Cerner Corporation
Q3 2016 Earnings Call Transcript

Published: 2 Nov 2016

[Operator:]

Welcome to Cerner Corporation's Third Quarter 2016 Conference Call. Today's date is November 1, 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 limitations, those regarding projections of future revenues or earnings, operating margins, operating capital expenses, product development, new product or prospects of the company's solution and services, and plans and expectations related to Health Services business and other clients achievements. 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 the Item 1A in Cerner's Form 10-K together with the company's other filings. A reconciliation of non-GAAP financial measures discussed in the earnings call can be found in the company's earning release, which was furnished to the SEC today and posted on the investors section of cerner.com. At this time, I would like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation. Sir, please go ahead.

[Marc G. Naughton:]

Thank you, Michelle. This is Marc Naughton. Good afternoon everyone, and welcome to the call. I'll lead off today with a review of the numbers. Zane Burke, our President, will follow me with results, highlights, and marketplace observations. And then Mike Nill, our Chief Operating Officer, will provide some operational highlights. Now, I will turn to our results. While solid overall, our results included bookings and revenue slightly below our guidance range and earnings at the low end of our range. Starting with bookings, our bookings revenue in Q3 was $1.434 billion, which reflects a 10% decrease from a very difficult comparable in Q3 of 2015 on bookings. We were an all-time high and had grown 44% over the prior year. Relative to our guidance, bookings were $16 million below the low end of our range, but Q3 was still our second highest bookings quarter ever. Our revenue backlog ended the quarter at $15.471 billion which is up 11% from $13.876 billion a year ago. Revenue in the quarter was $1.185 billion, which is up 5% over Q3 of 2015, but $15 million below the low end of our guidance range of $1.2 billion to $1.275 billion. The revenue shortfall was mainly in system sales and was a result of lower than expected technology resale and software bookings for the quarter. The revenue composition for Q3 was $301 million in system sales, $253 million in support and maintenance, $608 million in services and $22 million in reimbursed travel. System sales revenue for the quarter was down 7% compared to Q3 of 2015 with technology resale declining 21% and licensed software declining 12%, partially offset by 10% growth in subscriptions. System sales margin percent increased 150 basis points year-over-year to 69%, reflecting lower technology resale mix as well as lower commissions. Moving to services, total services revenue including professional and managed services was up 13% compared to Q3 of 2015. This is in line with our expectations and continues to reflect good execution by our services organizations. Support and maintenance revenue increased 3% over Q3 of 2015, slightly below our expectation in mid single digit growth due mostly to lower equipment maintenance revenue related to our lower technology resale. Looking at revenue by geographic segment, domestic revenue increased 6% over the year ago quarter to $1.06 billion and non-U.S. revenue was flat year-over-year at $130 million. Moving to gross margin. Gross margin for Q3 was 84.6%, which is up from 83.1% in Q3 of 2015, due mostly to the lower mix of technology resale and better services margins versus the year ago period. Now I will 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, Health Services acquisition-related amortization, acquisition-related deferred revenue, 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 were $759 million compared to $722 million in the year ago period. Adjusted operating expenses were $713 million which is up 8% compared to Q3 of 2015. This growth was primarily driven by growth in personnel expense related to revenue generating associates which is reflected in the sales and client service expense line that increased 11%. Software development increased 3%, G&A was basically flat and amortization and acquisition-related intangibles was down 30%. But this represents only $1 million decline from $3 million to $2 million as this line excludes Health Services acquisition-related amortization in the non-GAAP view. Moving to operating margins. Our Q3 GAAP operating margin was 20.4% compared to 19.1% in the year ago period. Our adjusted operating margin was 24.4% in Q3, which is essentially flat to the year ago period. This is in line with our previous indication that we expect margin expansion to be limited in 2016 but we do continue to believe we can expand margins 50-plus basis points annually after 2016. Moving to net earnings and EPS. Our GAAP net earnings in Q3 were $170 million or $0.49 per diluted share. Adjusted net earnings were $203 million and adjusted diluted EPS was $0.59, which is up 9% compared to Q3 of 2015. Q3 tax rate was 30%, which is slightly below our expected rate. The benefit of this was largely offset by a $3.7 million write-off of a venture capital investment that is reflected in the other income line. Now I'd like to preview an expense we expect to incur in Q4. We recently offered a new voluntary separation plan or VSP to eligible associates. Similar to our program in February of last year, the VSP was made available to U.S. associates who meet a minimum level of combined days in tenure. The irrevocable acceptance period for most associates electing to participate in the VSP ends in December. Based on the number of eligible associates and our estimate of participation, we expect the corresponding pre-tax charge in the fourth quarter of 2016 to be approximately $30 million. Similar to our last VSP, we believe we'll be able to fill many of the positions vacated by participating associates with existing associates, which should create efficiencies in the future, while also creating career growth opportunities for our associates. This completely voluntary program will have a very small impact on our total head count, as the number of eligible associates we expect to accept the offer represent less than 2% of our total associates. Also, this should not be viewed as a layoff, or a sign we don't expect to grow. We've grown our head count by over 2,000 people this year and expect to grow head count next year as well. Now, I'll move to our balance sheet. We ended Q3 with $837 million of total cash and investments, which is up from $720 million in Q2. We did not repurchase stock during the quarter which means $100 million still remains available for repurchase under the stock repurchase program authorized in March of this year. Moving to debt. Our total debt including capital lease obligations is $573 million, which is down slightly compared to Q2. Total receivables ended the quarter at $985 million, which is essentially flat to Q2. Our Q3 DSO was 76 days, which is down 9 days from 85 in the year-ago period. Operating cash flow for the quarter was $240 million, down from $272 million in Q3 of 2015. Year-to-date operating cash flow of $822 million still reflects strong growth over the $594 million of operating cash flow for the first three quarters of last year. We also expect strong Q4 cash flow. Q3 capital expenditures were $110 million and capitalized software was $74 million. Free cash flow, defined as operating cash flow less capital purchases and capitalized software development costs, was $56 million for the quarter. This is flat compared to Q2 and down compared to Q3 of 2015. Year-to-date free cash flow of $266 million is nearly double the $134 million generated in the first three quarters of last year. Next year, we continue to expect a decline in capital expenditures, which we expect to drive stronger free cash flow. Now, I'll go through guidance. We expect revenue in Q4 to be between $1.225 billion and $1.3 billion, with the midpoint reflecting growth of 7% over Q4 of 2015. Our guidance reflects our expectation that system sales will increase sequentially compared to Q3, but will still be below our original target for the quarter due to lower expected software and hardware. We expect Q4 adjusted diluted EPS to be $0.60 to $0.62 per share, which is below our original expectations due to the impact of the lower system sales. The midpoint of this range is flat compared to Q4 of 2015, but recall we had a $0.03 tax benefit last year. Moving to bookings guidance. We expect bookings revenue in Q4 of $1.425 billion to $1.575 billion and the midpoint reflects 11% growth over Q4 of 2015. When added to year-to-date actuals, the midpoint of our Q4 guidance implies the following expected full year 2016 results

