Cerner Corporation
Q2 2015 Earnings Call Transcript

Published: 5 Aug 2015

[Operator:]

Welcome to Cerner Corporation's second quarter 2015 conference call. Today's date is August 4, 2015, and this call is being recorded. The company has asked me to remind you that various remarks made here today constitute forward-looking statements, including without limitation those regarding projections of future revenues or earnings, operating margins, operating expenses, product development, new markets or prospects for the company's solutions, and plans and expectations related to the Health Services business and other client 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 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 to the Investors section of cerner.com. 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, Caleigh. 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. Mike Nill, Executive Vice President and Chief Operating Officer, will discuss the operations. Neal Patterson, our Chairman and CEO, will join us for Q&A. Now I'll turn to our results. Similar to last quarter, we delivered results that are mostly in line with our expectation with the expectation of revenue. While we are disappointed that we are below our guided levels of revenue, our continued levels of strong bookings and positive outlook set up a good second half of year. Our bookings revenue in Q2 was $1.29 billion, which is an all-time high and reflects 20% growth over Q2 of 2014, including record amounts of new business activity. Our revenue backlog ended the quarter at $13.3 billion, which is up [from] $9.7 billion a year ago, and reflects the strong bookings in Q2 as well as the inclusion of backlog from Health Services. Revenue in the quarter was $1.13 billion, which is up 32% over Q2 of 2014 and includes approximately $260 million of Health Services. The total is approximately $50 million below our guidance range, with approximately $40 million of shortfall related to core Cerner and $10 million attributable to Health Services. On the Cerner side, the lower revenue and resulting low single-digit growth is related to several factors. Some are in-quarter dynamics. Some are unique items in the prior-year period that drove 20% growth and created a tough comparable, and some are items that we didn't accurately forecast. The first factor is lower growth in services, which is primarily because of a year-over-year decrease in third-party services. Recall that in Q2 of 2014 we had a revenue over-attainment of more than $20 million that was largely related to higher third-party services and reimbursed travel. We are using less third-party services this year, and travel revenue excluding Health Services was down approximately 50% year over year. Just adjusting for these two items brings Cerner's core growth from approximately 2% to 5%. As you know, third-party services are lower margin and reimbursed travel is zero margin, so this lower revenue had little impact on our profitability. Another factor that has impacted our services revenue is we limited hiring in the months leading up to and the initial months after the close of our Health Services acquisition. Our forecasting model did not fully reflect this. We're now ramping up hiring to meet the strong demand reflected in the year-to-date bookings and our forecast, which will drive stronger services revenues growth. Both the impact of the additional resources as well as the impact of additional opportunities we see for the Works businesses will primarily be toward the end of the year and in 2016. An additional factor impacting revenues and our bookings this quarter included a higher percentage from long-term contracts, resulting in a lower percentage of items that generated in-quarter revenue. Finally, relative to Health Services, recurring revenue is tracking as we had forecasted, but non-recurring revenue came in lower than expected. While we're having ongoing success converting Health Services clients to Millennium, there is a portion of their base that is sitting tight during the transition, which has impacted the rate at which they make add-on purchases for things like lower-margin hardware. Otherwise, everything we are tracking for Health Services is at or ahead of our expectations. Now I'll quickly go through the total revenue composition for Q2. Total system sales revenue was $315 million. Support and maintenance was $255 million. Services was $538 million, and reimbursed travel was $18 million. System sales revenue reflects a 34% increase over Q2 of 2014, with the growth mainly driven by an increase in subscriptions, which is where the addition of Health Services has had the biggest impact, as well as growth in licensed software. Our system sales margin percentage was 64.3%, which is down slightly from 65.3% in Q2 of 2014 and 64.7% in Q1. The decline was driven by lower tech resale margins. Moving to services, total services revenue, including professional and managed services, was up 30% compared to Q2 of 2014, mainly driven by the addition of Health Services as well as growth in core Cerner managed services. Support and maintenance revenue increased 45% over Q2 of 2014, reflecting solid growth in core support and maintenance and the addition of Health Services. Looking at revenue by geographic segment, domestic revenue increased 30% over the year-ago quarter to $995 million, driven largely by the addition of Health Services. And global revenue grew 54% to $131 million, with good growth in core global revenue being augmented by the addition of Health Services. Moving to gross margin, our gross margin for Q2 was 82.9%, which is up from 80.9% in Q2 of 2014, with the improved margin reflecting the lower level of third-party services and reimbursed travel. Looking at operating spending, our second quarter non-GAAP operating expenses, which excludes share-based compensation expense, voluntary separation plan expense, and acquisition-related adjustments, were $661 million, which is up 37% compared to adjusted Q2 2014 operating expenses. This growth was primarily driven by the addition of Health Services business. The total year-over-year growth for each expense category on a non-GAAP basis was

