Cerner Corporation
Q1 2018 Earnings Call Transcript

Published: 3 May 2018

[Operator:]

Welcome to Cerner Corporation's First Quarter 2018 Conference Call. Today's date is May 2, 2018, and this call is being recorded. The company has asked me to remind you that the 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, taxes, solution development and future business outlook, including new markets or prospects for the company's solutions and services. 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 statements 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 Investors 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 G. Naughton:]

Thank you, Ella. 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 Brent Shafer, our Chairman and CEO will provide closing comments. Turning to our results. Our first quarter included strong bookings and record cash flow but revenue was below our expectations due to software, technology resale and subscriptions and the delay of the VA contract. The lower revenue was largely offset by expense control and a lower tax rate resulting in our earnings being in line with expectations for Q1 but the slow start to the year and ongoing uncertainty as to the timing of the execution of VA contract has led us to revise our full year revenue and EPS outlook. Now I'll go through the numbers. Our bookings in Q1 were $1.398 billion, which reflects a 12% increase over $1.25 billion in Q1 of 2017. Our revenue backlog ended the quarter at $14.6 billion. Notice, this reflects the adoption of the new revenue recognition guidance under Topic 606. Certain provisions within the guidance impact how we calculate backlog with the primary change being that we have removed a portion of backlog tied to long term contracts that include an option to terminate before the end of the contract. In our experience, almost no contracts – no clients exercised this option, so this doesn't change our total long term revenue opportunity as it shortens the duration of what is included in the backlog. Revenue in the quarter was $12.93 billion, which is up 3% over Q1 of 2017. You note that we have gone to a single revenue line on our income statement. This is also related to the adoption of Topic 606. While there's less detail in the face of the income statement, we're now including the business model detail that we previously provided annually as an additional disclosure each quarter. We'll use those to discuss our results instead of our old categories of system sales, support maintenance and services. Now I'll go through the business model detail and year-over-year growth compared to Q1 of 2017. Licensed software revenue was $135 million, down 5%, primarily due to lower than anticipated levels of licensed software bookings in the quarter as well as a tough year-over-year comparable, due to the shift in how we sold some content in 2017. As I discussed in our last call, a higher amount of content that is typically sold as a subscription was sold as licensed software last year. Technology resale decreased 1% to $63 million. The next item, subscriptions revenue, was impacted by Topic 606, which reduced the backlog of subscription revenue. The shift in sales approach in 2017 that I mentioned previously also lowered the run rate of subscription revenue. In addition, a portion of subscription revenue is now treated as support under Topic 606. This amount is classified as support and maintenance in the business model view for Q1 of 2018. The impact of these items results in subscriptions revenue of $77 million as compared to $113 million in the prior year period. Professional services revenue grew 11% to $441 million driven largely by growth in our Works businesses. Managed services increased 3% to $268 million with the lower growth rate mainly reflecting the tough comparable as Q1 of last year was the strongest growth quarter in 2017 for managed services. Support and maintenance was up 9% to $285 million, reflecting our expected low single-digit growth plus the adjustment for the support element, formerly reflected in subscriptions. And finally, reimbursed travel was $24 million which is up 7%. Looking at revenue by geographic segment. Domestic revenue was flat from the year ago quarter at $1.135 billion and non-U.S. revenue of $158 million increased 23%. Moving to gross margin. Our gross margin for Q1 was 82.1% which is down from 82.6% in Q4 of 2017 and 84.2% a year ago primarily due to the lower levels of licensed software and higher third-party services costs. 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 and acquisition related adjustments, all as detailed and reconciled to GAAP in our earnings release. Looking at operating spending, our first quarter GAAP operating expenses of $866 million were up 6% compared to $817 million in the year ago period. Adjusted operating expenses were $819 million which is up 6% compared to $773 million in Q1 of 2017. This growth was primarily driven by an increase in personnel expense related to revenue generating associates and non-cash items. Looking at the line items. Sales and client service expense increased 6%. Software development expense increased 10% driven by a 5% increase in gross R&D and 23% increase in amortization. G&A expense was up 1%. Amortization of acquisition related intangibles decreased 30% year-over-year. Moving to operating margins. Recall that in our last earnings call I highlighted a number of near term headwinds that we anticipate will drive operating margins down in 2018 including increases in non-cash software amortization and depreciation, traditional software revenue growth challenges due to the maturing EHR market, a shift to more SaaS models and the tough comparable created by our strong software growth in 2017, growth in our lower margin Works businesses and investments in projects ahead of revenue being recognized. Each of these factors did impact our margin in Q1 as GAAP operating margin was 15.1% compared to 19.4% in the year ago period and adjusted operating margin was 18.8%, down from 22.9%. Our adjusted operating margin was below our expectations due primarily to software being even lower than we expected. We do continue to believe that many of these factors are temporary in nature and that we do have opportunities to improve margins as our non-cash expense growth slows, we get return on investments we are making in our Works businesses and our SaaS revenue related to population health ramps and balances the increase in mix of Works revenue. In fact we believe the framework for margin expansion we laid out at our Investor Day is still valid. The principal change is that 2018, which we'd already indicated as an investment year, is now forecasted to have lower margins, which creates a lower baseline from which we expect to begin expanding margins next year. Moving to net earnings and EPS. Our GAAP net earnings in Q1 were $160 million or $0.48 per diluted share. Adjusted net earnings in Q1 were $194 million and adjusted diluted EPS was $0.58 compared to $0.59 in Q1 of 2017. Our GAAP tax rate for the quarter was 20%. And excluding share based compensation permanent tax items, the Q1 tax rate was 22% which is slightly below the high level estimate we provided on our call last time. For the remainder of 2018, we expect our tax rate to be closer to 23% to 24%. Now I'll move to our balance sheet. We ended Q1 with $1.093 billion of total cash and investments, which is up from $1.003 billion in Q4 of 2017 due to strong cash flow partially offset by use of cash for our stock repurchase program and making a debt payment. During the quarter we repurchased 1.4 million shares of stock at an average price of $62.99 per share for a total of $88 million. We now have $330 million remaining of the $500 million stock repurchase program approved by the board in May of 2017. Given our strong cash performance, we have the ability to be active on the repurchase program. Moving to debt. Our total debt including capital lease obligations was $446 million which is down from $527 million in Q4 of 2017. Total receivables ended the quarter at $1.041 billion which is essentially flat to Q4 of 2017. Our Q1 DSO was 73 days, which is up from 71 days from the year ago period and 72 days in Q4 of 2017. Operating cash flow for the quarter was a record high $409 million. Q1 capital expenditures were $80 million and capitalized software was $74 million. Free cash flow, defined as operating cash flow less capital purchases and capitalized software development costs, was a record at $256 million for the quarter. Note that our operating cash flow benefited from a tax refund in Q1, so we do expect it to go down sequentially. However, we still expect strong operating cash flow for the year to more than offset expected increase in capital expenditures and lead to another year of strong free cash flow. Now I'll go through the guidance. We expect revenue in Q2 to be between $1.31 billion and $1.36 billion with the $1.335 billion midpoint reflecting growth of 3% over Q2 of 2017. For the full year, we expect revenue between $5.325 billion and $5.45 billion with a $5.388 billion midpoint reflecting 5% growth over 2017. This guidance range is down from our previous range of $5.45 billion and $5.65 billion reflecting the lower revenue in Q1, a more cautious view on the market environment, and the delay of the VA contract. We are still confident we will sign an agreement with the VA, but we are now anticipating it will be in the second half of the year and will have less impact on our results. We expect Q2 adjusted diluted EPS to be $0.59 to $0.61 per share, the $0.60 midpoint reflecting $0.01 less than Q2 of 2017. For the full year, we expect adjusted diluted EPS to be $2.45 to $2.55 with the $2.50 midpoint reflecting 5% growth over 2017. This range is down from our prior guidance of $2.57 to $2.73 due to the follow through impact of the lower Q1 software, a more cautious view on software for the rest of the year and the VA contract delay. Moving to bookings guidance. We expect bookings revenue in Q2 of $1.35 billion to $1.55 billion. The $1.45 billion midpoint reflects a 11% decrease compared to a tough comparable in Q2 of 2017. We do expect to return to bookings growth in Q3 when we'll have a much easier comparable period. In summary while some aspects of our results were solid such as bookings and cash flow, we are disappointed in our revenue performance and that we needed to lower our outlook. However, it was necessary to factor in the VA contract delay to make sure we set attainable targets in what is a challenging near term environment even though we remain confident in our longer term growth opportunities. And 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, which were strong overall, as they grew 12% over Q1 2017 and were at the upper end of our guidance range. In Q1, the percent of bookings coming from long term contracts was higher than normal at 40%, reflecting good Works contributions and lower software and technology resale. As Marc discussed, the lower level of software and technology resale bookings and the delay of the VA contract did impact our revenue in the quarter. We did, however, have a good quarter from a competitive standpoint, with 27% of bookings coming from outside our core Millennium install base. Our ambulatory business had a strong quarter, driven by ongoing penetration in ambulatory settings of our large health system clients. We're also seeing increased activity in the large independent provider market. In the smaller hospital market we had strong Q1 success with our CommunityWorks offering. We continue to see record levels of activity in this space and are positioned for a strong year. Moving to revenue cycle. Activity remains very high as it included in almost all new deals and our existing clients continue to migrate from legacy systems to Cerner Millennium. Since beginning of last year we brought over 300 hospitals and more than 1200 ambulatory facilities live on revenue cycle solutions. In population health, we had a strong quarter. In addition to strong sales at HealtheIntent to provide our clients, we had good contributions from other markets further validating the broad applicability and addressable market for our population health solutions and services. One example of this in Q1 was a State of Montana, Department of Health and Human Services choosing HealtheIntent for their Medicaid enterprise system to help manage 300,000 enrolled Medicaid lives. Moving to our business outside the U.S. Following a strong second half of 2017, we continued the momentum into Q1 and had a very good quarter with 23% revenue growth. We also had strong non U.S. bookings in Q1 with some of the strength driven by the signing of our contract for the Region Skåne in. This is a major win for our non-U.S. business, as we will provide our core solutions to 10 hospitals and 190 primary care facilities. It also represents our first Nordic population health client, serving 1.3 million citizens. In addition to the strength in Sweden, we had stronger contributions from the U.K., Germany and Canada. Looking ahead, we expect to have a good year with Australia, Canada, Middle East, U.K., Ireland and Germany, all forecasted to provide good contributions to our growth. Next I'd like to provide an update on our federal business. Starting with the Department of Defense MHS Genesis project. The optimization phase of the project at the initial site has been completed. This phase of the project resulted in several improvements and we expect to begin the next wave of deployments this fall. We're also very pleased with the announcement last month that the United States Coast Guard now plans to adopt the same commercial EHR as DoD as part of MHS Genesis project. Now I'll discuss our opportunity with Department of Veteran Affairs. As you are all likely aware, the signing of the contract was delayed again in Q1. While this is disappointing, we continue to believe we have broad support from key stakeholders and initial funding for the project was approved as a separate line item in the budget. Therefore, we still expect to sign the contract. It's just difficult to predict exactly when. As I've indicated before, delay does not change in any manner the magnitude or importance of the overall opportunity. We are honored to have the opportunity to serve our nation's veterans and will be ready to deliver when it signs. Next I'll provide some marketplace observations and discuss how we're positioned for growth. While we remain optimistic about our overall market opportunity, particularly over the long-term, our results and outlook are reflective of an environment in which providers are financially challenged and have a lower sense of urgency to make purchase decisions due to the lack of hard regulatory deadlines. I'd like to discuss how we're adapting to the current environment and where we see growth opportunities. In the EHR market there are still about 2000 hospitals on legacy EHR platform. We believe most of these hospitals will need to move to a more modern platform at some point. While most of these are smaller, they represent a significant opportunity in aggregate and we're doing well with our CommunityWorks offering that aligns with the needs of smaller hospitals. In addition, because we have a footprint of 70 of the 100 largest health systems, many of these opportunities are accessible directly through our existing clients as they look to standardize on Cerner at sites that are still on legacy EHRs which can save them money by reducing the cost involved with managing multiple platforms. Our large footprint also represents meaningful whitespace for us to cross-sell our solutions and services. We believe that our lower penetration of revenue cycle, Cerner RevWorks, Cerner ITWorks and population health represents significant growth opportunity. A key to selling these solutions and services back into our base is demonstrating ROI, which has become increasingly important in the current environment. We have had a significant focus on delivering the value to our clients, with a focus on demonstrating hard ROI, whether it be increased charge capture and more efficient collections through our revenue cycle solutions and RevWorks services, lower cost operations with ITWorks or using our population health solutions to increase fee-for-service revenue or improve performance on value based contracts. We have also demonstrated that the addressable market for our population health platform goes beyond our traditional provider end market, and we expect to continue expanding the reach of our population health solutions and services. Our state and local and federal business also represent significant opportunity, and we expect these to contribute to growth as long as we continue to execute on our initial contracts. Clearly, getting to the next wave of DoD rollouts and getting start on the VA are important milestones that are needed to drive these meaningful contributions. As this plays out, we believe the timing of the growth will not only create a bridge to when we will have more contribution from our population health offerings, but will also become an important long-term contributor to our market presence and growth. 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, workforce efficiency, and provider communications, to name a few. 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 of our other solutions and services, I discussed. To conclude, while much of our end market is currently facing financial pressure and uncertainty, our solution and tech-enabled services are aligned with these pressures and could be sold based on value. We believe our ability to do this is an important differentiator that will allow us to grow as we help our clients address the challenges of the day while preparing for a post fee-for-service economy. With that, I'll turn the call over to Brent.