[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. While our Q3 bookings were slightly below our guidance range, it was still the second highest level of bookings in our history, second only to Q3 of 2015. In addition, we expect to return to strong bookings growth in Q4. Looking at mix, 34% of bookings in the quarter were from long-term contracts, reflecting one new ITWorks client and strong managed services bookings. This is in a more normal range for long-term bookings, but our year-to-date mix is still lower than normal because of the lower long-term bookings in the first half of the year. Bookings this quarter included several large contracts with 35 contracts over $5 million, including 26 over $10 million. From a new client perspective, 34% of bookings this quarter came from outside our core Millennium install base. This high level of new business reflects our ongoing competitiveness and good market activity. Looking ahead, we continue to believe the replacement market will remain active given the high number of hospitals on legacy platforms, some that are being sunset while yet others are preparing for future regulatory and payment models that many legacy platforms are not well equipped to handle. As we have previously discussed, the timing in these contracts is proving to be less predictable which I will discuss more in a minute. First I'll provide some more highlights on the quarter. I'll start with Revenue Cycle, which continues to be a strong contributor to our results. The market remains very focused on clinically driven Revenue Cycle, which is driving strong sales into our base as well as inclusion in new EHR deals. We also had good contribution from RevWorks services in the quarter, with the expansion of an existing relationship and good contribution from our acute and ambulatory Revenue Cycle services offerings. Our competitiveness in Revenue Cycle continues to improve across both acute and ambulatory, and this is reflected in the fact that we have displaced more than 10 different competitors so far this year. Looking ahead, we remain optimistic that Revenue Cycle will continue to be a strong contributor to our growth. We still have significant white space on solution penetration, and opportunities for our consulting services remain high. Now I'll shift to Population Health where we continue to do very well. Our comprehensive approach to population health remains differentiated in the marketplace. The power of our platform and ability to integrate with EHR workflow remained key differentiators. But we also continue to strengthen our competitiveness against the niche competitors we face across different categories, such as registries, enterprise data warehouse, analytics, and care management. We are very pleased with our overall progress in Population Health. Just two and a half years after our first HealtheIntent solution went live, we've now sold solutions to over 100 clients and the HealtheIntent platform has over 300 data connections from more than 80 unique sources. As we have discussed, the scope of many initial Population Health contracts are small, because most clients are not at risk for large portions of their populations. But we expect that ongoing shifts in reimbursement will lead to broader risk assumption, which should lead to adoption of more solutions and more lives being managed on a per-member-per-month model. Additionally, we're discovering through the use of our solutions, the access to more data will enhance our clients' fee-for-service models. Also, our addressable market for Population Health goes beyond our traditional EHR clients to include ACOs, health plans, governments and employers. In addition, the opportunity goes beyond module (15

[Michael R. Nill:]