[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 our results. Our bookings revenue in Q2 of $1.29 billion reflects strong growth of 20% over Q2 2014. Bookings this quarter include an all-time high level of large contracts, with 38 contracts over $5 million, including 23 over $10 million. We also had strong contributions from long-term bookings with a large ITWorks contract and an expansion of an existing ITWorks relationship. This led to long-term bookings making up 35% of total, which is a few percent higher than normal. The main highlight of the quarter was that we signed a record number of new footprints, both in terms of number and dollars. This resulted in 34% of our bookings coming from outside our core Millennium installed base. This success reflects our strong competitiveness and the continued large opportunity for competitive displacements. Our wins span many market segments, including IDNs, regional hospitals, children's hospitals, community hospitals, state behavioral health, ambulatory surgery centers, and physician groups. We're also continuing to sign Health Services clients to migrate to Millennium. These clients range from community hospitals selecting our CommunityWorks offering to large IDNs. And we continue to see cross-sell activity for solutions like Population Health and ambulatory. While not part of Q2, I'd like to highlight a significant win for Cerner that was announced today. We were recently selected by Baptist Health South Florida, a leading healthcare organization in the region, to implement Cerner Millennium and HealtheIntent across their seven hospitals and over 50 outpatient facilities. Baptist Health is recognized as a national leader in quality, safety, and patient satisfaction. And they're looking to Cerner solutions to optimize the physician experience, improve quality of care, and support their efforts to improve patient experience. In addition, they expect to leverage our enterprise-wide solutions and HealtheIntent platform to advance their goal of improving care coordination and reducing the cost of care. This recent win combined with our record level of new footprints in Q2 is evidence of strong momentum we have in the marketplace. Looking forward, we believe we can build on this momentum, and we remain bullish on new footprint opportunities. Our positive outlook is based on a very large and active pipeline and all-time high levels of new business activity, such as demos, reference calls and visits, and vision center visits. We continue to believe we have a multi-year opportunity to expand our client base, as about half of the market is on a legacy system and we think will need to be replaced. One observation about the buyer in today's market is they are very focused on the predictability of costs and transparency of the total cost of ownership, and we believe this is something that plays to our strength. We believe our ability to offer fixed-fee pricing on implementations because of our automation tools and implementation methodologies is a competitive differentiator. We also differentiate in our ability to provide services ranging from remote hosting to taking over an entire IT department, which can make our clients' total costs much more transparent and predictable. In addition, I believe we have credibility in the industry because of our track record for delivering value. And this credibility is bolstered by our large presence in investor-owned systems that are known for making ROI-based decisions. These clients, along with many of our other large IDNs, represent some of the largest healthcare IT deployments in the industry. I think it is worth noting that our ability to deliver value, on time and on budget projects is a meaningful differentiator relative to our primary competitor, who has a long list of making headlines when the significant cost of deploying and maintaining their system is cited as a key reason for job loss, financial challenges, and debt rating downgrades. Another marketplace observation is that openness, interoperability, and population health capabilities are becoming more important. This also benefits Cerner because of our longtime commitment to interoperability and open standards and our robust HealtheIntent cloud platform for population health. We continued to expand the presence of HealtheIntent across our client base, and the number of opportunities outside of our base is growing. Moving to our revenue cycle business, we had a good second quarter. All of our new EMR footprints in Q2 included revenue cycle, which supports what we have been saying about the market looking to buy integrated systems. Revenue cycle is an important component of almost all deals in our pipeline. In addition, we are gaining momentum in our existing installed base, with several clients selecting us to replace their legacy revenue cycle systems in favor of an integrated system. Based on these trends and the growing pipeline for related services, I expect revenue cycle to continue contributing to our growth for years to come. Moving to the ambulatory market, where we had an all-time high level of bookings in Q2, the bookings were driven by success at displacing our key competitors, both by expanding our solutions to the ambulatory venues of our acute care clients and as part of new business footprints. In addition, we are continuing to have success selling ambulatory solutions into the Health Services base. Finally, we continue to gain momentum in ambulatory business office services and expect there to be additional sites where we displace the cloud business office services offering of a certain cloud competitor because of our ability to demonstrate better service and value. We also had a record bookings quarter in the small hospital market, driven by a combination of traditional new footprints, extensions to our health system clients, and Health Services migrations. Outside of the U.S., we had a good Q2, with total revenue growth of 54%, consisting of good organic growth and the addition of Health Services. The organic growth was primarily driven by strength in the UK and the Middle East. We are also off to a good start at integrating the global components of Health Services. We now have a presence in more than 30 countries, and believe we are well positioned for our global business to be a good contributor to our growth over the next decade. Before turning the call over to Mike, I'd like to comment on the recent announcement on the Defense Healthcare Management System Modernization project, referred to as DHMSM. We are pleased that last week the Department of Defense announced its decision to award the contract to Leidos, Inc. As you know, the Leidos partnership for Defense Health includes Cerner as the core EHR supplier. We are honored, humbled, and excited to be part of a team that won what we believe was the most objective and comprehensive evaluation of technology platforms and solutions ever conducted. We now have the opportunity for the Cerner suite of integrated solutions to replace the DoD's legacy health IT systems in its 55 hospitals and more than 350 clinics worldwide, as well as in ships, submarines, and other locations in the theater of military operations. We are pleased to be partners with Leidos, Accenture, Henry Schein, and a number of small business partners in making this important transition for our military health system and its 9.6 million beneficiaries. Intermountain Healthcare is also a strategic partner and is providing clinical governance of solutions and workflow. The partnership is fully prepared to meet the staffing requirements of DHMSM, and our globally deployed team stands ready to support the DoD and DHMSM mission. We believe this is a positive development for our clients, and they should have confidence that Cerner will continue to execute to meet all our current and future commitments. As many of you saw in the announcement, Leidos was awarded a contract for $4.3 billion over 10 years, consisting of a two-year initial ordering period, two to three-year option period, and another two-year option period. We're not able to comment on Cerner's portion of this, but note that we do not expect this to have a material impact on bookings, revenue, or earnings in the near term since the project will have several phases and will start with a small initial rollout. I know many of you also saw an $11 billion figure cited in regard to the contract before it was announced. As noted in the DoD's press release, this estimate is now approximately $9 billion and represents the total estimated program cost over 18 years, not the value of the contract awarded. In summary, we believe the selection by the Department of Defense reflects positively on the achievements of Cerner, our partners, and all our clients. The Department of Defense is already in the Cerner family as a lab client, and we're excited to expand our relationship. With that, I'll turn the call over to Mike.

