Cerner Corporation
Q3 2017 Earnings Call Transcript

Published:

  • Operator:
    Welcome to Cerner Corporation's Third Quarter 2017 Conference Call. Today's date is October 26, 2016, and this call is being recorded. The Company has asked me to remind you that various remarks made here today constitute forward-looking statements including, without limitation, those regarding projections of future revenues or earnings, operating margins, operating and capital expenses, bookings, solution development, new markets or prospects for the Company's solutions and services, and plans for CEO succession. Actual results may differ materially from those indicated by the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statement may be found under item 1A in Cerner's Form 10-K, together with the Company's other filings. A reconciliation of non-GAAP financial measures discussed in this earnings call can be found in the Company's earnings release which was furnished to the SEC today and posted on the Investor section of cerner.com. Cerner assumes no obligation to update any forward-looking statements or information, except as required by law. At this time, I'd like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation.
  • Marc Naughton:
    Thank you, Vince. Good afternoon, everyone, and welcome to the call. I'll start with a review of our numbers. Zane Burke, our President, will follow me with the results, highlights and marketplace observations. And then Mike Nill, our Chief Operating Officer, will provide operational highlights. Turning to our results. While Q3 included revenue in earnings in our guidance ranges and record cash flow, our booking results were disappointing. Our bookings in Q3 were $1.111 billion, down from $1.434 billion in Q3 of 2016, and below our guidance range for the quarter. As Zane will discuss, the shortfall was primarily due to several large deals that were forecast for the quarter that did not come through, though we expect a strong Q4 bookings performance that would put the year back in line with our original expectations. Our revenue backlog into the quarter at $16.532 billion, which is up 7% from $15.471 billion a year ago. Revenue in the quarter was $1.276 billion, which is up 8% over Q3 of 2016. The revenue composition for Q3 was $324 million in systems sales, $263 million in support and maintenance, $664 million in services and $24 million in reimbursed travel. Systems sales revenue for the quarter was up 8% compared to Q3 of 2016, with growth in license software and subscriptions being partially offset by a decline in technology resale. Our system sales margin percent of 67.5% was up from 66.3% in Q2 2017, due to the lower technology resale; and down from 69% in Q3 of 2016, due to the mix of technology resale including the lower levels of third-party software margin. This dynamic had a similar impact on our total gross margin, which was up 140 basis points sequentially and down 50 basis points year-over-year. Moving to services. Total services revenue, including professional and managed services, was up 9% compared to Q3 of 2016. Support and maintenance revenue increased 4% for the quarter, which is in line with expectations. Looking at revenue by geographic segment, domestic revenue increased 7% over the year ago quarter to $1.13 billion and non-U.S. revenue of $142 million increased 10%. Now, I'll discuss spending, operating margin and net earnings. For these items, we provide both GAAP and adjusted or non-GAAP results. The adjusted results exclude share-based compensation expense, share-based compensation permanent tax items, health service acquisition-related amortization, acquisition-related deferred revenue adjustments, and other acquisition-related adjustments, which are detailed and reconciled to GAAP in our earnings release. Looking at operating spending, our third quarter GAAP operating expenses of $825 million were up 9% compared to $759 million in the year ago quarter – or year ago period. Adjusted operating expenses were $779 million, which is up 9% compared to Q3 of 2016. This growth was primarily driven by an increase in personnel expenses related to revenue-generating associates and non-cash items. Looking at the line items, sales in client service expense increased 10%. Software development increased 13%, driven by non-cash items as we had $7 million less capitalized software and $9 million more amortizations than Q3 of 2016. G&A expense was down 1%. Amortization of acquisition-related intangibles decreased slightly year-over-year. Moving to operating margins. Our Q3 GAAP operating margin was 19.4%, compared to 20.4% in the year ago period. Our adjusted operating margin was 23.1% in Q3, which is down 130 basis points from the year ago period due to the previously discussed technology resale mix and non-cash expense. One impact that has been greater than we expected is software capitalization and amortization. We expected net software capitalization to represent about $35 million of a $70 million annual increase in non-cash items, but because we have capitalized less software, along with the expected increases in amortization, our earnings have been impacted by $43 million through just three quarters. So, it is on pace to be over $55 million or $20 more than we projected. This does reflect better earnings quality as our amortization catches up with capitalization, but I wanted to highlight it as it has had a bigger than expected impact on our margins and earnings this year. Moving to net earnings and EPS. Our GAAP net earnings in Q3 were $177 million, or $0.52 per diluted share. Adjusted net earnings were $206 million and adjusted diluted EPS was $0.61, up 3% from $0.59 in Q3 of 2016. Our GAAP tax rate for the quarter was 29%. And excluding the share-based compensation, permanent tax items, the Q3 tax rate was 31%, which is up from 30% a year ago. Now, I'll move to our balance sheet. We ended Q3 with $964 million of total cash and investments, which is up from $748 million in Q2. Moving to debt. Our total debt, including appear capital lease obligations, was $535 million, which is down slightly compared to Q2. Total receivables