Thanks, Zane. Good afternoon, everyone. Today, I'm going to discuss ITWorks and service collaboration with a large employer and leading health system. I'll start with ITWorks. We had a good quarter with one new ITWorks client and a strong sales back into our client base. Our new client in the quarter was a community hospital that also has six clinics. Like most of our ITWorks clients, they added additional solutions to the roadmap as part of their agreement. In this case, they will be adding critical care, oncology and cardiology solutions. In addition, they're adding HealtheIntent Population Health solutions as well. As Zane mentioned, we've had less ITWorks activity so far this year than expected, but our pipeline remains strong and includes some clients that are much larger than any of our existing ITWorks clients, which is why we're confident about the growth in ITWorks bookings for 2017. The value proposition to our clients remains very appealing, especially in an environment where they have pressure on operating costs, limited access to IT talent and increasing pressures in light of the industry issues related to security. Now I'd like to discuss a new partnerships between Cerner, a large employer, and Memorial Hermann. Together the three of us have collaborated to create a high performance health network for employers. Employers are looking for strategies to improve quality, cost and experience. Leading health systems are creating and looking to grow their insurance offerings. As this emerging takes shape, Cerner is investing in new capabilities to address this market opportunity. We think the chance to positively disrupt and drive revenue is compelling. Cerner and Houston based Memorial Hermann have a long history of collaboration and innovation. In addition to broad adaption of Cerner Millennium Solutions, they're an early adopter of our initial HealtheIntent Population Health solution and have been steadily adopting more solutions and replacing niche suppliers over the past three years. This has contributed to their success at running one of the largest, best performing ACOs in the country. Memorial Hermann also has its own health plan built around their vast provider network in Houston. Within their plan, they've created their own custom fully insured product for a Fortune 500 employer. As part of the overall approach, Cerner is providing a concierge member services that will be tightly integrated into the health plan and health system, helping members maximize their benefits. We're also providing the technology for the consumer engagement platform which brings disparate patient and member portals into an organized consolidated experience. As you know, we have administered our own health plan for the past decade, which has allowed us to reduce the growth in our health care costs while also leading to a better health experience for our associates. By leveraging this experience and partnering with an innovative world class provider like Memorial Hermann and a large forward thinking employer, we are building an approach to value-based care that can be a model for other markets. We believe our tailored systems are uniquely positioned to play a role in helping employers move toward value-based care by offering high performance networks comprised of high-quality doctors. They can provide plans that help employers bend the cost curve while also providing a better overall experience and improving the health of their workforce. We look forward to sharing more about this collaboration as we move through the enrolment and the launch this offering and then expand these capabilities to other leading health systems, employers and markets. With that, I'll turn the call over to questions.

[Operator:]

Our first question comes from the line of Garen Sarafian with Citi Research. Your line is open. Please go ahead.

[Garen Sarafian:]

Good afternoon. Thanks for taking the questions. Hey, Zane, could you just elaborate a little bit on what you're seeing in the market and some of the delays? Could you just maybe give a couple examples? And then what gives you guys confidence that it's sort of just getting pushed over to a little bit farther down the road and not necessarily disappearing? Are they putting anything into their budgets for next year that gives you that confidence or any other metrics that we could rely on?

[Zane M. Burke:]

Yeah, Garen, thanks for the question. So, in the new business marketplace, I'd say our metrics are at all-time highs. So the activity levels are incredibly good, and in fact we had a very strong new business quarter overall. So we did very well. We just had anticipated doing slightly better and there were a couple of opportunities that moved and mostly from a just a pure timing perspective. So, it's not a question of if they're going to do it, it's a when. And without the challenges or without the regulatory elements behind it, the regulatory mandate times behind it, some of those clients are moving a little bit slower than they have in the past. So, the budgets are there. The activity is there, and we had a high performance quarter in terms of numbers. We did not meet our expectations and what we had anticipated to come through for the quarter. So, and as we look forward, we see our pipeline of activity and those that are in the pipe as very strong and record levels of activity there. And as those of you who have followed us for a long time know, we go through a rigorous process in terms of how we qualify those opportunities, how they run through our forecasting process and that's helped us to provide good predictability historically around the closing of some of those opportunities. In this case, as I have discussed previously, there are some timing gaps. So the activity remains strong. The ability to accurately predict within the number of weeks, days, et cetera on how we close our business was not where we have seen it previously. So.

[Garen Sarafian:]

Got it.

[Zane M. Burke:]

Does that make sense?

[Garen Sarafian:]

Okay, no, yeah, that's useful. And then as a follow-up maybe for Marc. In setting guidance for 2017, given just more uncertainty and sort of predictability in achieving these results, has the methodology in coming up with guidance any more conservative than in prior years? So for example, what percent of the midpoint of next year's revenues come from backlog versus prior years, or any other metric for that matter.