[Michael R. Nill:]

Thanks, Zane. Good afternoon, everyone. Today I'm going to discuss ITWorks and provide an update on our relationship with the University of Missouri. In the second quarter we established a new ITWorks relationship and also expanded an existing ITWorks relationship. Our new ITWorks client is Catholic Health Initiatives, and this relationship was announced in July. CHI selected ITWorks to improve continuity of care across 47 hospitals and multiple clinic settings, and Cerner will assume operational and administrative responsibilities for CHS's IT at its facilities in multiple states that use Cerner Millennium. This will include current and future implementations, upgrades, enhancements, optimization, application and operational management, and support of the system and clinical service desk support. CHI has been a client for more than 12 years, and this will tighten our alliance and support of CHI's vision of pioneering models to enhance patient care, safety, and clinical outcomes. The tighter alignment will also help accelerate the implementation of the latest technology advances available. The second ITWorks agreement I'd like to discuss is the expansion of our relationship with the University of Missouri Healthcare. MU has been a Cerner client since 1996, and we formed the Tiger Institute for Health Innovation with them in 2009. The Tiger Institute has produced a number of innovations to transform the delivery of care. Examples include e-visit technology, integrating calculators into the EHR, and developing a consumer-facing mental health app. This year the Tiger Institute launched OpenNotes, a function that gives patients access to their clinical notes through the MU Healthe patient portal. MU Health has also achieved multiple healthcare IT successes, including HIMSS Stage 7, being the first academic medical center to meaningful use Stage 2, and being designated "Most Wired" by the AHA each of the past four years. Going forward, the Tiger Institute will focus on redefining patient engagement through mobile healthcare, developing a population health strategy and network to better position MU Healthcare to lower costs while improving the health of Missourians, increasing the role of healthcare IT and academic medical research, helping transition to value-based payment models, and developing a Tiger Institute Value Creation Office to identify cost savings opportunity. The University of Missouri was one of the first ITWorks clients and institute relationships, and we're very pleased with what we've accomplished together as it demonstrates the power of close alignment with our clients. With that, I'll turn the call over to questions.

[Operator:]

Thank you. Our first question comes from the line of Eric Percher with Barclays. Your line is now open.

[Eric R. Percher:]

Thank you. Just to start, Marc, as you were talking through the Health Services business, you mentioned that non-recurring revenue was running a little lower on those that are sitting tight. I'm not sure I quite caught that dynamic. Would you mind walking through that?

[Marc G. Naughton:]

Sure. For clients that are not immediately looking to go transition to Cerner Millennium and make the switch, they are not putting in a lot of new solutions from HS into their environment. They're holding pat with their hand. That's impacting some of the services that we see normally from HS. It's certainly impacting what their normal hardware and third-party sales would be. So those clients don't want to invest in the current infrastructure if they think they're going to switch to Cerner because many of them when they switch to Cerner will go to our hosted methodology, and they won't need these computers and the hardware that they'd normally be buying. So we expect that as people decide what their timeframe for moving is that we will see that free up, and people will say I've got a three-year window or whatever the window is I need to make these purchases, and we'll see that start bouncing back. But as we look at that business, the one thing that's lower is these add-on type sales into the base that surround their existing platforms. People are waiting to get their go-forward decision before they continue to make those incremental investments.

[Eric R. Percher:]

That's helpful. And my follow-up would be, as you think about the op margin and now that you won't have the 200 basis point impact, how much of that is attributable to mix versus actions that you've taken on expense?