in the quarter at $1.021 billion, which is down from $1.037 billion in Q2. Our Q3 DSO was 73 days, which is down from 76 days in the year ago period, and flat compared to Q2. Operating cash flow for the quarter was very strong at $363 million, Q3 capital expenditures were $73 million, and capitalized software was $67 million. Free cash flow defined as operating cash flow less capital purchases and capitalized software development cost was $223 million for the quarter, representing an all-time high. Now, I'll go through guidance. We expect revenue in Q4 to be between $1.3 and $1.35 billion, with the midpoint reflecting growth of 5% over Q4 of 2016. The midpoint of this range would bring full year of 2017 revenue to $5.15 billion, which reflects 7% growth over 2016 and is at the low end of our prior guidance range. We expect Q4 diluted EPS – adjusted diluted EPS to be $0.60 to $0.62 per share, which is flat compared to Q4 of 2016. The midpoint of this range would bring full year of 2017 EPS to $2.42, which reflects 5% growth over 2016. Moving to bookings. We expect bookings in Q4 of $1.75 billion to $2 billion, with the midpoint reflecting 30% growth compared to Q4 of 2016. This strong expected growth reflects our expectation that we sign large contracts that pushed from Q3, in addition to an already strong level of forecasted activity for Q4. The midpoint of our Q4 guidance would bring full year of 2017 bookings guidance to 8%. Our guidance does not assume a significant booking for the VA contract, as we expect this initial booking to be relatively small. I'd like to provide some more color on our Q4 revenue and earnings guidance. Primary driver of the lower Q4 revenue and earnings is lower Q3 bookings. While we were within our Q3 revenue and earnings guidance ranges even with the lower Q3 bookings, the timing of the pushed bookings reduces Q4 revenue and earnings, as those contracts won't contribute much to the quarter. Much of the booking shortfall was related to ITWorks deals that pushed, which has a bigger impact on Q4 revenue than earnings, but some of the shortfall was related to managed services and professional services bookings, which typically begin converting to higher margin revenue relatively quickly and therefore have a bigger impact on earnings in Q4. Tech resale is also expected to increase in Q4, which helps close the revenue gap. This does not contribute much to margins. On the spending side, our Q3 expenses benefited from lower variable compensation expense associated with lower bookings, and reduction on the accrual for full-year variable compensation since we expect to be below our internal targets. Since the full-year accrual has already been reduced, there'll be no additional expense benefit in Q4. Another factor impacting spending is upfront investments we are making in large projects that increase personnel spend in Q4, but will not start delivering revenue until 2018. Additionally, most of our workforce receives their annual salary adjustments at the beginning of Q4, which is another factor increasing compensation expense. Finally, we expect the ongoing impact of non-cash expenses which, as I mentioned, has had a bigger than expected impact this year. Now, I'd like to provide initial expectations for 2018. We'll provide more formal guidance after we report Q4 results and finalize our 2018 plan. But based on the initial version of our plan, we currently expect 2018 revenue between $5.5 billion and $5.7 billion, reflecting 9% growth at the midpoint. And 2018 adjusted diluted EPS between $2.52 and $2.68 per share, reflecting 7% growth at the midpoint. Current consensus estimates for revenue is in our guidance range. Consensus for adjusted diluted EPS is above our guidance range, largely reflecting the fact that consensus was formed before our Q3 results and Q4 guidance. Our initial 2018 outlook reflects revenue growth in our long-term targeted range of 7% to 11%. While this is off of the slightly lower 2017 revenue number, our expected 2017 growth is also within our targeted range, so both years would be in line with our stated range. Regarding EPS. Our expected EPS growth rate is slightly below our revenue growth rate. Current consensus estimates reflect margin expansion, with earnings growing faster than revenue, which is not consistent with statements we made at the beginning of this year about margin headwinds for 2017 and 2018 tied to revenue mix and non-cash expense growth. Recall that we indicated depreciation and amortization growth would be a headwind to margins for a couple of years. As I indicated earlier, these items have had a more significant impact than originally projected in 2017. Consistent with our comments at the beginning of this year, we expect these increases in these non-cash items to continue in 2018, again, largely driven by increased software amortization. The other factor we cited at the beginning of 2017 is revenue mix, as we projected a higher volume Works business in 2017 and 2018. While the Works business is shaping up to be back-end loaded for 2017, we do expect the volume of Works revenue in 2018 to result in a mix shift that pressures margins. As we also said at the beginning of the year, we believe the non-cash headwinds will subside after a couple of years and, longer term, we believe SAS revenue related to population health can offset the impact of the Works revenue mix as it ramps, but the timing of this is uncertain. We also believe we'll be able to expand Works margins as we achieve scale in these businesses. Finally, please keep in mind our initial guidance does not reflect any impact from the new revenue accounting standard, often referred to as Topic 606. We are still working through the impact and it's too early yet for us to estimate an amount at this time. In summary, while we are disappointed with our Q3 bookings results and the related lower than expected Q4 earnings outlook, we are pleased with the very strong Q4 bookings outlook, which we believe will allow to us finish the year on a positive note and position us for good visibility into 2018 results. With that, I'll turn the call over to Zane.