[Marc G. Naughton:]

Hey yeah, Garen. Once again, it's early. What we're providing is our kind of view as of now. We don't have a 2017 plan completed. As we go through the process, the process will remain as it's always remained. We will look at the business. We won't make any assumptions that we're going to grow bookings. We will expect bookings to be relatively flat, a mix to be relatively similar. And we will then look at our forecast that goes out four quarters to see if that forecast supports those assumptions. We'll do all the things we do relative to look at spending and look at opportunities. I would expect, while I don't have a number today, that a material component similar to what we saw coming in 2016, which was in the 80%, 79% range, that we would see that same contribution from backlog as we roll into next year. I don't know what the number exactly is going to be, but I think we're going to have that visibility. Once again, I think it will be a focus on the 20% that we've got to go drive, a lot of which comes through system sales, and that's going to be what we're going to focus on relative to our forecasting and our assumptions. But my philosophy is we're going to do all the work, and then we're going to provide you guidance based on our best work. So we can't really, as I said, we can't – my planning process assumes certain things, one of which is flat bookings. I don't expect to have flat bookings next year. We were basically guiding today that we're going to be relatively flat for bookings, but I think as we look next year, we would certainly expect to get back on an uptick after coming off a very challenging year with a significant increase in bookings last year. Exceeding that very tough mark this year is actually a good accomplishment, but we'd expect to get back on track to growing bookings at a similar pace that we've seen in the past. So once again, my comments on plan is we've traditionally always done from a actual expectation of bookings, the business expects to grow our bookings. Especially, Zane talked about in 2015, the Works businesses, or 2016, the Works businesses weren't a integral part of a lot of our bookings number. We didn't do a lot of big ITWorks deals. In the pipeline, there are more opportunities in that space. And given that and the size of those bookings gives us kind of a higher level of confidence that 2017 bookings are going to be stronger than 2016.

[Garen Sarafian:]

Okay. That's useful. Thanks for the questions.

[Marc G. Naughton:]

Sure.

[Operator:]

Thank you. And our next question comes from the line of Robert Jones with Goldman Sachs. Your line is open. Please go ahead.

[Robert Patrick Jones:]

Great. Thanks for the questions. Marc, actually I just want to follow up on some of those bookings comments. Just to be clear, is it 2017 preliminary revenue outlook that you're providing tonight? Is that assume no bookings growth? And then I guess, just as I think about the short-term bookings, it does look like you're calling for a pickup in 4Q. I'm just curious as you look out into next year, is it just a conservative assumption to assume you don't see bookings growth or are you actually baking in some as you think about 2017?

[Marc G. Naughton:]

Yeah, and let me be very clear. We expect bookings to grow in 2017. That is our expectation. The business is there. Everything we're seeing in our forecasting process, which goes out four quarters, so we actually have a view out that long as to what the opportunities are. And as Zane says, it's at record levels. So we see bookings growing next year. My point is, relative to us doing a plan, the question kind of came up as, is there a level of conservatism. And for us, we don't expect, we don't plan the bookings are going to grow. We expect them to grow, but by not building that into the plan, that gives us some degree of cushion should they not grow to deliver the numbers that we provide in our guidance. And so, I think that's our expectation. I expect bookings to grow. Zane expects bookings to grow. The opportunities are there. So, we will see higher bookings in 2017, but relative to giving you guidance, especially preliminary guidance, we're not going to go build growth and bookings into those preliminary numbers. When we come back to you after Q4 ends with a completely built backlog and have our best view, then we will certainly tie down those numbers. But at this point, based on our normal process, which we've done every year, we're comfortable with the guidance we're providing relative to a first look at 2017 and once again realizing we got to get through our planning process to tie it down.

[Robert Patrick Jones:]

No, that's fair. And I guess just one more specific follow-up around that. If I think about 2016 and maybe one of the things that was disappointing relative to your expectations coming into the year, probably would be around the work pipeline. It seems like the expectations for some of these large Works deals to be implemented has obviously moved throughout the year. I guess the question is what changes in 2017 as far as the systems that you've been talking to around IT and ITWorks and RevWorks, what changes that you see them actually moving forward with those contracts?

[Zane M. Burke:]

Robert, this is Zane. I think what we're seeing is some of those things moving through the pipeline a little bit faster in terms of – or not faster, but just maturing more appropriately through there. And so, what's really going on is when you make this move is, it's a combination of things. So there's always the how to go faster. And so, when you look at MACRA and MIPS, our clients are going to have a need to be able to measure and monitor a number of different metrics and to begin to prepare for that. And when they look at what the pressure they're under from meaningful use for MACRA, MIPS, those kinds of things are going to drive additional behavior around ITWorks. In addition, the decreasing reimbursement environment creates a cost strain at a time when they need access to more data. They need more IT to actually be able to answer all these questions. So the combination of those regulatory elements in a capital and operating constrained environment at a point in time when they're trying to just flat out execute, what we offer for our clients is provide that kind of leverage. And I think what we saw in 2016 is there was almost a catch your breath mentality in that we did not have any of those major elements around meaningful use. In the current year, we didn't have the MACRA, MIPS. And in addition, the bottom lines for our clients were still pretty strong. What you're seeing as you go to the back half of the year is a little bit of weakness with the bottom lines and that regulatory environment coming on. That's actually a really big positive for the IT, for the Works programs themselves, both Revenue Cycle and ITWorks. And so in the conversations that we're having, they're continuing along. And I feel like those are going to mature in a good way in 2017 that we just didn't see in 2016 with that kind of catch your breath element in some of those areas.