[Brent Shafer:]

Thanks, Zane. Good afternoon, everyone. Marc and Zane did a good job of covering the results in the current marketplace. We understand we didn't deliver against the expectations we set, and we are disappointed. We have revised our outlook to factor in the near term reality Zane discussed and we work very hard to deliver against these expectations. Now I'd like to give you an update on my areas of focus. On our Q4 call in February, I mentioned that I'd be spending my first 100 days doing a deep dive into Cerner, talking with our clients and working with our leadership team to review our opportunities and investment priorities. It's now about 90 days in and we're on track in making excellent progress on our review of markets, clients, workforce, solutions, services and opportunities. Together with the leadership team I've spent significant time with our clients. I've gained a clear understanding of our strategic value to them as well as some real opportunities for us to make improvements. After a period of focused review and assessment we recently got together as a leadership team for a three-day strategic planning retreat. We discussed our findings and spent the majority of the time getting aligned on the elements of a refined strategic plan. We emerged from the retreat with a set of strategies that we intend to test and improve as we draw closer to our formal planning processes this fall. Broadly, the refined strategies fall into three categories, first, focusing on the client experience, second investing in the platform, solution and service innovation; and third profitable growth. Focusing on the client experience is a set of objectives for ensuring our clients have full access to Cerner's best capabilities and get what they need from Cerner to help them succeed. Our belief is that as we have grown in size and scope, our relationships with clients have grown more complex than they need to be. We want to simplify the experience of working together, so that we can be a better transformational partner. This has become increasingly important in a consolidating marketplace where we need to align with our large clients and provide them with tools to be successful to achieve their targeted benefits as they grow. Investing in platform, solution and service innovation is a group of objectives focused on making targeted improvements to our technological platforms, solutions and services and speed in innovation of solutions and services that address new market opportunities. Finally, we have a set of objectives around profitable growth that are focused on supporting markets that have the highest growth potential over the next few years, consolidators, community hospitals, governments, global markets, employers, payers and non-hospital providers. In summary, regardless of the near-term challenges the assessment process we've just gone through makes me optimistic about our market opportunities and prospects for growth. We have work to do. But if we execute and we will, I believe the long-term growth targets we have shared with you remain attainable. Cerner's leadership team is exceptional and we're working together extremely well. I'm very excited about our future together. With that I'll turn the call over to the moderator, so we can take some of your questions.

