Markets

Growth Still Possible For Some In The HCIT Industry

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By Value Hawk :

Investment Thesis

The healthcare information technology (HCIT) industry grew at a 9.3% CAGR since 2009, dragging healthcare providers into the 21st century with the help of the Affordable Care Act. Healthcare providers will take the driver's seat as the benefit of digital systems increases their demand. However, healthcare providers have also become more price sensitive when negotiating HCIT contracts. Well-positioned companies (those who focus on large hospital systems and interoperable solutions) will grow at a 6-12% CAGR through 2017.

Risks to Thesis

· Changes in product requirements: Changing government specifications will significantly increase costs for HCIT companies as they rework products to meet new requirements.

· Significant security issues: Security breaches could create patient mistrust of the system, reducing demand for HCIT solutions and increasing costs for the industry.

Industry Description

The HCIT industry includes companies specializing in software development, technology consulting, medical device integration, records maintenance, and revenue cycle management. The industry had revenues of $35 billion in 2013, low market share concentration, and it was the beneficiary of increasing government regulation since 2004. 3 Companies compete by selling software products and winning long-term service contracts.

The HCIT industry is widely regarded as a growth industry, which has benefited significantly from government regulation. Companies who specialize in providing electronic medical record services for doctors and medical facilities saw the largest gains, as this was the goal set out by legislators. While most of the growth has occurred in the United States due to the transitioning health care system, opportunities also exists internationally. 1

With many health care providers meeting the first benchmark established by the HITECH Act, HCIT companies transitioned to meeting the second benchmark, improving care by using EMRs established in Stage 1. This transition will shift revenues from software sales to systems management and maintenance. This is because healthcare providers have already adopted EMR software, and HCIT companies will have to provide new services to generate secondary revenue streams. For many companies, this secondary revenue stream is built in to their contracts through maintenance and services. For others, secondary revenues will come from the additional products they market to existing customers.

Companies compete in this industry in several ways. First, some companies benefit from working with health care providers of a specific size. For instance, Allscripts Healthcare Solutions Inc. ( MDRX ) made gains in market share by working primarily with small and mid-sized medical practices. In contrast, Epic Systems Corporation gained the largest market share by focusing on large health care organizations and academic medical centers. Companies also compete through their product offerings, where successful companies tailor their software to the needs of clients.

HITECH Act

The key topic discussed throughout this report is government regulation. This trend started with the American Recovery and Reinvestment Act (ARRA) of 2009, specifically the provision titled the HITECH Act. The Federal government established this policy to promote the use of EMRs in the United States' health provider system. The ultimate goal was to create a universal electronic health record (EHR) system. The universal EHR system would enable health care providers to access a database of EMRs not only from their system, but also from organizations across the country.

The HITECH Act is characterized by three stages, which healthcare providers are required to meet. The chart below lists the requirement timeline for healthcare providers based on when they initiated the process. The numbers in the middle identify which stage a company should be in. For instance, a provider who started the process in 2011 should be in Stage 3 by 2016.

Deadlines for Stage Attestation

Source: Centers for Medicare and Medicaid Services

According to the Centers for Medicare and Medicaid Services Stage 1 involves adopting EMRs and using them in ways that positively affect patient care. 4 For attesting to Stage 1, providers can receive Medicare incentives up to $43,720 spread over five years and Medicaid incentives up to $63,750 spread over six years. Additionally, eligible providers who choose not to participate face Medicare payment reductions of 1% per year (up to a maximum of 5% annual adjustment) beginning in 2015. Many healthcare providers initially focused on meeting Stage 1 goals, which represented the first wave of industry demand. However, it is the second wave of demand that will drive the HCIT industry forward.

Stages 2 and 3 represent the second wave of demand, and it is characterized by the focus on interoperable systems. Stage 2 meaningful use involves increasing the amount of digitally available data and using secure electronic communication between doctors, labs, and pharmacies. Healthcare providers have until 2016 to meet Stage 2 requirements. The transition to Stage 2 will result in software sales below those recognized during Stage 1. As a result, companies will need to sell new products to their customers. Cerner ( CERN ) is a company who has made this transition. Their revenue cycle management product is offsetting slowing software sales, and it generates reoccurring revenues, unlike the software sales in Stage 1.