[Marc G. Naughton:]

I think that's a good point. When you look at the results for this quarter, clearly I think our software – licensed software was one of the strongest revenue quarters we've ever seen. So that obviously brings with it higher margin. It doesn't contribute as much to revenue growth but it certainly contributes to earnings growth. So I think from a mix perspective, we saw that. We're continuing to certainly on the HS side, the lower tech resale elements with lower margin help overall margins, don't help the revenue so much. And I think just the activity around the acquisition and thoroughly reviewing not only HS spending but Cerner spending to make sure we were appropriately investing was good for the business. So I think that's overall given us a little bit of a tailwind from the expense side. So it is a mix to some extent, but there are some real savings on the spending side that we've incurred. Part of it even is in the services business, where we are just starting to ramp up hiring now to meet the 2015 bookings demand that we saw in the first half and that we expect to see in the second half.

[Eric R. Percher:]

Okay, great. Thank you.

[Marc G. Naughton:]

Sure.

[Operator:]

Our next question comes from the line of Charles Rhyee with Cowen & Company. Your line is now open.

[Charles Rhyee:]

Thanks for taking the question. Marc, first on the revenue here, obviously you talked about less third-party in the quarter than you expected, and now you're going to ramp up the hiring. Was there something that changed that made you realize that you needed to do more of the hiring that you didn't anticipate earlier? What was the signal to you that we didn't really have enough people for the demand?

[Marc G. Naughton:]

I think we're certainly meeting all of the demand relative to project work and implementation work. Part of it was a desire to make sure that we thoroughly had a chance to review all of the HS service resources, decide what we need to stay in that business, what we could convert to doing Millennium work. I think that probably the services business we didn't address as much might have been some of the optional non-implementation work that we often see and often get signed and executed within a quarter, but I think that was prudent as we went through. I think I would certainly take it on me as probably not having the resource element reflected as accurately in our forecasting model as I should have, so although a bit of a lower revenue being a little bit lower than guidance, it's just on that. We've adjusted that going forward so that the rest of the year we feel very confident on the revenue guidance that we've provided. But it's not getting to these new projects as much as it is some of the ancillary service activities we get. And then third-party, we really like to minimize how much we use third-party services. We had a lot of meaningful use activity in the year-ago quarter, lots of work going on, and that's why you saw the much higher third-party and the much higher travel revenue that came through the P&L.

[Charles Rhyee:]

That's helpful. And then as a follow-up, obviously you highlighted revenue cycle management as an important area. Can you talk about how you feel about your capabilities in this regard internally? And you have obviously a lot of cash on the balance sheet. Is there any thoughts to deploy that to add to your capacity there – capabilities there? Thanks.

[Marc G. Naughton:]

From the revenue cycle, I think we're very happy with where we are relative to the solutions that we have out there and relative to certainly the initial RevWorks and revenue cycle activities. As we've talked about in the past, we can do anything from a full outsourcing of the revenue cycle, which we call RevWorks, to business office to just assisting with providing the solution that is state of the art relative to revenue cycle. So as far as deploying our capital in some type of an acquisition that would be in that space, I think we're very happy with where we're at right now, and I think we're doing the normal Cerner strategy of developing, spending our capital on R&D and taking the market share right now a client at a time.

[Charles Rhyee:]

Okay, thank you.

[Operator:]

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

[Donald H. Hooker:]

Hey, good afternoon. So it seems like this ITWorks business is doing very well. You gave some numbers for last year, it did well, and it seems like you keep landing nice deals there. I keep wondering in my mind whether ITWorks is perhaps somewhat of a leading indicator as well of the business for you. Is it the case where people adopt the ITWorks service and then you can really sell more product to them, or is it a lagging indicator where it's a culmination of a relationship with a client?

[Marc G. Naughton:]

This is Marc. ITWorks usually tends to be later in the life cycle of the client. It's really an indicator that the client has decided to go all-in Cerner and that they are going to replace every ancillary system they have with Cerner. They want to do it as quickly as possible. They want to do it with people that really know how to go operate in that environment. That's usually where we see the ITWorks activity occurring. Certainly as we have more and more experience, more and more clients that we can show as examples of how that's worked, it is getting to be something that our client base is developing a higher level of interest. They want to make sure that they can get their costs managed well and that they can be certainly predictable. And ITWorks lets them make their costs in the IT space highly predictable relative to running their system. So it really is, although when they sign up for ITWorks, there certainly is follow-on solutions as they switch out those ancillaries as they occur. But really once they go into ITWorks, there's follow-on business. But that's really almost not necessarily the culmination of the relationship. But at that point, we are pretty sticky in their environment, and switching from that is very, very difficult, and certainly we don't give them any reason to want to switch. That is in certainly the ITWorks opportunity. We see RevWorks starting to be able to follow in that same line. As we get through ICD-10, we think that the desire for many systems to get out of the revenue collection business and outsource the revenue cycle is going to continue to build. And we think actually when we look at how do we grow our revenue in the future, we think those Works businesses are certainly big opportunities because each ITWorks business is at least $7 million to $10 million a year of additional revenue, and some of them will be more than that. Our pipeline for the next 12 months on the Works business is pretty strong.