[Operator:]

Our first question is from Sean Dodge with Jefferies. Your line is now open.

[Sean Dodge:]

Yeah. Good afternoon. Thanks for taking the questions. Maybe starting with the VA contract. Zane, you're now expecting it will be signed in the second half of the year. You touched on it a bit. But I guess since there aren't any permanent senior leaders in place at the VA right now, what gives you confidence this is something you can still get done and get done as soon as the back half of this year?

[Zane M. Burke:]

Yeah. Great question, Sean. We continue to remain linked to kind of the Hill, the White House, and the agency, all of those folks, and there are obviously the Secretary position's on an interim basis right now, but all of those factions are all seemingly moving ahead. And we feel strong about that. And the line item in the budget is a critical item as we move forward that gives us the confidence in that side. But obviously, it's been very challenging for us to predict the actual completion of that contract. And such we've moved that to the back half of the year.

[Sean Dodge:]

Okay. That's helpful. Thanks. And then your comments in the prepared remarks about revising your outlook down because of the large contract delay and a less predictable end market. I get the delay portion, but can you give a little bit more color on what you mean about a less predictable end market? Is it contracts are getting bigger and it's tougher to pin down timing? Or are you seeing clients get a little bit tighter with HCIT budgets and pushing off or delaying projects?

[Zane M. Burke:]

I think it's multiple things. We had the one contract which obviously the VA was a significant contract that moved out of the quarter that we had planned on. At the end market side of this, there's quite a bit of M&A activity. There's a competition for capital. The bottom lines are under pressure and technology is still a lever by which people can make a difference in this space. And so what you're seeing is, as we've discussed over the last several quarters, is there's an unpredictability to the completion of some of that business. And I think that continues forward and can create some lumpiness in some of those elements and some predictability in part of those pieces.

[Sean Dodge:]

Okay. Very good. Thanks again.

[Operator:]

Our next question is from Ricky Goldwasser with Morgan Stanley. Your line is now open.

[Ricky R. Goldwasser:]

Yeah. Hi. Good evening. So when we talked about the profitable growth and the goal supporting markets, with largest growth areas, you've listed quite a large number of growth opportunities. I think you listed most of your clients. So can you give us maybe some perspective on within that group, where do you see the most realistic opportunities in the near term? And then also in the long term, as the healthcare landscape evolves and changes, we're seeing a lot of obviously M&A, vertical integration which would suggest that the market might look very different five years out versus today. And within this context you reiterated the long term growth rate for the company. How long do you think it's going to take to return, go back to these growth rates?

[Marc G. Naughton:]

Yes, this is Marc. I think the things that Brent laid out relative to the markets, if you will, that we're looking at from consolidators on. Clearly we think all of those have potentials. That's why we're identifying them all as different markets. The consolidator market is completely – is very different from what the non-consolidator market is from a provider perspective. The provider market on the non-consolidated end is very active. Lot's of activity going on. Lots of opportunities. But as Zane said, there's a real ROI focus. There isn't a meaningful use. There isn't an external item that is forcing them to get to decisions. They have to go through the process to get to that ROI. In the consolidator market, we've got to be the people that are providing the tools that allow them to gain leverage and to gain scale as they go forward and work on taking these accumulated assets and turning them into a single health system, which is the goal of most of those. But each of those areas, and obviously governments with VA, with foreign governments as we realized with our Swedish deal with Skåne this quarter, those are big opportunities that we see. So each of those has a different timing and different uptake. As we talk about our 10-year view, or that we've shared in our ability to continue that and strive to get to that, really as you look at the elements that are out there that drive a lot of that growth, the Works businesses in both ITWorks and RevWorks, if you look at the population health element of that, all of those things still remain elements that all of health care is looking to add. And as we look globally, the population health certainly is an additional element that has helped us succeed in those global markets where some of our primary competitors have been unsuccessful. So I think without quantifying, I think our 10-year model gives you an idea if you look at each of those markets when we think they're going to start providing more lift, and I think employer, on the population health side, those are likely in the out years as we've indicated. Governments, we're starting to see uptick currently. We've seen more uptick in the government in the global side. And then we continue to see activity in the, certainly the non-consolidator market, as well as the consolidator market. So some of that, the providers are probably more near term. The others are going to be medium to longer term.

[Operator:]

And our next question is from Sandy Draper with SunTrust. Your line is now open.

[Sandy Y. Draper:]

Thanks very much. Can you hear me, okay?

[Brent Shafer:]

Yes.

[Sandy Y. Draper:]

Okay, good. And I guess just a little bit of a follow-up to Ricky's question, but more on the expense side. When you think about still being optimistic about the long term impact of the higher growth, when you think about the near term challenges, how do you balance at what point do you pull back on expenses, and recognize, okay, so this period we're not going to hit the higher end, so we need to curb expenses, because you guys over the long term have done a great job of growing, it's been a spend and grow and spend and grow. The market right now as you said is challenging. There's no obvious end. How do you sort of balance the long term focus versus near term, hey, we don't know when this is going to get better. We're going to pull back on expenses until we have clear signs. Just thoughts about that, and don't know, Brent, if that was something you brought up and discussed in the plain view strategy? Thanks.