  • Zane M. Burke:
    Thanks, Marc. Good afternoon, everyone. Today, I'll provide color on our results and make some marketplace observations. I'll start with bookings. After a significant bookings over-attainment in Q2, we had lower than expected bookings in Q3 due to some of our largest forecast opportunities pushing out of the quarter. Our Q2 over-attainment and strong Q4 bookings outlook more than offset the lower Q3 bookings, so we are still positioned for good bookings growth for the year if we deliver against our Q4 guidance, which is our key focus. I believe two key factors contributed to the lower Q3 bookings and overall less predictable nature of our bookings in recent quarters. We've discussed both in the past. First, some of our contracts are getting larger and more complex, particularly Works opportunities in our pipeline. As a result, the timing of a few contracts can have a material impact on bookings. Second, predicting timing of the contracts is more challenging in a post-meaningful use era, so even though we have a large pipeline, there isn't an external set of dates creating urgency for clients to sign. We work to address these factors with wider guidance ranges, but even with that approach, we had the significant upside in Q2 and the downside in Q3. The net of it is that we still remain positioned to have a good full year of bookings, but are clearly disappointed we didn't deliver against our guidance in Q3. Now, I'll provide some color on our bookings mix. In addition to having large ITWorks contracts pushed, we also had lower level hosting bookings, resulting in just 25% of the bookings coming from long-term contracts. We expect this to be much higher in Q4. I would also point out that we do not believe the lower bookings were related to our competitiveness. Our win rate remained high during the quarter. The lower volume of business was related to deal timing. This quarter, 30% of our bookings were from outside our core Millennium install base. We continue to see success against our primary competitor in an environment where prospects are focused on return on investment. We also continue to do well with our CommunityWorks offering in smaller hospitals, where we believe incumbent suppliers are struggling to keep up with regulatory requirements and new entrants have over-promised and under-delivered. One area I'd like to highlight this quarter is revenue cycle. On the solutions side, we made significant progress that has contributed to our higher win rate on new business and led to strong sales back into our base, as our clients replace legacy revenue cycle platforms. Beyond our solutions, we have been steadily building out and improving our revenue cycle services capabilities. Our services include transition services that help clients wind down legacy AR, targeted projects, business office management, and full outsourcing. As we've increased penetration of revenue cycle solutions to our install base, the demand for our services has increased. As a result, we expect larger contributions going forward from revenue cycle services, including full outsourcing. In population health, we continue to make steady progress at adding clients to the HealtheIntent platform and expanding the scope at existing clients, even though uncertainty remains regarding exactly when the broader shift from fee-for-service to value-based care will occur. In this environment, we are focused on selling our analytics capabilities and tools that support and optimize fee-for-service models, while also preparing our clients for the shift to value-based models. We also continue to build out population health services capability, which we believe represents a meaningful opportunity. Moving to our business outside of U.S. We had a solid quarter. In addition to the improved revenue growth Marc mentioned, we had solid non-U.S. bookings performance, with strength in Canada, Australia, France, Germany and the Middle East. A more recent major development for our non-U.S. business was Cerner being selected as supplier of choice in Sweden for the region SkΓ₯ne, where we will provide our core solutions to 10 hospitals and 190 primary care locations. We will also establish our first Nordic population health client serving 1.3 million citizens. We are looking forward to finalizing this relationship after getting through the contract challenge period. Next, I'd like to provide an update on Department of Defense MHS GENESIS project. Last month, we went live at Naval Hospital Bremerton, the third site to come online as part of Department of Defense's initial operating capability program. Then, just this last week, Madigan Army Medical Center went live, which completes the initial operating capability program. These are significant milestones, as we have now deployed a full set of capabilities and these go-lives keep us on schedule to begin broader deployment next year. I'd also like to provide an update on our opportunity with Department of Veteran Affairs. We made good progress working with the VA on scoping the full work effort, designing the project plan, and negotiating a contract, and we expect to sign the contract by the end of the year. As we mentioned last quarter, we are expected to be the prime contractor on this project. Concurrent with our contracting with the VA, we have been finalizing contracts with our partners that will help us on the project, and we will announce our key partners soon. We are confident in our ability to deliver, given our experience with the DoD project and the complementary skills and resources that will be provided by our partners. We feel a great sense of pride and our responsibility to have the opportunity to support our veterans and extend their reach of the platform being established through our work with the Department of Defense. Through our solution, service, and interoperability capabilities, we are creating an integrated and longitudinal patient record designed to enable seamless care coordination across the continuum for active and former military members. Before handing the call over to Mike, I'd like to frame how we are looking at the marketplace and our near- and long-term growth opportunities. First, there are still 2,000 hospitals on a legacy EHR platform. While many of these opportunities are smaller, there are still some large opportunities. Many of them are accessible directly through our large existing clients that are looking to standardize on Cerner's at sites they have acquired or they're still on legacy EHRs. Beyond the EHR, we believe there are still meaningful whitespace for us in revenue cycle solutions and we are very early in the revenue cycle services opportunity. Another big service opportunity is ITWorks. While ITWorks has underperformed recently, I believe it is on the verge of an inflection point as it is a key lever for our clients to improve efficiency and IT performance in an environment where they need to do so. There are also several niche markets and smaller venues that collectively represent a large opportunity, including ambulatory, behavioral health, post-acute, advisory consulting, employer services, to name a few. We believe we are also in the early stages of government business contributing to our growth, and this goes beyond DoD and VA, as it includes the opportunities like the Federal Bureau of Prison, Coast Guard, Indian Health, and state Medicaid programs. Finally, our non-U.S. business is picking up and it represents an earlier stage EHR market opportunity than the U.S., as well as an opportunity for nearly all our other solutions and services I've discussed. I believe these areas of growth provide a solid bridge to ramping of what we believe to be an even larger opportunity around population health. We believe we can create significant value in the post fee-for-service economy with our core population health solutions, as well as service that we will be rolling out in the coming years. There are also several related capabilities we're investing in, such as artificial intelligence, we believe will widen our competitive edge while broadening our revenue opportunity. With that, I'll turn the call over to Mike.