[Robert Patrick Jones:]

Got it. Thank you.

[Operator:]

Thank you. And our next question comes from the line of Steven Valiquette with Bank of America. Your line is open. Please go ahead.

[Steven J. Valiquette:]

Thanks. So I guess I'm just curious on just an update on the VA opportunity. There was some rumblings obviously a few months ago that the VistA system could potentially be replaced and potentially bidding to third parties. Just curious to get an update on what's going on there from your perspective. Thanks.

[Zane M. Burke:]

Thanks for the question. So, from a VA perspective, I think with the administrations changing and some of those elements, that there's a – I don't think there's an expectation that that's going to be in the immediate horizon, but there is clearly a dialogue. It has been from them around making a change out of VistA in the long run. And should we be called upon to respond to that and get asked, we'd be excited to perform. I think our best model is to continue to perform on the DoD, which we are performing very well on. And the follow-on opportunities for that are quite significant in and of themselves. So as you think about 2017 and 2018 and the future, we have a unique position both from the DoD perspective obviously, the additional opportunities that are not yet booked as part of that opportunity, but also to set us up to be in good position to think about competing well around the VA. And so our motto is to put our head down, be very successful with the DoD. That will yield a lot of positive results for 2017 in terms of system sales for Cerner Corporation that are unique to Cerner, as well as position us for the VA.

[Steven J. Valiquette:]

Okay. Just based on that comment then on the DoD part of that then, it sounded like maybe you were saying that could be a source of upside to bookings next year. Or is that going to be counted in the bookings already as far as the opportunities? Just wanted to get clarity on that, that comment you made around that.

[Zane M. Burke:]

I would say part of those are in the bookings. And I'd say part of those could be upside to the bookings. So, I think as we have visibility to what that looks like, we're anticipating where we are. We have not set any guidance at this point around bookings other than to say, as Marc has said, our anticipation is to grow for next year. And given we haven't set that, I can't really tell you that piece. But in our forecasting process, we are forecasting opportunities around that and I think it will be both to provide some coverage for what we're doing from a guidance – what we will do around guidance as well as provide some upside opportunity.

[Steven J. Valiquette:]

Okay. Got it. Okay, thanks.

[Operator:]

Thank you. And our next question comes from the line of David Larsen with Leerink. Your line is open. Please go ahead.

[David M. Larsen:]

Hi. How much did the DoD contribute to the quarter, if any, in terms of like bookings and revenue? And what would with that contribution be next quarter, please?

[Marc G. Naughton:]

David, as we've said, the bookings from DoD tend to be kind of steady and not significant in any one quarter. They weren't significant similarly. There isn't a big impact in any one quarter. The revenue doesn't have a big impact in any one quarter and it's not a number we're disclosing. But if it was something material, then we'd talk about it. But it spreads out through multiple periods. And as Zane said, as we complete certain processes and elements of the project in 2017, that opens up additional task orders for us to realize, not one of which will be a giant booking in the quarter. But it will be definitely a strong support for overall bookings as well as the potential to provide some guidance, some upside to our guidance.

[David M. Larsen:]

Okay. That's helpful. And then, Zane, just one more question, talking about like pipeline activity and new sales efforts, are there any metrics you can provide like for example, number of leads, how that's trending on a year-over-year basis? Or can you give any more sort of detailed color around which segments of the market you're seeing greater activity from? Is it community hospitals, physician offices, large hospitals? Thanks.

[Zane M. Burke:]

Sure. Happy to help with some of those pieces. There are some things that we do not provide numbers around but – those are proprietary for us. What I will say is in terms of absolute dollars across all segments, our pipeline is at the highest level in the history of the company. So that's kind of the ultimate metric in terms of what we're looking for. And that's after we took the second highest level of bookings in the history of the company out of the pipeline. So, I think that's an important element to think of first when you're thinking about the health of where we are. As far as certain areas of strength in the marketplace, certainly you look at community hospitals, that's a very strong marketplace for us. The small hospital marketplace is very strong. Some places where we uniquely compete, around the investor-owned segment, around the government, both from a federal and a state and local perspective, those are very active parts of the marketplace, as well as our Population Health solution sets. So there are just a number of areas that we're very strong and continue to be very active.

[David M. Larsen:]

Great. Thanks very much.

[Zane M. Burke:]

Pleasure.

[Operator:]

Thank you. And our next question comes from the line of Sean Wieland with Piper Jaffray. Your line is open. Please go ahead.

[Sean W. Wieland:]

Hi. Thanks. So, a year ago you said that you're comfortable with revenues in excess of $5 billion. And so, we're about $200 million or so short of that. Can you just, looking back at over the past 12 months, what areas of product or market or services could you account for that $200 million?