[Marc G. Naughton:]

Yes. This is Marc. Certainly we talked about our cost structures as part of the retreat. I think the key for us is we divide our resources and our associates into revenue producing and those that aren't. We are making – and we said on the last call, we are making an investment in 2018 relative to the market. We believe the VA's going to happen. We're going to be absolutely prepared to deliver on that when it does, and we're going to continue to have a level of investment in that business. We talked about adding a Kansas City Works business. We hired 200 of those people in Q1 versus our 600 target. So we are continuing to invest in those businesses because we think that it's the right thing to do. Those businesses are there, and they're going to happen. We're going to continue to invest in our IP organization because innovation is our differentiator in the marketplace. Certainly as we look at anything that isn't revenue producing or isn't creating innovation, we look at those expenses very carefully. We're managing, as those of you know me, can expect a travel level at open cards or open head count positions as far as do we fill those immediately or do we hold them for a month or two. So if you look at the total spend we incurred in Q4 and compared to total spend in Q1 I think we went up about $3 million in total spend. And that was an increase in amortization. So I think your points are great Sandy. We're certainly focused in making sure that we're not spending crazily and spending in a way that doesn't match the opportunity we see. But as an investment year and given our history that we've been able to invest in and drive future growth, we see 2018 as one of those years. And we are going to control spending that isn't directly related to accomplishing those goals, but we are going to spend where we think that going to – we can drive those goals forward.

[Sandy Y. Draper:]

Great. Thanks for the comment.

[Operator:]

Our next question is from Eric Percher with Nephron Research. Your line is now open.

[Eric Percher:]

Thank you. Back to your comment about (32

[Marc G. Naughton:]

Yes. We've missed the first part of the question but I assume it was based on the VA and the ramp expense related to that.

[Eric Percher:]

Yes.

[Marc G. Naughton:]

Yes. For the most part, the third party expense we're not incurring third party expense at this point. They're doing the same thing. They're ramping up. They're being prepared, but we are not incurring any third party expense. It is all on the far side of the – that the expenses being incurred and that includes the services teams, it includes the hosting of the VA, data center, it includes provisioning and getting ready in the data center. So there's elements – those are the elements that we're ramping up. So from a timing and ability to repurpose those, certainly the people on the services side, we're filling some of their time with short term projects to get some revenue out of them, but they're not going to be as productive as they will be if they were fully on this fact. And keep in mind from – that's just relative to what our cost structure is, the VA is working through a process. It's a federal procurement process. So we've got to be careful how much we talk about that. But from what we're doing to be prepared I can tell you that certainly we're doing – we're incurring this cost that we think we need to. But those – the ability to change in direction on those will be something, at this point we don't see the need to do that. I mean if that was necessary the services people have skills that can be applied to other places in the organization and the capabilities – other capabilities are ones that we can expand in our existing clients.

[Eric Percher:]

And just following up to Brent's commentary, from the timeline he laid out, it sounds like the process is really one that looks at the forward year. When will we begin to hear about what's coming out of that process? Is there a period? I know you have your health care conferences. Is that when you start to speak to clients? And when do we as investors start to hear about some of the outcomes?

[Brent Shafer:]

It's I think definitely in that same time period we'll try to align there and make sure we're keeping you informed appropriately.

[Eric Percher:]

Thank you.

[Operator:]

Our next question is from Jeff Garro with William Blair. Your line is now open.

[Jeff R. Garro:]

Yeah. Good afternoon, guys. Thanks for taking the question. Wanted to ask about the comments around lower software sales, and maybe if you could just follow up with any particular areas where you're seeing weakness more so than others, maybe acute versus ambulatory or the core segment versus population health or revenue cycle?

[Zane M. Burke:]

This is Zane. I think what you'd see is, it's really the mix of the clients themselves. So it's really – we saw – actually quite a lot of activity from a number of deals. It was just some of the larger opportunities weren't there that we'd anticipated being there in the first quarter. And so we saw great activity really in the community hospital side, but it was probably in the larger opportunity side that some of those were not where we thought they would be. And those just come with more software.

[Jeff R. Garro:]

Got it. And then one more, if I could. Zane, you mentioned it was a good quarter from a Works contribution aspect. And maybe you could provide a little bit more detail on ITWorks versus RevWorks, and fully outsourced ITWorks clients that you're adding to the cohort there? Thanks.

[Zane M. Burke:]

Sure. We saw strong activity in our business office services from a RevWorks perspective. And so that was a big contributor. We saw some additional ITWorks extensions into some other areas that we hadn't previously worked in, but not really a new footprint per se.

[Jeff R. Garro:]

Great, thanks.

[Operator:]

Our next question is from David Larsen with Leerink Partners. Your line is now open.

[David Larsen:]

Hi, of the 200 individuals that were hired for like I guess the Works area in Kansas City, what is their utilization right now? Are they all billing 40 hours a week? Or is it more like 20 hours a week each? Any sense for I guess how utilized they are?

[Zane M. Burke:]

So this is Zane. These folks are in training at this point because these are going to be on our shared services groups for our enhanced revenue cycle solutions. And that will yield significant results, both top and bottom line, over time, but there's a ramp up to that and there is a much more significant investment frankly in these resources than in some of our implementation resources, just given the nature of the activities of what these folks do. So what I would tell you at this point they're all in training and it takes a time period for them to get productive and into full use.

[David Larsen:]

So are there projects that you have lined up for them to work on in the back half of the year where they will all be able to bill?