  • Michael R. Nill:
    Thanks, Zane. Good afternoon, everyone. Today, I'm going to provide some highlights from the Cerner Health Conference where several of our key initiatives and marketplace differentiators were on display. The conference drew about 14,000 attendees, including representatives from 728 client or prospect organizations in 19 countries. Clients had the opportunity to engage in more than 450 education opportunities, in addition to content on major industry topics. One theme at the conference that I'd like to discuss is interoperability and open development. We believe Cerner is playing a leadership role in moving interoperability and open development forward in health care. Cerner supports many methods not only for provider interoperability, but also to empower consumers to manage and share their health information. Through CommonWell Health Alliance, Cerner enables a complete picture of a person's health story to be exchanged between providers. CommonWell now includes 5,500 provider organizations and more than 60 million records, representing good interoperability progress. A consumer is able to approve participation in the exchange, as well as verify the location of their encounters over time as opposed to only the last visit. This results in a more complete health record and enables a provider to interact, consume and contribute to all outside health data within the workflow. This enables interoperability across multiple data points for the patient, which we view as true interoperability, not just intraoperability. At the Cerner Health Conference, Zane announced the extension of a free CommonWell service to all our clients for three additional years, along with the commitment to next generation interoperability capabilities and a consumer-directed care record. The growth of our open development ecosystem was also a big focus at the health conference. The most attended sessions, besides the general sessions, was a session focused on SMART on FHIR open standards. Recall that when we launched the Cerner open developer experience last year to enhance collaboration with third party and client developers on SMART on FHIR applications. A great example where this has been successful was shared by Dr. Dan Nigrin, the CIO at Boston Children's Hospital. He provided several examples about how his organization has benefited from Cerner's commitment to open standards by deploying pediatric-specific applications on an open platform. In summary, Cerner is committed to taking a leadership role in interoperability and open platforms. We believe this is a competitive differentiator. But more importantly, we believe it will facilitate better consumer access to personal health information and more rapid innovation across health care. With that, I'll turn the call over to questions.
  • Operator:
    Thank you. (Operator instructions) Our first question is from George Hill of RBC. Your line is open.
  • George Hill:
    Hey, good afternoon, guys, and thanks for taking the question. I guess, Zane, can you provide, I guess, any color around what types of deals slipped out of the quarter? I guess, what were the product types that customers were looking for? Were they more Works or services deals and kind of the scope of the transactions? And, I guess, talk about confidence level that these deals close in Q4, or have they closed already?
  • Zane M. Burke:
    Sure, George. Most were Works types opportunities and sort of other service – large services opportunities. So, complex relationship opportunities, which we had every belief we're going to close as we approached the end of the quarter, and did just shift past the end of the quarter. Those are tracking well as we are sitting here today, and so, have either – many have either closed or are in the process of closing here as we move forward.
  • George Hill:
    Okay. And if I can get a quick follow-up. When I was out at the health care conference, one of the things that I thought was interesting is there wasn't like an ITWorks or a RevWorks booth, and it seemed that the outsource service offering was the composite of a lot of Cerner offerings put together and offered to a client. I guess, could you kind of draw a parallel between where that business is with outsource services compared to – I'm trying to figure out end market demand, with the parallel of just the regular EMR market and when you saw customers really start to buy services in bulk? What I'm trying to get to is, in what inning are we in with customers moving towards the Works services model with Cerner?
  • Zane M. Burke:
    Sure. Great question. So, I would say, as it relates to the revenue cycle piece, we're in about the first inning, as we really think about that. As it looks at the – as we look at the ITWorks, it's still early in the game, so second or third inning as we think about that. And what we do is, really, we look at these as very relationship-oriented and very targeted opportunities that are really much more at the CxO suite and so for a broad Cerner Health Conference that represents not quite the buying audience for that opportunity. So, it's just – it's a thing that just doesn't make as much sense to be on display there as that kind of represents why we do what we do there. If you think about the ITWorks opportunities for instance, out of our 400 or 500 prospects, we have approximately 25 clients today that are on ITWorks, and so that just kind of gives you a flavor for where we are on a saturation perspective.
  • George Hill:
    Okay. That's great color. I'll hop back in the queue. Thanks.
  • Zane M. Burke:
    Thanks, George.
  • Operator:
    Thanks. Your next question is from Donald Hooker of KeyBanc. Your line is open.
  • Donald H. Hooker:
    Great. Maybe just – you guys alluded to sort of limited near-term impact from the VA, but I know a lot of people are talking about it. Is there any incremental clarity you can provide around how we should think about revenues from that pending relationship play out over time?
  • Zane M. Burke:
    Well, first off, on the revenue side, we anticipate this will likely be a percentage of completion model. So, as it is shaping up, we obviously have not finished with the contracts, so we don't have anything to discuss there, but as we see it now, it appears that it will play in that way. And we don't anticipate it will have a material impact – booking – I'm sorry, earnings impact on the fourth quarter, or bookings impact as we've really established that. So, as we talked about before, again, we have not finished anything, but we anticipate that the VA would commit to the broad project, but then they do that, they do the contracts in a series of task orders, and so those series of task orders will play out over a several year period, and so we would anticipate a small task order to begin that work here in the fourth quarter.
  • Donald H. Hooker:
    Okay. And then maybe a sort of a separate follow-up question. I know it's a small part of your business but I think maybe a year ago you talked about the Value Creation Office service offering where you sort of partner with your hospital system clients. I know it's small, but I'm kind of interested in that as a direction for Cerner over time kind of becoming more of a partner and sharing in outcomes. Maybe – can you talk about how you think about how that's progressed over the past 6 to 12 months, and how do you think about that looking ahead over time?