[Donald H. Hooker:]

Got you, and then one other one and I'll hop off. You all mentioned that you had strong growth in the smaller hospital segment. I guess I'm thinking here of the CommunityWorks offering. I also had heard anecdotes that that's moving into larger – that offering is successfully selling into larger hospital settings. Is that true? Are you seeing more traction of CommunityWorks in larger hospitals than you had seen before, or it is still predominately the small hospitals?

[Zane M. Burke:]

This is Zane. It's still a predominately small hospital offering. What we have seen are certain large clients that want to create part of their networks and use the CommunityWorks model in some of those critical access connector facilities. So if you've heard about that in some of the larger organizations, it may be part of their feeder systems as they look to create more network in their own areas.

[Donald H. Hooker:]

And did you say how many sites you have live on that service? Can you share that?

[Zane M. Burke:]

I know what the number is.

[Marc G. Naughton:]

I don't know if I've got that number right offhand, but I bet I can get it before we finish the call.

[Donald H. Hooker:]

Okay, thank you very much.

[Zane M. Burke:]

This is Zane. We have 90 sites that are contracted. Not all of those are live at this point in time.

[Donald H. Hooker:]

Thank you.

[Operator:]

Our next question comes from the line of Michael Cherny with Evercore. Your line is now open.

[Michael Aaron Cherny:]

Good morning – or afternoon, sorry, long day. Going back to the DoD contract, it's been less than a week since you and Leidos and your partnership were awarded that contract. Have you heard from any of your customers or potential prospects already in terms of what this means in terms of the way they view you? I assume some of your key customers – obviously Intermountain is thrilled to see it – but any other feedback from the field? I know you talked about the implementation and the resources you're going to have to make sure this contract is executed on plan. But I'm curious more to the upside if people view this in the market in terms of further validating just how successful you've been.

[Zane M. Burke:]

This is Zane. Clearly our clients are actually very excited for the win. We've seen a lot of very positive momentum from them, and really I do expect it to have a positive impact as we look forward to some of the competitive environments. And as you look at where we come out of Q2 with our best win rate, with the highest number of new footprints in our history, and then you add to that the selection by the DoD and our announcement today on Baptist South Florida, you get a flavor for what's happening in the marketplace that the momentum is clearly on our side. And so I do think that's a big positive.

[Marc G. Naughton:]

Michael, this is Marc. I think certainly it is pretty near term, but we had a lot of momentum going. This merely continues that strong momentum. I think it certainly was a process that was more rigorous than any we've ever seen, and to win is a big accomplishment. And I think as you look at our Q3 bookings guidance, which is up significantly, you're seeing not only our existing momentum, but our belief that this will help us close business as soon as Q3.

[Michael Aaron Cherny:]

Got it. Thanks, that's helpful, and then just one question too. Long-term bookings percent in total has been spiking up. I know we talked a bit about the Works deals. Is there any change in some of the long-term bookings you have in terms of how they are being recognized? Are you seeing any elongation or potential shortening of some of the bookings that have gone to that number versus maybe two years, three years, four years ago?

[Marc G. Naughton:]

No, we're using the same approach. It's just a lot – the deal mix just happened to have more of the 10-year deals as a component of it relative to the traditional 30% or so that we've seen in the past. It comes and goes depending on what the deal is.

[Zane M. Burke:]

This is Zane. Principally we had two very large Works deals in the last two quarters, which is also a bigger indicator in the mix of how those were. So given the size of those two big items, that had some impact on the percentage size of that.

[Michael Aaron Cherny:]

Got it. I guess it helps for the visibility long term. So thanks, guys.

[Marc G. Naughton:]

Thanks.

[Operator:]

Thank you. Our next question comes from the line of Steve Halper with FBR. Your line is now open.

[Steven P. Halper:]

Hi. So if you think about the revenue miss from the first quarter and you have the second [quarter] revenue disappointment this year, and so now you're telling us that you scrubbed those numbers, and now the guidance is – you feel really confident in that. But could you tell us what didn't happen or what changed from one quarter to the next? I'm just trying to understand what's at work here.