[Zane M. Burke:]

So this is Zane again. We absolutely have a backlog of revenue cycle opportunities, and we've had a good contribution – a good contribution again in bookings on business office services. So the work is there. We're feeling good about where that work is. But this is a little bit different in terms of billability and how that works. It's not a straight up professional services rate per hour kind of a situation. These are the folks that are filling needs and for a revenue cycle position. This over time it will give us much more leverage in our cost model as we move forward in that space. But at this point in time you're doubled up on cost from either the resources still out of the client side and you're paying for the training on this side of the house as well.

[Marc G. Naughton:]

Yes, David this is Marc. The goal is to obviously create the centralized billing center in Kansas City and use that to not only take on new business but to take on some of the business we're already funding from some diverse resources that are located in different places throughout the country. So I think that's a key to bear. If you will, it's almost like a fixed fee engagement. We charge the clients a certain amount of money, and then we do the work that's necessary to deliver the service. It's not, we don't get paid by the hour. We get paid by the month, if you will, and timeframe based on the size of the client and what they're doing. So, but, as Zane said, right now those people are not driving any revenue as they train.

[David Larsen:]

Great. Thanks very much. Sounds like your international team is doing a great job. So, thanks very much.

[Marc G. Naughton:]

Thanks.

[Operator:]

Our next question is from Sean Wieland with Piper Jaffray. Your line is now open.

[Sean W. Wieland:]

Thanks very much. Couple of quantification questions. So, first, content sold as license that would normally be sold as subscription. Could you quantify that from last quarter? And is that an ongoing trend that you saw again in the first quarter? I misunderstood that.

[Marc G. Naughton:]

We can't necessarily quantify it, but the point is that in 2017 as we sold subscriptions and we would sold content and historically we might have sold that as getting paid for it over time. The new 606 revenue standard basically would have said on the date those were signed that's when the revenue will be taken into the new standard, and when the new standard took effect January 1, all of that future revenue would have gone out of our backlog. So as we looked at it, we were able to convert some of that content into lot perpetual licenses, which allowed us normal licensing treatment to take into revenue, and it goes – it would rolled into the licensed software number. So that's the main point. Under 606, which is the rules beginning in Q1, there isn't a distinction between subscriptions of a certain type and license software. It's all, to the extent it's both our point in time revenue that are recognized on the appropriate either signing date or first productive use or whatever the milestone is. But those – so the – what we did in 2017 and what we talked – we're referencing is the licensed software number was a little bit stronger because of our ability to convert some of those deals to license. What it did going forward is reduces the subscription number going forward because we didn't book as much subscriptions in 2017 as that revenue would have gone away anyway. We're now basically operating under the same way we did in 2017 relative to that. As you look at Q1, the amount of subscription bookings was below plan. So that's part of the shortfall we had in licensed software. So while the accounting treatment would be the same to how we sold it as perpetual software last year, it didn't have an impact in Q1 because of the level of bookings we had in that space.

[Sean W. Wieland:]

Right. So if I get this straight, it's not an end market like a customer wanted to buy it differently. It was the accounting treatment of it that caused you to account for it differently. Am I hearing that correctly?

[Marc G. Naughton:]

It caused us to sell it differently as a license rather than a subscription, and therefore the accounting treatment followed the way it was sold. But we did alter it in advance of 606 being adopted to minimize the impact of 606. If you look at the overall impact of 606 on our company, I mean, the net retained earnings adjustment, which is just kind of the net revenue or the net impact on earnings for all the adjustments that were made is probably $7 million. So I think we did a pretty good job of managing and trying to be prepared for the reduction of backlog that you would see for subscriptions coming from that. You also see an increase in backlog coming from some other items and you also see commission expense, which we had previously taken 100% of commission expense in the past, we now get to take it again as it rolls out over a period of time. But the net of the backlog adjustment plus the expense impact kind of nets down to that $7 million over a period of time as all of those things roll out. So that was part of that activity.

[Sean W. Wieland:]

Okay. And the other quantification question I had. Could you quantify the direct costs associated with the VA in the quarter? And when you eventually sign this contract, are you going to get made whole on those expenses?

[Marc G. Naughton:]

No. I can't quantify it.

[Sean W. Wieland:]

Will you be made whole?

[Marc G. Naughton:]

I can't quantify them. It's a federal procurement. And I can't discuss anymore. Sorry.

[Sean W. Wieland:]

Got it. Don't want to get you in trouble. Thanks so much for taking the question.

[Operator:]

Our next question is from George Hill with RBC. Your line is now open.

[George Hill:]

Good evening guys and thanks for taking the question. Maybe I'll ask part of Sean's question in a different way which is, I guess, can you quantify the risk to the guidance in the balance of the year should the VA not sign, if this kind of process continues to drag on?

[Marc G. Naughton:]

Yes, I mean, as Zane indicated, we still have in our guidance the signing of VA in the back half of the year. So that is part of the forecasting we've done. That's part of the assumptions we have. So if in fact VA did not sign at all during the year, that would have an impact. But currently it's obviously lower. We reduced our guidance based on the fact that the number we have in there is less than we initially had in as we went into the year moving it from the first half of the year to the second half of the year. But I think at this point, I can't really quantify it any more than that just based on things we talked about before. But the number still does have VA in it with the second half impact.