  • Zane M. Burke:
    We're really pleased with what I'd is the two handfuls of clients that are in the Value Creation Office mode where the results have been incredibly positive for those clients, and we're achieving benefits and making payments. And while those are not in any way significant to our financial statements, we believe that's the future of where health care is and where we will be with our clients. And so, we're very bullish on that business and excited about the early returns on that. And our ability to scale more broadly is something that we'll be looking to do as you look at 2018 and 2019.
  • Donald H. Hooker:
    Do I think about that as a sale on top of your ITWorks? Is that where you typically might get growth there, like building on ITWorks?
  • Zane M. Burke:
    It doesn't have to be, but it's related to ITWorks, so we often start with a smaller Value Creation model and then it grows over time. ITWorks is a way by which we take one of the things off the plate of our clients that they're often sometimes struggling with to free their resources up. So, they can go hand-in-hand, but they do not have to. But you will – it's not – it's perceptive of you to think that that is the next progression on a ITWorks arrangement or that that's also an enabler to having the cycle time and the people on the client side to be successful to go after these types of initiatives.
  • Donald H. Hooker:
    Okay. Great. Yeah, that's what I was thinking but – okay, thank you so much.
  • Zane M. Burke:
    Thank you.
  • Operator:
    Thank you. Your next question is from Ricky Goldwasser of Morgan Stanley. Your line is open.
  • Ricky R. Goldwasser:
    Yeah. Hey, good evening. So, just a question about the macro environment. Obviously, we're hearing a lot about pressure on the hospitals picking up again in terms of bad debt expense and utilization. What type of conversations are you having with your clients? And when you think about kind of contract being pushed out to end of the year, do you see any read- throughs from just kind of like the overall macro environment for them?
  • Zane M. Burke:
    Well, Ricky, obviously the client, the environment is such that it does have some impact, and some of those work both ways in the long run. I actually look at those as hugely positive for Cerner in that the challenges that our clients face, they need more technology, they need better information, they've got to figure out ways to significantly reduce their operating costs, they've got to think about ways for appropriate coding and revenue. Those all lend themselves to the types of both services, solutions, software that we provide, and that's really why we believe the Works businesses, both from ITWorks, revenue cycle works, and population health services will unfold in a fashion which will drive significant growth for us. So, in that pain, which does have some short-term cycles from time to time at us, we look at over the long range that that's one of those areas where we can really help our clients succeed and also grow our business at the same time.
  • Ricky R. Goldwasser:
    So, when you think about contracting long-term versus the short-term, from what you've kind of observed historically, do you think that this is kind of like a couple of quarters of wait-and-see approach, or how should we think about timing?
  • Zane M. Burke:
    This one was not really a wait-and-see approach in terms of where we were. We really believed in these handful of deals were right at the end of the quarter. But they're the types of relationships here where you're not making an extra ask or an extra push, they're almost mini acquisitions, if you will. Because in many cases we're rebadging their associates to our associates, and so it's a really different type of sell, if you will, and I really almost hate to use that terminology in the same conversation when we're talking about these Works opportunities. These are where clients are placing their associates, their long-term assets with us, and betting on their future with Cerner. And so, there's just no pushing right at the edge. And so – and we don't. And so, I would look at this as actually the – both the short and mid and long-term, there is a lot of activity and opportunity in these spaces. They just are a little less predictable.
  • Marc Naughton:
    Yeah. Ricky, this is Marc. I think the level of bookings guidance in Q4 being so high would kind of indicate that Q3 was more a matter of timing. We're still seeing a strong business in Q4 that was there anyway. So, you're seeing that fall over from Q3 being somewhat additive to it, so.
  • Ricky R. Goldwasser:
    Okay. Thank you.
  • Operator:
    Thank you. Your next question is from Robert Jones of Goldman Sachs. Your line is open.
  • Adam Noble:
    Great. Thanks for the questions. This is Adam Noble in for Bob. I just wanted to ask around the margins. Marc, you laid out, I thought really well, some of the headwinds and pushes and pulls for next year, but as we think about beyond 2018, do you think that there is, given the mix shift, there is the possibility to expand margins again in 2019? Or is this really an extended multi-year period where market expansion is going to be very tough?
  • Marc Naughton:
    Yeah. I think we looked, certainly our initial view was the non-cash headwinds, which is the main thing we've talked about relative to certainly amortization expense on capitalized software, really was a 2017, 2018 phenomena. I think, 2019, it's a little early to comment. We believe that there are efficiencies available in the operation as we continue to develop these tech-enabled service offerings. I think we've got – there's going to be some efficiencies we can drive in those businesses that will help overall operating margins. At this point, 2019, we don't have the non-cash headwinds that we have had in 2017 and will have in 2018, so the opportunity to grow margins should start in 2019, but once again, it's a little early to talk about that until we get a little bit better view of that.
  • Adam Noble:
    All right. I completely understand. And just to ask a follow-up question on the VA. I appreciate that it's not going to be a major contributor to bookings or revenue in the fourth quarter. And I just wanted to make sure, to what extent is that in 2018 guidance from either a bookings or revenue standpoint? And what would you expect the ramp-up could be within that year?
  • Marc Naughton:
    Yeah. Once again, that contract isn't signed. And until we sign that and understand how the task orders will lay out, we really can't provide a whole lot of guidance as to what period it's going to impact. All we know for sure is that it feels good that it's going to get done in Q4 and that the impact in Q4 relative to bookings and revenue isn't going to be material.
  • Adam Noble:
    Okay.
  • Operator:
    Thank you. Our next question is from David Grossman of Stifel Financial. Your line is open.