[Marc G. Naughton:]

Steve, it's a great question. Clearly as we went into Q2 and prepared talk to you guys last time, services is primarily the focus for us relative from a revenue perspective. Licensed software is doing well. Other elements are doing well. We are seeing some lower tech resale, certainly from HS and a little bit from us, which is impacting revenue, but the lion's share of it is related to services. Some of that, as I indicated, as we went through in more detail this quarter and we reviewed our forecasting process, I think there was something in those forecasts that gave us a bigger number than it should have. And that included including more third-party because third-party is something we have a little hard time getting visibility to because it's not necessarily – while it's coming out of backlog, it's not necessarily something that's coming out of our resources, so it's a little bit of a different model. So I think services clearly missed their forecast in this period. And I think just in the quarter, there were a couple of deals that would have contributed some decent sized revenue to the quarter, not necessarily high-margin revenue, but some revenue that didn't happen in the quarter that we would have forecasted from a revenue perspective. But at this point, I think there's nothing in the business that is causing us to miss our guidance. I think it's more the guidance was probably higher than it should have been when we went into last quarter. We've now adjusted it. I feel very confident, as you know, and you could expect to beat this really hard since we closed the quarter and prior to that to understand it well. And I'm pretty confident that we've got good numbers out there for you going forward. And I'm pretty confident that that services business bounces back as we continue to ride the momentum in 2015, continue to add to our services personnel, and have that pipeline of Works businesses that we think will contribute pretty significantly likely to the 2016 revenue number. So definitely take it as my bad on the guidance variance to date, but I'm not going to have a my-bad next quarter.

[Steven P. Halper:]

And just quickly, the Baptist deal was not in the quarter bookings?

[Zane M. Burke:]

That's correct. That was a Q3 signing.

[Steven P. Halper:]

Okay. And CapEx expectation for the rest of the year around the new campus?

[Marc G. Naughton:]

As we go forward, you're going to see us obviously spending more than we did in 2014. As you see on the cash flow, you see us having periods where we invested capital heavily. So if you go back to 2012, we had 100%; we delivered free cash flow at 100% of net income. In 2013, we bumped up CapEx significantly, and that went down to 34%. Last year we had less CapEx. This year, we're going to have strong CapEx. So we're looking at building CapEx priced somewhere in the $150 million range. So it will be pretty strong in our other capital expenditures. Including HS, it will be up from last year. But as we roll forward and we get the first phase of the campus completed, you should see us starting to bounce back from a free cash flow perspective. We got hit pretty hard this quarter from just a working capital perspective of probably $100 million of working capital. On the balance sheet, I just went negative relative to operating cash flow. That will reverse as we go forward plus my expectation as we roll forward into 2016 and 2017, you see us getting working ROI closer to getting to our goal of net income equaling free cash flow.

[Steven P. Halper:]

And what was the $150 million number that you just put out there?

[Marc G. Naughton:]

That was basically building CapEx.

[Steven P. Halper:]

Okay.

[Marc G. Naughton:]

A rough estimate of what we will probably spend because right now the last half of this year will be a pretty intensive investment relative to our buildings.

[Steven P. Halper:]

Okay, thank you.

[Operator:]

Our next question comes from the line of George Hill with Deutsche Bank. Your line is now open.

[George R. Hill:]

Hey, good afternoon, guys, and thanks for taking the question. Marc, I think I'm going to want to drill into the services revenue shortfall a little bit more too. If we look at from where the guidance originally came out in February to where we are now, it's almost a $0.5 billion negative revision at the revenue line. Can you talk to us a little bit more about where those services revenues lines get sprinkled on the income statement? Is any of it in system sales, or is it all just in that services sub-line under support, maintenance, and services? And then if a lot of this is tied to third parties, that seems like a real big move relative to the size of what we expected the income statement line there to look like for the year. I guess can you give us some examples functionally of what's going on that's pushing that line around in a pretty significant direction?

[Marc G. Naughton:]

I'd be happy to do the math on the $0.5 billion number, but I think the key is relative to, compared to the year-ago quarter, when we had a bunch of third parties getting to the meaningful use projects, that we are not doing that as much. That is harder for us to forecast and we did not do a very effective job of putting into our forecast the significantly reduced number. So that was probably $20 million in the year-ago quarter. We are lower than that this quarter. So that's a pretty big change relative to the total. I think part of the difference you talked about when you're going back to the revenue line, you've got to go back to last quarter when we talked about the Health Services deferred revenue. It was about $100 million. So there are other elements than GS Services if you're going to step back for revenue discussions we've had in the last 12 months. But from a services perspective, the key for us is forecasting accurately based on our backlog that's got to be delivered and the resources we have available to go deliver that, and we did not do that as effectively in Q2 as we should have. We've now gone through that forecast with a fine-toothed comb. So from a business perspective, it's pretty logical that with less third-party, that revenue is not going to be there. We're going to deliver the services from our own personnel, and we're adding to that personnel line every day certainly with a lot of the college hires coming out of schools that will hit us basically Q2 – Q3. Those are the resources that we need to go out and deliver the work that Zane and his team are delivering for us. So that will drive out the revenue that we've got projected. We're up against a very difficult comp relative to 2014 when we grew revenue 17%. So you've got to back of your mind at least keep that present because if you look at it two years, we still are growing revenue relatively good on average. In addition, as we roll into next year, because of what we see or at least what I see in the opportunities from the Works businesses and with the ramp-up of services opportunities from a delivery perspective, we should still be talking about being able to deliver double-digit growth in 2016. Obviously, it's early to talk about that. We haven't given you any guidance to that, but I believe it is laying out in a way that some of these Works deals could be a significant tailwind for us to get that double-digit revenue growth.