[George Hill:]

Okay. And then I kind of wanted to ask Sean's question a different way which was typically the accountants make you report the business from an operating perspective, the way that you guys run the business. You guys have kind of moved from reporting to, what we'll call the business model perspective versus the prior perspective. Is it changing anything about the way that the company goes to market and approaches its customers? And is it changing the way in which Cerner tries to contract with customers at all? Like is the new reporting reflective of any actual go to market changes?

[Marc G. Naughton:]

No. The line of business that we're doing to provide additional detail on the revenue line is a number that we've shared with you guys annually for as long as I can remember doing this. So I think that's one of the reasons we went to that is 606 said, your revenue is one line on the income statement, but you need to provide a disaggregation of that number in the financial statements. We decided that the business model was the one that was most familiar to investors, and for the most part other than the subscription differences I discussed earlier is consistent with what you've seen that number be in the past. It absolutely is going to provide more transparency, as you look to analyze our results because you're going to see elements that would have been included in another category on the former income statement. So I think from an accounting perspective it's, the goal would be to provide some additional level of transparency, and certainly for our standpoint it's merely taking a number that we provided annually and now providing it quarterly. But you will see some fluctuation in those numbers because those numbers can vary somewhat quarter-by-quarter to the extent that they are one-time items and not recurring in nature. But I think that's part of the transparency that's the goal of the standard. So there is no change in how we do business. No change in how we're going to go to market other than obviously the retreat we had and things that we'll certainly look at as we go look at the markets and decide how we want to attack those, but accounting is not driving how we're operating the business. In fact this is one time when what they've asked to do on the transparency line actually makes sense.

[George Hill:]

Okay. All right. Thank you.

[Operator:]

Our next question is from Michael Cherny with Bank of America Merrill Lynch. Your line is now open.

[Michael Cherny:]

Hey everyone. Thanks for the color so far. I just have one question, a lot of them have been asked. You talk a lot about whether it's the VA contract being timing oriented, some of the choppiness in the market, but still confident in the long term health of the business. You guys have very frequently had a very clean, almost pristine balance sheet, so nice cash flow in the quarter. Why not any thought to being more aggressive in the capital deployment side, particularly given the opportunity potential to do something like whether it's accelerate share repurchase, a more sustainable return of capital to investors, even the long discussed and questioned dividend. Any thoughts around change in the capital deployment structure, particularly given that this seems to be at least from your perspective a very short term or at least medium term blip in your business versus something that's permanently impairing the organization?

[Marc G. Naughton:]

Yeah, Michael. This is Marc. We certainly had record free cash flow for Q1. So that was certainly a huge positive. We have $339 million of stock repurchase authorization still remain to be exercised. And I would believe that our expectation is to be aggressively working on that as we work through this quarter. And we may, Mike, expectation is that certainly the board will consider more, may, board and shareholder meeting expanding that to a broader repurchase. Because I think today from a capital deployment, we look at the opportunities to repurchase shares and we look at the opportunities to, is there anything from an M&A perspective that might make sense for us or an investment perspective that might further these businesses that we expect to be long term growth potentials for us. So we want to be able to be able to do that. I think from a dividend perspective that's probably not in the near term opportunities just because I think we are a growth company. We think there are other opportunities for things for us to invest our capital in. And I think that at this point we'll probably focus from a shareholder perspective on stock repurchases as our capital deployment vehicle.

[Michael Cherny:]

Understood. Just more curious because I think you're probably the only the company I cover that has a net cash position on your balance sheet. So appreciate the color on that. Thanks.

[Marc G. Naughton:]

Sure.

[Operator:]

Our next question is from Steven Halper from Cantor Fitzgerald. Your line is now open.

[Steven Halper:]

Hi. Appreciate the comments around you're still a growth company. But I guess when you look at the current environment and how and what you go to market with, what gives you the confidence to say that we can reaccelerate the growth back to those established long-term targets, given what you know today obviously things can change, but what do you know today that can help us sort of believe that that is attainable?

[Zane M. Burke:]

This is Zane, Steve. There are – things that our clients need are the kind of tech enabled services that we have around ITWorks, RevWorks and what we do in our population health. So actually solving the challenges they need more technology and they need those tech enabled services and solutions. And the uptick of that, I think is continuing to go well. And that gives us a lot of optimism in the future in our core marketplace. Then as you think about that government marketplace, the state, local, federal space that really has an opportunity to become incredibly meaningful on a growth top line perspective for Cerner overall. And then some new marketplaces that our technology really works effectively and really we have all kind of the pieces, as you look at employer and payer and the beginnings of some of that coming together. Those pieces are picking up steam in some pretty meaningful ways. And I think the pace of change causes some to freeze at some point in time. And I think that's a little what we've seen in some of the marketplaces but it will also cause enough pain that people will have to make decisions and make moves that they haven't historically considered like outsourcing their revenue cycle, like outsourcing their IT shop. And I see that picking up in the long range quite significantly. And I think you can see, this would be a different conversation had this VA Secretary been in place at the end of the first quarter. And I think we'd be having a different conversation about how the outlook of the year is. And so I think it's important not to look too far past what that really means to the overall business and really how we're viewing this from an optimistic perspective and where we are.

[Marc G. Naughton:]

Yeah, Steve. I'd just add that from the Works businesses, one of the good things about them is the client is already spending those dollars. You're not looking for additional spend. You're just trying to take the dollars they're already spending. And so that's a pretty key element, and as the ROI and the focus becomes even more intense, as Zane said, those businesses we just – our conversations are more people thinking I know I'm going to probably get there. It's just I got to decide what the timing is.