  • David Michael Grossman:
    Hi. Thank you. Based on the ITWorks pipeline and conversions, can you help us better understand how these contracts are expected to convert to revenue and how that mix shift will impact margins and free cash flow conversion?
  • Marc Naughton:
    Yeah. This is Marc. When an ITWorks (36
  • David Michael Grossman:
    And on the margin and free cash flow, what is the kind of trajectory it look like as the contract evolves for those two items?
  • Marc Naughton:
    Yeah. Keep in mind ITWorks for us is rebadging associates. We don't take over the assets. We don't have capital expenditures related. The client still handles those capital expenditures. So, from a cash flow, we are doing the services, we are getting paid for the services kind of on a monthly basis. So, the cash flow is right up there with the revenue, very closely matched.
  • David Michael Grossman:
    All right. Got it. Thanks very much.
  • Marc Naughton:
    Sure.
  • Operator:
    Thanks. Your next question is from Jamie Stockton of Wells Fargo. Your line is open.
  • Jamie Stockton:
    Thanks for taking my questions. Zane, maybe just one more quick one on bookings in Q3 and the expectation around Q4. How much of this was just distraction in DC? Because a lot of the repeal, replace noise intensified in September, and then now it's gone.
  • Zane M. Burke:
    You know, Jamie, it'd be easy for me to step back and say that had an impact. I can tell you one of our larger opportunities, the hurricane, had an impact, and I can give you all sorts of those kind of things. I look at these and say, we were still tracking against those pieces. Clearly, all the – there's a number of factors that have an impact, and given we're not going to push unnaturally on these types of opportunities because of what they mean for the long haul, fill in the blank for lots of reasons why not to go ahead and do that. What I would tell is you those have all progressed very, very well here in the fourth quarter, and we're feeling very comfortable about those as well our other opportunities in the pipeline. And so, what I'm very pleased about is we're seeing those come through and continue on as we anticipated, as well as our ability to move along other opportunities in our pipeline and make us feel comfortable about the other bookings in the quarter. So, my biggest fear often is you have something push and then all of a sudden you can't work on the next piece, and so the opportunity – the ability to work on – to get these pushed through the pipeline and continue to move the other opportunities has been very, very good and very focused by our teams. But I'm not going to blame it on – I won't blame the hurricane, I won't blame DC for us not delivering.
  • Jamie Stockton:
    Okay. Well, admirable. And then, Marc, just kind of the margin trajectory in 2018. And I hear you that you'd already thrown up a flag that they weren't going up. Can you touch on just maybe what the embedded capitalization rate is versus 2017? And maybe also – I assume that you're not baking any kind of investment related to the VA end at this point, but maybe you are. If you'd touch on that.
  • Marc Naughton:
    Yeah. I think, from a software capitalization, we expect it to be similar to what we see in 2017. We expect kind of the total dollars spent to be similar, but I would expect to see the uptick in amortization, which is the thing that's causing the headwind in 2018. From any major contract that we're working on, there's clearly work that we're doing ahead of time on those contracts. Any work we're doing ahead of time on a large contract until that contract signs is expensed. So, you're going to see some of that impact in Q4. Given the signing timeframes that we expect, certainly for VA, those costs would likely go into the percent of completion calculation and therefore be aligned with revenue as we move forward. So, I think for Q4 we certainly are seeing an impact on – from a personnel spend that would be a little higher than we would normally expect because we are covering the cost of people that are working on those projects ahead of time. But I think for 2018, there's not a whole lot of additional costs that we're ramping up ahead of time currently. And as you – for most of the ITWorks deals, as you know, the costs come when we rebadge and the revenue comes when we rebadge. So, for the most part, there's not a lot of upfront costs that aren't covered by some type of a contract, unlike some of the ones we're in today.
  • Jamie Stockton:
    All right. That's great. Thank you.
  • Marc Naughton:
    Sure.
  • Operator:
    Thanks. Your next question is from Sean Wieland of Piper Jaffray. Your line is open.
  • Sean W. Wieland:
    Hi. Thank you. Let me just put this other one on mute here. So, on the 2018 guidance, can you just give us a little bit of help on expected DNA levels for the year and maybe thoughts on EBITDA?
  • Marc Naughton:
    Yeah. I think for the – as we say, we would expect from a non-cash basis that you're going to see an uptick clearly in amortization is one of the things, but you'll also see an uptick in depreciation as we've – based on the capital spending. So, I think both of those would tend to ramp up. I think we talked this year about kind of a $70 million increase that we were gonna see in 2017, looks like that might – the net impact especially when you're factoring capitalization is higher than that. I think if you look some place around that, that's similar $70 million uptick, I think it's – I think that that works. I think, once again, our point would be that relative to operating margins, the operating margins will be flat. I mean, that was our original take, and that's our current view of it. I think, from an EBITDA perspective, because of the depreciation increases, you probably look to see that up about 100 basis points.
  • Sean W. Wieland:
    Okay. That's helpful. And on the DoD business, what kind of info can you give us? I know you don't like talking about specific contracts, but some kind of percentage of revenue or profitability, what's been recognized, what's in backlog? Is there any additional insight that you can give us on that other than the headlines of what's going live?
  • Marc Naughton:
    Yeah. Keep in mind, Jamie, this is – the contract is a series of tasks – contains a series of task orders. We're working on that first task order right now, getting through this, as Zane took us through. Great success on that project. There was a period of time that they go through and analyze everything that's happened and decide basically at that point, sign off, and we continue to move forward. That's when the next tax task orders can start becoming available. But relative to any revenue or certainly any booking in a particular period, we've been pretty consistently saying there isn't any one period that that's going to be something that is notable relative to the quarter results, especially as a big a company as we are. It will be great business, part of our core growth that we're looking for, but it's not going to – because of the nature of the accounting of those contracts, it's not going to hit any one period significantly.