[Marc G. Naughton:]

Well. I think you can just, even looking at the last two quarters, there's $150 million that's come out of our revenue guidance. Half of that came out this quarter as a result of lower system sales, right. We did not contemplate hardware decreasing 21%. We didn't contemplate software decreasing. The business is out there. As Zane has talked, it's primarily timing issues. But once those things hit a quarter, so you're down half of that $150 million, you're out this quarter, that's going to have a carryover effect. So, even in our Q4 guidance where we expect system sales to rebound and get back to good levels, you've got the follow on impact of that. So that's going to impact basically, take you down the $150 million just in the last half of the year. So, I think that's the material amount obviously. When we were giving guidance, we were looking for pretty significant uptick as we went through. And if you look at our Q4 guidance, I mean we're looking at a $78 million uptick at the midpoint of our revenue guidance range. So, we are still looking to get a significant bump in revenue to get to Q4. So, I think relative to what we saw at the beginning of the year, the backlog has played out just like we expected it to. It's the system sales and some of the other things that are signed during the year that impact us. But, Zane, do you have any thoughts on that?

[Zane M. Burke:]

Yeah, I think the other thing I would add is that the big difference is, as Marc discussed, first off low margin tech resale and frankly low margin ITWorks bookings that we would have anticipated would have been in the numbers that don't significantly add to the bottom line overall, but would have added to the top line in a revenue perspective. And if you look at the first half of our ITWorks bookings, they led to lower second half revenue results. So, I think the combination of both the tech resale, as Marc mentioned, as well as the ITWorks pieces, both low margin businesses for us. And both things that, and particularly the ITWorks side, as we look forward, having opportunities take back up, we feel better about that as we move forward.

[Sean W. Wieland:]

Okay. Thank you. And then you mentioned that you replaced your large, your cloud-based competitor at an investor-owned site. Is that a full rollout and when is that scheduled to go live?

[Zane M. Burke:]

It's a single region, so we look at it with opportunity to grow from that piece, but it's a single region at that one particular organization. And it'll be a go-live in the 2017 period.

[Sean W. Wieland:]

Okay. And one last quick one. Do you have any thoughts on free cash flow for 2017?

[Marc G. Naughton:]

Yeah. This is Marc. Clearly, we've talked about the CapEx we're spending on our new campus for Mike Nill that we expect that spending will moderate significantly when we head into 2017. So, we expect CapEx to be $100 million less next year. So if you look at the $100 million left to CapEx overall, and you look at kind of some level of increase just in operating cash flow that flows down through, I think you'll see a pretty strong increase in free cash flow as you look to model what that looks like next year.

[Sean W. Wieland:]

Okay. Thanks so much.

[Marc G. Naughton:]

Sure.

[Operator:]

Thank you. And our next question comes from the line of George Hill with Deutsche Bank. Your line is open. Please go ahead.

[George R. Hill:]

Yeah. Good afternoon, guys, and thanks for taking the question. I guess, Zane or Marc, just first, if we assume that bookings are flat in 2017, would it be right to assume that the mix of business that comes from installed clients versus new clients shifts more towards the installed clients as it's largely cross-sell and renewals as opposed to new business? That's kind of question one. Then question two for Zane. If we think about books of business that would not have been impacted by the lapping of stimulus spend, I guess maybe can you talk about what you're seeing in the international markets and government markets? Thanks.

[Marc G. Naughton:]

Let me just take the mix of business because we're talking hypothetically if we're talking flat bookings, because bookings will grow next year. And so, what reality is going to show in that growth is our expectation, a similar mix between new and existing clients, as we continue, as we move forward. Relative to our assumptions, we're going to assume a similar mix relative to our planned assumption, flat bookings. Zane, I'll let you take the second half of that question.

[Zane M. Burke:]

Thanks, Marc. Around the international marketplaces, there are a few markets that feel very positive as we look at it. There are some who are investing more in healthcare IT like Belgium, like Sweden and you see that like Australia. And then there's some interesting ones where you look at a country like the UK which is under incredible cost pressure, and that pressure really forces the change and forces the need for more IT frankly. And we were, you may be aware, we were awarded six of the 13. Our clients were awarded six of the 13 challenge grants around innovation. So, £10 billion innovation grants by which they are charged with figuring out ways to use IT to lower costs and improve efficiencies in the UK. And so, I look at a couple of markets where there's recognition for they're doing well economically and they want to go invest in healthcare structures like Belgium, like Sweden, or they're struggling and it's going to force the change like the UK. And I think we're well positioned in those marketplaces to have some good success. I also think Canada has the opportunity in 2017 and 2018 to be a very strong marketplace as they look at some more provincially wide procurements and those tend to take time and are very challenging in which to predict how those will come to closure. But, I feel very good about how we're positioned in many of those strong marketplaces.

[George R. Hill:]

Okay. Appreciate the color. And Marc, I'll hold you to a barbecue dinner or no?

[Marc G. Naughton:]

You got it.

[Operator:]

Thank you. And our next question comes from the line of Eric Percher with Barclays. Your line is open. Please go ahead.

[Eric Percher:]

Thank you. I'd like to go back to the discussion of the replacement market. And I know you talked about some delays across the book. But within the replacement market, what are hospitals coming to you for today? What is able to drive through some of those delays? Is it integration? Is it specific products around the ambulatory Rev Cycle? Can you tell us what is reverberating?