[Steven Halper:]

And just one follow-up. Just a housekeeping question. I appreciate the comment. When you look at the cash flow statement, the capitalized software cost and CapEx is that both of those items, are those good proxies for the rest of the year? Or is there any change?

[Marc G. Naughton:]

Relative to the amount incurred in Q1 compared for the year?

[Steven Halper:]

Yeah.

[Marc G. Naughton:]

Yeah. I mean I think that as you look forward for CapEx, we probably, we talked that it's probably going to be in the range of $450 million to $500 million would be my expectation. Capitalized software is probably going to be slightly above what it was last year. So I think that gives you a sense of where we're at. Our overall thought is that free cash flow for the year basically lands about what it was last year, maybe just slightly – a little bit up from last year but in that range.

[Steven Halper:]

So based on that commentary you're expecting an increase in CapEx the next three quarters and that's based on projects at the new campus? Is that-

[Marc G. Naughton:]

Yeah, basically projects, the campus projects is the one that's – has the biggest impact. And as you said, it's probably $100 million more CapEx year-over-year based on those projects.

[Steven Halper:]

And then it should moderate next year?

[Marc G. Naughton:]

Yeah. We have a second year on one of the campus expansions that will impact but some of those projects will reduce as well. So we'll give it another view but it could be a two year version at that level and then declining after that.

[Steven Halper:]

Okay, thank you.

[Marc G. Naughton:]

Sure.

[Operator:]

Our next question is from Donald Hooker with KeyBanc. Your line is now open.

[Donald H. Hooker:]

Great, good afternoon. So obviously a lot of questions asked, but I'll throw in one sort of more detailed question. I was curious if you could elaborate on that Medicaid agreement in Montana. It was probably small in terms of its contribution of course. But it seems a little bit different. And I wonder – I would like to hear what kind of solutions you're offering there and what that might bode going forward for state opportunities?

[Zane M. Burke:]

Donald, thanks for the question. So this is the state's Medicaid population and they're deploying our care registries to start with, and then they'll move into a full enterprise data warehouse and analytics of their Medicaid population. And this is direct competition against kind of a different bigger competitor that we suit and play against in a public procurement. And this is reflective of the marketplace that we think is pretty significant. And this is a multimillion dollar booking arrangement for us. So it is significant. It's meaningful, and it's the precursor to additional work that you can go do beyond the software and analytics. It's the additional services that you can go do in those spaces. So we do view that state and local government is a great growth opportunity for us as we move forward. And we sell – we have offerings well beyond the EHR in this space. It's probably – it's one of those things that we'll spend some time highlighting as we move forward. So thanks for the question.

[Donald H. Hooker:]

I mean are there other states, remind me if are there other states that you're working with in this manner as well?

[Zane M. Burke:]

This is a first of its kind. Yes, we do work with other states on a number of different – a number of different solutions. So we work with states from an employer clinic perspective. We work with states from a behavioral health perspective or from a electronic health record. We work with states in multiple ways. So we're working with I think about seven different states. The Department of Corrections in California is a very large client of ours. So they just – there are some pretty significant markets that are just not thought of in a traditional sense that give us quite a bit of optimism in the state and local space.

[Donald H. Hooker:]

Thank you.

[Marc G. Naughton:]

We would take one more call.

[Operator:]

Our last question is from Matthew Gillmor with Robert W. Baird. Your line is now open.

[Matthew D. Gillmor:]

Hey, thanks. I just had two quick follow-ups. The first one, Marc, was Topic 606 a headwind to revenues for the quarter or was it about neutral?

[Marc G. Naughton:]

Yeah, I mean for the – it rolls out differently each quarter. Overall it was probably a slight positive when you talk about the backlog revenue side and you talk about the commission expense offset against that. For the quarter, from an earnings perspective, it was about a negative $2 million impact. I think for the overall revenue, those two items netted to a pretty small amount. There is also – Topic 606 did impact the Venice West (58

[Matthew D. Gillmor:]

Okay. And then another topic that you touched on, on a previous question, but I was hoping to get some more details. Does the VA readiness crowd out other revenues that, and other projects you don't otherwise be working on that would generate revenue? And do you have an estimate for what that would be?

[Marc G. Naughton:]

I don't have an estimate. There's certainly people that could be on other jobs working more efficiently than some of the things we have them filling in on today. So certainly, it is a loss of revenue relative to those. And that's why we characterized it as an investment. It's clearly, I wouldn't expect that my spend would exceed my revenue as it is on those resources. And that's what it is today. But I can't quantify that for you right now.

[Matthew D. Gillmor:]

Okay.

[Brent Shafer:]

Okay. Thank you, Marc. This is Brent. I'd just like to thank you all for joining us today. I want to reiterate what a pleasure it is to be here at Cerner. And now that first 90 days have passed in a heck of a hurry, it's already clear to me that Cerner is a company with great opportunities. We've talked about some of those today and we'll talk more with you as the year goes on. And I know we have a lot of work to do. We have a very strong leadership team and a strong associate base. And I really believe we can deliver lasting growth by making focused investments and innovation and ensuring we do the things necessary to make our clients successful. And that's what we're all about. So, thanks for being with us. Have a good evening.

[Operator:]

Ladies and gentlemen, thanks for participating in today's conference. You may now disconnect. Everyone have a great day.