  • Zane M. Burke:
    Yeah. I think the only thing I would add to that, Marc, is this is the completion of the foresight on the initial operating pilot. And so, as Marc described, there's a process by which they'll actually do a full evaluation to determine the success of that. We're feeling incredibly good about that. That would lend itself to some bookings opportunities in mid-2018 timeframe.
  • Sean W. Wieland:
    Okay. Thank you very much.
  • Marc Naughton:
    Sure.
  • Operator:
    Thanks. Your next question is from Steve Halper of Cantor. Your line is open.
  • Steven Halper:
    Yeah. Hi. Could you just give us an update on the CEO process?
  • Marc Naughton:
    Sure, Steve. It's Marc. It's continuously ongoing. There's not a lot of difference from anybody we talked to at CHC. The board is – absolutely feels like the company is being run by a solid team, don't have any concerns with the opportunities or the level of execution. So, they're going to take their time and go through the process very – in a very careful manner. So, I think they understand that they need to – their goal is to get to an answer, but they want to get it to be a good answer, and they're going to be looking at internal candidates, they're going to be looking at external candidates, and that's going to be a process they continue to go through. So, I think that's ongoing, and as soon as we know something different or have any news to impart, we will let everybody know. But right now, they're doing one of the main jobs they do as the Board of Directors, and I think they're doing it very carefully and conscientiously.
  • Steven Halper:
    Fair enough. Thank you.
  • Operator:
    Thanks. Your next question is from Richard Close of Canaccord Genuity. Your line is open.
  • Richard Collamer Close:
    Thanks for the question. Marc, I was wondering if you could just give some thoughts in and around bookings for 2018, whether – I guess, given the ITWorks pipeline being as strong as it is, do you think you could achieve bookings growth in 2018?
  • Marc Naughton:
    Yeah, I think – we certainly believe we'll see bookings growth in 2018. I think, as you know, when we do our plan, we don't plan for an increase in things like one-time software, bookings or tech resale bookings. But certainly, with the pipeline of ITWorks deals, the fact that those are starting to finally kind of come to fruition and start getting signed, which we've kind of been waiting for this for a little bit now, yeah, I think the opportunity is there to grow bookings. Obviously, we don't guide more than one quarter out for bookings. But I think we have tended in the past to say that we feel pretty good about bookings growing year-over-year, and I think we're in that position today.
  • Richard Collamer Close:
    Okay. Thank you.
  • Operator:
    Thanks. Your next question is from Sean Dodge of Jefferies. Your line is open.
  • Sean Dodge:
    Yeah. Thanks. Zane, you mentioned the strength you all continue to see, not in RevWorks specifically, but in the smaller back office, business services offering. Can you give us a sense of how meaningful that business is for Cerner now, maybe in terms of the proportion of the long-term contract bookings that are coming from those types of deals?
  • Zane M. Burke:
    What I can tell you is we've crossed, we're into over 1,000 associates that are focused on those types of opportunities today. And so, that growth is – that's nearly double what it was from about 18 months ago. So, it continues to ramp up in a very nice way. Our margins have improved on that significantly over the course of that time, continue to get more efficient, and our – more importantly, our churn is very low. So, we think it – it's not significant as it relates to the financial statements overall, but I think over time it has the opportunity to be a meaningful portion of our business.
  • Sean Dodge:
    Okay. And then, Marc did a good job of explaining how ITWorks contracts convert into revenue. Are the dynamics or the pacing for these RevWorks light type deals similar?
  • Zane M. Burke:
    They are similar. They tend to be a little – they're smaller in nature on the small elements. A full revenue cycle outsourcing would be very similar to what Marc described on a ITWorks opportunity, where it may have some embedded software, may have some other services, may have some things to go along with that, and a full rebadging, along with some centralization of certain of those workshare pieces. So, as Marc described, for full revenue cycle outsourcing, it's very similar on the rev cycle side, on the smaller side. They tend to just be more fee-for-service oriented, and we – and it almost mirrors what we do from a professional services perspective in our business model. We hire pretty much as needed as we sign that business.
  • Sean Dodge:
    Okay. That's helpful. Thank you.
  • Zane M. Burke:
    Yeah.
  • Operator:
    Thank you. Our next question is from Nicholas Jansen of Raymond James & Associates. Your line is open.
  • Nicholas M. Jansen:
    Hey, guys. Thanks for all the color. Just one for me. As we think about the VA contract, I understand it's not signed yet but since Cerner's never been a big prime on anything, I was just wondering kind of how we should be thinking about the margins associated with that incremental revenue that you'll be seeing, again, because we understand how your commercial business is, but on the prime activities, how do we think about that? Thanks.
  • Zane M. Burke:
    Yeah. Great question. Obviously, it is a little too early to comment overall on exactly what that looks like, and much of it depends on the workshare. And we will, because we have, frankly, managed a number of significantly large operations, and so while we haven't necessarily been a federal prime contractor, we've been the prime contractor on many, many large implementations. And so, from that perspective, this is not something that's out of the ordinary for us to think about managing and having expertise around managing very large implementations with a number of third parties. So, if you think about it from that perspective, I would anticipate margins to be similar to very large implementations that we've done in the past using other third parties, but some of those pieces will depend on the workshare and on how we manage through some of those pieces as we finalize that. But, I would look at it and say, on our very largest contracts it will mirror the margins on those types of contracts.