[George R. Hill:]

Okay. Then maybe asked another way, it sounds like is this a capacity issue on you guys end? Do you guys just not have the service capacity to...

[Marc G. Naughton:]

No, no, we have plenty of people to go address the work. The key is the implementation work that we're working on primarily now is that which was signed in 2014. We've seen a lot more activity in 2015. We're ramping up, so when those projects get to the point where they need resources, we'll be absolutely ready to go deliver those. But from a revenue standpoint, because of preparing for HS to come onboard, we're being very careful about over-hiring. There are certain optional services around elements that are not related to implementation that we didn't necessarily go after. That work is always going to be there. We can go pick that up at a later time, but we wanted to make sure that we didn't hire a bunch of people relative to the work that was going to be able to be out there. When you look at services, you also have a little bit of an HS element that just because of the transition that they are not as efficient as we would normally have our services people be from an availability standpoint. So those are all factors into it. At this point, I think we've got the right number out there. We feel very confident in it. We're delivering on projects as we believe we should be delivering, and we are not resource constrained relative to the business.

[George R. Hill:]

Okay, all right. I appreciate the color. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Ryan Daniels with William Blair. Your line is now open.

[Jeffrey R. Garro:]

Good afternoon, guys. It's Jeff Garro in for Ryan. I wanted to ask about the better profitability. Previously, you've talked about margins declining this year because of Health Services, but now they're looking flattish year over year. So does that mean we should expect less of a lift in 2016, or should intermediate-term margin targets be moving up?

[Marc G. Naughton:]

I think at this point we probably need to digest. And obviously when we get to Q3, we'll give you our first view of what 2016 looks like. Certainly we like the fact that our margins are trending higher; that we didn't have the negative that we anticipated with Health Services. But I think relative to 2016, it's a little early for us to give you a good view as to what that number is going to be. Our expectation obviously with Health Services was that once we set the baseline that we would be migrating them toward our margins, which should allow for margin improvement. So that would be my expectation, but at this point it's a little early to quantify it.

[Jeffrey R. Garro:]

That's fair. And then just to follow up on that, though it does seem like on the expense side of things, both in terms of Health Services and Cerner, you're doing well to take a close look at the business and manage those expenses. And how does that offset potential shifts in the business mix where maybe some of these services are going to come back in 2016; and the Works businesses, how those are going to mix in with the rest of the business model? And if there's anything from an accounting perspective that we should think about in terms of longer-term margins, that would be helpful as well.

[Marc G. Naughton:]

Most of the hiring that you could expect us to do will be on people that are revenue producing. And for the most part, our services businesses have a contribution margin in excess of 30%. So given our current operating margins, those people coming on and delivering revenue is going to be accretive to our operating margins. So I think that when you see us increasing spending, it will be in revenue producing areas. The Works businesses are a little bit unique in that for the most part I'm taking over an existing workforce. So I don't have to ramp up internally my resources to be able to handle that work. For the most part, I bring in a team that is already doing that work, and I have a core group of people at Cerner that can add some of that initial initiation of that client as part of their normal workflow. So that's easier from a resourcing perspective because once they come on, they're instantly workforce in place, the revenue and the expenses driven immediately without having to – for us to do any resourcing.

[Jeffrey R. Garro:]

Great, thanks for taking the questions, guys.

[Marc G. Naughton:]

Sure.

[Operator:]

Our next question comes from the line of Matthew Gillmor with Robert W. Baird. Your line is now open.

[Matthew D. Gillmor:]

Hey, thanks and thanks for taking the questions. I just have a couple quick clarifications. Marc, you provided some commentary around the DSO trends. Can you maybe give us a little more detail on the delayed billings you mentioned? And also, do you anticipate DSOs can get back down to the mid-60-days range, or should we be thinking about a higher long-term target?

[Marc G. Naughton:]

I think the key just on the billings was – the hardest part of some of the acquisition work is getting bills out to the clients and making sure the bills are right so that they can get paid. I think if you look at our receivables, you'll see that there was a pretty significant increase in those receivables. So I think we did a good job as we closed out Q2 of getting bills out, but you've got to get the bills out before you can start getting paid. So that was a key focus for us. And I think that's – now that those bills are flowing that we should start seeing the cash come in. And that will impact the receivables by reducing it, which would obviously will help our DSO number. As far as the – what is the optimum DSO number, 66 days was a pretty – when you're selling into healthcare, which is a traditionally slow pay industry, 66 days was a pretty low number. I'm not willing to say that that's not the number that we should be targeting and shooting for, but we'll certainly be looking at it carefully as we go forward. And once we start getting the trend down, we should get a better view as to if there should be a different expectation of getting down to that. But I think anything from around 70 days is probably a pretty good target for us to be shooting for.

