there were sufficient IT to save & retrieve data.

Enter Cerner (CERN), purveyor of medical software. Cerner's revenue streams come from software sales and the ancillary/follow up services it provides for its clients. Clients include large hospitals, but Cerner has recently penetrated the tighter, smaller private physician space in order to diversify it client base and augment its long term contractual agreements. Currently, Cerner lacks the scale its rivals enjoy, and as a result, Cerner has to spend more in order to develop content solutions and haul clients through the door.

Nevertheless, Cerner has done an exceptional job turning the orders it has received into recurring revenues. In addition, Cerner's brand visibility is a competitive advantage we think the firm should capitalize on in the near future. Should hospital budgets loosen up -- and the firm carve out an impenetrable niche in this terribly fragmented category -- we think Cerner could see great upside.

RISKS Cerner's balance sheet is far from perfect, and the company has already announced much higher R & D
expenses going forward as it shrugs off increasing competition from formidable stalwarts like IBM (IBM) and Accenture (ACN), who could arguably blow Cerner out the water if they decided to leverage their name and deploy cash on acquisitions. Record-keeping software maker Quality Systems (QSII) should also be watched closely. A small but powerful player, Quality Systems is cash flow positive and growing at a torrid pace.

SUMMARY Will Danoff, who manages $65 billion for Fidelity Contrafund, is arguably one of the best stock pickers of his time -- Danoff was recently caught adding Cerner to his holdings. We believe Cerner is an up-and-coming star in a white hot category. Although the competitive landscape and valuation picture (CERN trades at 27x next year EPS, 3x sales, and 13x EBITDA) aren't exactly screaming "buy," we'd easily shoulder the risk of adding Cerner to our portfolio, as long as the firm's long term prospects remained sound. Our price target is $52.

Parts of this report appeared in this research report published on 2/24, when CERN was trading at $41. The stock is up 10% since then -- we believe now is still a good time to initiate a position.

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