  • Nicholas M. Jansen:
    And just on a – so, just to understand that, just on a relative sizing basis, are those large contracts that you've implemented in the past kind of above or below your consolidated level?
  • Marc Naughton:
    Yeah. I mean, once again, we're being very careful not to comment too much on the VA margins, so kind of trying to compare it to our corporate operating margins is something that once we get signed and once we have a better view of, we'll be able to give you some more color. I think Zane's point is to the extent that we're doing our own work and doing it internally, it will look like one of our big projects, it will have software and services and those elements in it. And for the other workshare, it will be stuff we have lower margins on. But as far as the blended margin on the entire dollars, all of which are flowing through Cerner as the prime, it's a little early for us to give you – really to give you a neighborhood of where those numbers are. We're very happy to have the business, and once we keep to the point where we can share that, we will.
  • Nicholas M. Jansen:
    Understood. I'll hop back in queue.
  • Operator:
    Thank you. Our next question is from Matthew Gillmor of Robert Baird. Your line is open.
  • Matthew D. Gillmor:
    Hey. Thanks for the question. Just one here as well. I want to ask about the professional services staffing over the next couple of years, and you all have a number of very large and high-profile implementations with DoD and VA, but just curious how you're thinking about the staffing requirements for those rollouts, if that creates any kind of perception with maintaining high quality experience with the rest of the clients and your ability to pull revenue out of backlog.
  • Zane M. Burke:
    This is Zane. The DoD, we built the team early. We've been able to supplement that team and work through that. With the VA, we've undergone a similar process as part of that. It has been fairly self-contained as part of that process, and we've had that slotting in for quite some time. Over time, I believe you'll see those teams working closely together, so that helps, that really helps in how we leverage our resources. And we've developed quite a competency around adding experience and managing through those pieces, not to say that everything is perfect in that space, but I think the teams have done a really nice job in that area and I think we feel prepared for the growth of both the enhancement of the DoD as well as the VA.
  • Matthew D. Gillmor:
    Got it. Thank you.
  • Operator:
    Thank you. Our next question is from Jeff Garro of William Blair. Your line is open.
  • Jeff R. Garro:
    Yeah. Good afternoon, guys, and thanks for taking the question. Maybe one for Zane. Just like to put ITWorks aside and think about the broader demand environment, how would you describe the pacing of client buying decisions? And do you have any perspective on client investment in IT relative to other expenses? So, really trying to get down to, is it clear to your salesforce that IT is still a top strategic priority for health systems and other health care providers?
  • Zane M. Burke:
    I think it is still clear that it's an imperative in a world moving forward. The level of activity remains very high in our pipeline, and the number of opportunities, those organizations are still on a legacy EMR/EHR perspective from a 2000 plus organizations in the U.S., as well as our outside the U.S. opportunities are quite significant to the extent that they face the financial challenges have impact – that can impact the timing in quarters that those things close. But we still see that as a growth opportunity for us as we move forward, and we think the replacement market remains robust. Our small hospital market space was incredibly active and very strong. I think that remains a strong portion of the marketplace, our community hospital marketplace is very strong. And so, I think there's a number of areas where there's a lot of buying opportunity into the future. Why don't we take one more question?
  • Operator:
    Yes, sir. Our next question is from David Larsen of Leerink. Your line is open.
  • David M. Larsen:
    Hi, Zane. Just sort of adding on to that last question. Can you talk about what's sort of driving these EMR buying decisions? Is it really hospital M&A activity or is it something else? And then, which vendors are you going in and displacing? Thanks.
  • Zane M. Burke:
    Well, without naming names, it's those that have a legacy – a currently non-marketed solution, which is a number of the key players today. So, those are the suspects, if you will, if you look through that. The reasons for buying are really preparing for the future. Every – and really what that means is, do I have foundational plumbing that's going to get me all the information that I need to perform in the future? And what clients are figuring out is they need more information rather than less. They need more data sets from other places to bring that together. They need intelligence in the workflow. They need intelligence above all that data to help them drive their operations in a more effective and efficient manner. And so, it is – those that are strategic are continuing on that journey. And then there's just some that the reality of I have to get off this system that is being sunset or won't be supported over time, and so you end up with this interesting mix of those that are very much on the forefront and looking in on how they want to be prepared for the future, and then have you those that are the laggards, which have held onto their dying solutions for a very long time and need to – they just need to move.
  • David M. Larsen:
    Okay. Thanks very much.
  • Zane M. Burke:
    Sure.
  • Marc Naughton:
    Well, thank you all for being on the call. I'd like to make a couple of quick comments as we close. While we understand a level of disappointment in our Q3 bookings and near-term earnings guidance, we remain financially strong and are confident in our growth opportunities. Our full year 2017 results are still projected to be solid, with bookings revenue and adjusted EPS all projected to grow at either mid- or upper-single digit rates, and cash flow is on a pace to be a record. For 2018, we're also projecting upper-single digit top and bottom line growth, which we believe is very strong for a company our size. We're on the verge of beginning the largest health care IT project of all-time with the VA, which we expect to steadily ramp to where it is providing large predictable revenue and earning streams that will help support our long-term growth. And we continue to believe the health care industry shift to value-based care will represent an even bigger opportunity than the EMR era, and Cerner is well-positioned to benefit which, combined with other factors we've discussed today, gives us confidence in our ability to maintain solid levels of growth over the longer term. Thanks for your time, and have a good evening.
  • Operator:
    Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone, have a great day.