[Matthew D. Gillmor:]

Okay, great. And then I just wanted to add one follow-up on the DoD contract. I know you haven't provided a lot of details around this, and I understand the sensitivity, but can you maybe give us a sense in terms of timing for when you'll be able to discuss the financial implications in more detail?

[Zane M. Burke:]

This is Zane. It's still in the procurement stage, so there are still pieces of that. So I would anticipate it will be over the next 30 days to 90 days depending on what the rest of the procedures look like as part of that.

[Marc G. Naughton:]

As soon as we're able to, we'll...

[Zane M. Burke:]

We'll let you know.

[Matthew D. Gillmor:]

Okay, thanks a lot.

[Operator:]

Our next question comes from the line of Nicholas Jansen with Raymond James. Your line is now open.

[Nicholas M. Jansen:]

Most of my questions have been asked, but I just want to get a little bit more detail surrounding the better margin performance in context of the synergies from the HS transaction thus far. I understand the mix component, but just wanted to get a sense of are we pulling forward synergies, which are driving better margins, or are the synergies tracking as expected and we should think about that building as previously communicated through 2017? Thanks.

[Marc G. Naughton:]

I think our prior communication relative to what we think HS does in 2017 is still on track. I don't know that – as I said, HS is doing a good job of delivering just based on our expectations, except for the add-on sales into their base. So I think they are on track, and we would expect them to deliver the 2017 synergies that we've discussed.

[Nicholas M. Jansen:]

And then my last question would be in terms of the gross R&D spend. Obviously, you guys have spent a lot of money when you factor in capitalized development costs and things along those lines. I wanted to get a sense of how you guys measure return on that investment. Certainly it's ballooned over the years and it's paying dividends through strong bookings growth. But I wanted to get a better sense of your ultimate view on R&D dollars and maybe when we could see that number potentially start to level off a little bit to drive faster earnings growth. Thanks.

[Marc G. Naughton:]

This is Marc. As we've moved forward certainly over the last three and four years, we've become even more convinced that acquiring technology is not an effective strategy relative to the complex systems that we're developing. So we have decided we're going to invest the dollars that we might spend on acquisitions, invest that in R&D and building the capacity. As a finance guy, trying to compute an ROI on broad R&D, if someone's got a good way of doing that, let me know. I think for me it's been a matter of faith that we need to invest in it. We certainly have a rigorous process by which we examine hundreds of projects and then decide which one of them is going to get the resourcing to get the work done. And a component of that is the expected economic return we think that that's going to drive. So there is an ROI component, but I think our strategy so far has proven very effective to build it ourselves to incorporating the Millennium and HealtheIntent platforms. And that's probably more a focus of ours than deciding based on each project what the ROI is. It's such a big view of the world we have relative to R&D that trying to segment out a single solution would be difficult. Zane?

[Zane M. Burke:]

I would just look at this and say I think we see so much opportunity out there in the future that we're going to just continue to invest in R&D and develop the solutions because the future outlook is incredibly bright. And as we look forward, we're continuing to invest for the future of the company, and we'll continue to make those investments.

[Marc G. Naughton:]

And that being said, certainly we are investing a lot of money in R&D. and it would be logical to me that the increase in R&D spend grows at a slower rate than the growth of revenue. So there should be based on the size of that number leverage in the future. But we are right now in an environment where we are highly competitive, lots of business activity, and we're going to invest to meet that opportunity.

[Nicholas M. Jansen:]

Thanks for the questions.

[Marc G. Naughton:]

Sure.

[Operator:]

Our next question comes from the line of Jamie Stockton with Wells Fargo. Your line is now open.

[Marc G. Naughton:]

Why don't we make this the last question?

[Jamie J. Stockton:]

All right, Marc. I'll sneak in the last question.

[Marc G. Naughton:]

Absolutely, Jamie. Go ahead.

[Jamie J. Stockton:]

Just an easy one. And you may have already touched on this and I missed it, but we've seen the longer term portion of bookings elevated for a couple quarters here. Should we view this mid-30% range as the new reality? You guys have a good opportunity on the Works front, not only I would assume within your customer base, but the Siemens base as well. You're obviously looking for a very healthy bookings number in the third quarter. Could you just touch on that please?

[Marc G. Naughton:]

It still is pretty quarter dependent, and lot of it's driven by there are large Works deal that's going to occur. So I think we talked about can we get to a point where we've got a good sized Works deal every quarter on a pretty consistent basis? If we got to that point, would we get into the mid-30s relative to percent from long term? I expect our non-long-term bookings to continue to grow as well. So I don't know that I'm at a point where I think 35% is the number that is going to be the standard going forward. I'd say let's see what's the percentage in Q3, and then we'll revisit that.

[Jamie J. Stockton:]

Okay, thank you.

[Marc G. Naughton:]

Sure. I want to thank everyone for joining the call today. We appreciate your attendance, and we look forward to talking to you in the next days and months. Thanks for your attention. Bye-bye.

[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 wonderful day.