[Zane M. Burke:]

Yeah, I want to be clear. All of these organization are making a decision they need to change. And so, the delays don't have anything to do with, from a solution perspective or anything like that. It is truly a process and a need to – these are significant purchases for these hospitals. It's literally a do I want to buy a new EHR, which they know they have to to compete for the future. Or am I going to go invest in some sort of the other pieces. On the existing clients, the ROI around some of the connectivity pieces to other parts of the business, whether that's device connectivity, whether that's their ambulatory marketplace, whether it's efficiencies, there is a focus on return on investments which breaks through the pause, if you will, or the kind of breathing, the sigh of breathing for 2016. Those kind of projects gain traction in this environment where we're competing for capital. So, it's kind of the hard ROI elements, our staff schedule, our staff acuity solution sets, having a clinically integrated revenue cycle has been a very strong element. Again, it's bringing things together, same things that drive actually the new marketplace. How do I go round out my solution set such that I have a fully integrated solution capability and I've got data liquidity across my enterprise. And ROI doesn't any hurt anything in terms of getting it moving forward. So, thanks for the question.

[Eric Percher:]

And how do you measure ROI among those different products and how difficult is that in the sale prices?

[Zane M. Burke:]

It's a good question. We have a set of tools by which we work with our clients with on their specific data and knowing our solutions work and spend time in their processes. And we run those against our models and determine, along with the client what that return on investment should be.

[Eric Percher:]

Thank you.

[Operator:]

Thank you. And our next question comes from the line of Michael Cherny with UBS. Your line is open. Please go ahead.

[Michael Cherny:]

Good afternoon, guys, and thanks for the details so far. So, I'll just keep this kind of quick. And I apologize if some of this has been answered, but I want to ask it a bit of a different way. Marc, historically hadn't broken down the system sales as closely as you did today. And I know typically the tech resale has been something that's been very hard to predict, obviously non-core. I don't recall licensed software number coming down at that pacing, obviously offset by subscription. As you think about it on go forward basis, I'm not specifically talking about this quarter or maybe if you want to give any color, how should we think about the long-term mix of subscription versus licensed software relative to your business?

[Marc G. Naughton:]

Well I think clearly, licensed software or subscription is just two ways of selling intangible intellectual property, right. So from our view, Q3 was a little bit of a unique circumstance in that, as Zane talked about, there was a lot of business in the quarter and a lot of software opportunities that because of the timing issues that we're seeing didn't get done in Q3. We see that rebounding in Q4 and expect to get back kind of to more traditional levels. The reason you haven't heard us talk about software before is it really hasn't been different enough to highlight. The tech resales has been different enough that it has been a cause of the difference. So, that's one reason. The variance between subscription and license, it really just depends on how we're selling it and how the client's buying it. We will, as we got market, we'll go to market in a variety of ways, they want to buy the software, they want to buy it as a time term license that's more of a subscription. If they want on the Pop Health side, a lot of it is, much of it's bought per member per month. So, much more like a ASP or subscription basis. So, I don't know that that mix is relevant to our business as a Q3 where some of those opportunities – some of them of size have moved to a different period. But I think overall, we are a software company. We expect that to rebound. Our pipeline is strong and we have the opportunity to go sell software. People are still buying software in this marketplace. So, I think there are opportunities that are there and we just got to get to the point where we can – and we are at that point where we can effectively deliver on a fixed-fee basis the technology they need. You know, Zane made really a good point earlier about MACRA and the impact that has on just the general desire for technology. I think as he was talking about the existing client base and what they're needing, some of that's going to be driven by their desire to have all of the data that's going to be required under MACRA and make sure that they have a single point of truth to go get that data and be able to get all the data they need. So, yeah, I don't know how we sell it makes much difference. We still sell it. Q3 I think was a low number. We've highlighted it because we want to be transparent. Q4, we don't think that's going to be an issue.

[Michael Cherny:]

Okay. Thanks, Marc.

[Marc G. Naughton:]

Sure.

[Operator:]

Thank you. And our next question comes from the line of Jamie Stockton with Wells Fargo. Your line is open. Please go ahead.

[Jamie J. Stockton:]

Hey, good evening. Marc, just on the expense trends that are backing up the 2017 view that you guys have given, and I understand that the budget is not fully baked at this point, but specifically as we think about R&D expense and what flows through the income statement, you guys have a relatively large gap between how much R&D you're capitalizing right now and how much you're amortizing. Can you give us a feel for how much of that gap is going to close next year or what the cadence over the next two or three years might be for that gap closing?

[Marc G. Naughton:]

Well, obviously, we continue to spend a significant amount of our R&D on new IP and new items that capitalize and that then go GA at some future point. We talked coming into this year that we had expected to have non-cash expenses on some of the amortization on that hitting us in 2016. It has hit us. It has not hit us as much as we had originally expected. So, I think you will see some carryover impact on the 2017 R&D expenses as that amortization starts, ramps up early next year. We're continuing delivering the code. We're doing it on a timely basis. In some cases to get to GA, we require some testing by our client partners and sometimes that timing is not exactly within our schedule that we would do amortization. So I think you'll see next year similar levels of capitalization, because we are still working on new stuff. The overall expense will take a slight hit from the amortization element of being slightly higher for the amount that didn't get hit into the number this year. So, R&D expense basically is likely as we look at it goes up a little bit as we head into 2017, but it's not a significant adjustment. But once again, what we didn't see in 2016, it will come to roost in 2017.

[Jamie J. Stockton:]

Just as a follow-up, when you think about the gross R&D spend, I mean, I know when you guys announced the Siemens transaction, one of the major bullet points was the amount of kind of combined R&D spend between the two organizations and the likelihood that there wouldn't need to be significant growth for a number of years in that gross R&D spend. If we think about the gross amount, I think this year it's probably going to be somewhere around $710 million or $715 million. Is that a number that we shouldn't expect to see grow materially over the next couple of years?

[Marc G. Naughton:]

Yeah, no, I think that's definitely part of our plan, that you're going to – the goal was around the $700 million, that that should be enough for us to go deliver on what we're trying to do. At the very worst, any gross changes should be kind of low single digit. So, definitely growing at a rate lower than our revenue is growing. But I think long term, if you're just looking at kind of ordinary increases, kind of mid single digit growth would be something that would be along the lines of our expectation. We still have opportunities. We are still using some of the acquired resources to work and get to a point on some of the HS solutions. And so those people will become available as we roll forward. And we are investing heavily in our India campuses. So our expectation there is that we will be bringing online more IP resources in that environment, which from a head count perspective will increase, but from a cost perspective will fit in with that mid single digit future growth.

[Jamie J. Stockton:]

Okay. Thank you.

[Marc G. Naughton:]

Why don't we take one more question.

[Operator:]

And our next question comes from the line of Ricky Goldwasser with Morgan Stanley. Your line is open. Please go ahead.

[Ricky R. Goldwasser:]

Yeah. Hi. Good evening. And thank you for getting me on. So a couple of questions here. So first of all, when we look at the contract history, right, it seems that this quarter the percent of contracts that are long term in nature is the highest it's been since Q2. So, shouldn't we think about this as a leading indicator for just, again, a step down in booking conversion into 2017? I know that you talked about, in the call about MACRA and meaningful use. But it seems that the size of contracts, the bigger the contract is, it seems to me it's more complicated and therefore slower to convert. That's question one. And then second of all, if you can give us some sense of booking growth. What percent came from Pop Health and what percent from these big international contracts you've talked about?

[Marc G. Naughton:]

Let me just address the bookings. I think the comment kind of revolves around the long-term element of the bookings. Keep in mind that if you look at year-to-date, in 2015 long-term bookings were 34% of our total bookings. You look at this year, it's been about 29%. So actually, for us to be relatively flat and looking to be slightly up over a year where we're actually not getting the support from the long-term bookings, which we talked about from the Works deals, I think that's actually a point that shouldn't go unnoticed. But I think relative to the overall contracts, every contract has some degree of – these aren't simple but they're not rocket science, right. I mean if they want to buy stuff and we want to sell stuff, there's a lot of parameters around that. But there are a lot of – we have a lot of experience. They have a lot of experience. They also have a consultant that helps them put the contract together. So, I don't think the complexity of the contracts is delaying the signing of the contracts. I think the delay, I think that is just more a matter of the organization's timing and focus and strategic planning. And they don't have an outside regulatory timeline that they have to go meet for some of these things. MACRA could change that. MACRA may make them be more focused on making sure they have these solutions throughout all of their departments so that they can get the data they need to do that reporting. But, so, I don't think the complexity – these have always been somewhat complex. It's just a matter of the timing of the client to do that. The money is there, as Zane says. It's in our pipeline. It's just timing, tying down the 90-day period at which it's going to actually sign. It is a little bit more traditional to what it was prior to having meaningful use and all of these regulatory things that occurred.

[Ricky R. Goldwasser:]

And then on the booking growth and from Pop Health, what percent is Pop Health and what percent is international?

[Marc G. Naughton:]

Pop Health is a very little piece of bookings growth at this point. I mean, we have some today with the pilot version of Pop Health, a $5 million booking is a good sized Population Health booking. So, it's not moving the meter on a $1 billion bookings number. And relative to global, those bookings have been basically relatively flat, if not a little bit lower over the last year. As Zane said, there's some opportunities going forward, especially in Canada and some other countries that look like demand is beginning to pick up. So we think that will help the global side. But most of the bookings and most of the stuff, growth your seeing is not Pop Health, not international. It is our core businesses that we've always been in.

[Ricky R. Goldwasser:]

Okay. Thank you.

[Marc G. Naughton:]

Well, I want to thank everybody for their time. I think we're still on pace to grow bookings and revenue this your over a very tough comp. And I think we're all absolutely on path to grow revenue and earnings double digit in 2017. So I think based on our pipeline, based on the ITWorks opportunities we have, we do continue to expect to grow bookings year-over-year in 2017. With that, I will thank you for your attendance and bid you good day.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.