Stage 3 meaningful use is focused on improving "quality, safety, and efficiency through decision-support tools and patient self-management tools." 5 The deadline for early adopters to attest to Stage 3 is 2017. Companies who invested early in patient-friendly products will benefit most from Stage 3. Companies who have a proven track record in data security will also benefit from the transition to Stage 3.

Transition to Stage 2

Data source: Wells Fargo Equity Report15

As of December 2014, almost 89% of hospitals and 63% of physicians attested to Stage 1 meaningful use requirements, signaling an industry shift to Stage 2. The December 2014 data also reported that 55% of required hospitals and 8% of physicians met Stage 2 requirements (physicians have until March 2015 to meet Stage 2.)

The push to meet Stage 2, and eventually Stage 3, will benefit the HCIT industry because it puts pressure on providers to adopt new technologies. Stage 2 involves installing interoperable programs, which connect hospitals to improve communication of EMRs. Stage 3 will also benefit HCIT companies, because it requires providers to communicate medical information with patients through secure methods. One example of this is eClinicalWorks' Patient Portal, which gives patients access to their medical records and a means to communicate with their doctors. 6 As providers attest to Stage 3 requirements in 2017, expect the maturing industry to grow 5-6% annually.

Companies that provide interoperable systems will see the strongest growth through 2017. However, only companies that can effectively sell their business efficiency products will see above-average growth beyond 2017.

Consolidation of Healthcare Providers

According to IBISWorld, "Healthcare reform will likely lower industry prices and enforce reimbursement models that create powerful incentives for hospitals to form large systems of care… As a result of these changes, reform is expected to increase both the number and size of [hospital] mergers." 13 In 2014, there were 95 hospital mergers, which represents a 44% increase since 2010. This is in addition to the 105 deals reported in 2012 and 98 reported in 2013. 14 These mergers are a result of the increased efficiency of large hospital systems. This is important in the post-Affordable Care Act environment, where there is strong pressure to reduce healthcare costs. While the industry is still largely fragmented, the increased consolidation will create more and larger contracts for HCIT companies. Additionally, companies who hold contracts with the purchasing healthcare provider increase their market share because of a merger. Ultimately, this trend will lead to more consolidation in the HCIT industry.

SaaS and Cloud Computing Focus

SaaS models involve providing clients with software solutions through a subscription system. Software is made available online, and updates are conducted through the cloud. SaaS is projected to account for 30% of industry revenue in 2014. 1 The resulting effect of SaaS on HCIT companies is a decline in revenues from maintenance services. Since providers are able to update their own software through the cloud, their demand for a HCIT company's support will decline. On the other hand, maintaining a cloud is an expensive endeavor, and the spending in cloud-based solutions is expected to grow at a compound annual growth rate of 20.5% from 2012 to 2017. 3 The benefits of a SaaS and cloud system are widely recognized by healthcare providers, and the decline in software revenues from SaaS models will be offset by service revenues from cloud maintenance.

Markets and Competition

Data Source: Company Financials

The 2009 HITECH Act opened the field of competition in the healthcare technology industry. As healthcare providers work to meet the stage goals, they depend heavily on HCIT companies to provide solutions that meet government requirement, make their businesses more efficient, and improve their patient outcomes.

In this market, companies vie for contracts through price, effectiveness of services, support, maintenance of systems, and the ability to tailor solutions to their client's needs. While some companies benefit from working with large or merging healthcare providers, as discussed above, others are able to grow by working with small to mid-sized providers. In doing so, they provide more tailored solutions for their clients.

In general, the market concentration is low. While some companies hold a large share of a specific client type, few are able to provide solutions that meet the needs of all client segments. 1 Investing in research and development (R&D) and skilled programmers is very important in the industry. This enables HCIT companies to meet a client's specific need and provide new, differentiated software solutions. However, this also has a significant impact on their cost structures, so a fine balance must be achieved in this regard.

Finally, as with many growing industries, the competition level is very high. As shown in the discussion of recent contract moves, the type of competition HCIT companies face is mostly within the industry. The availability of substitutes gives clients bargaining power, and the poor performance of an HCIT company's software or support could lead to the shift of an important contract.

Data Source: FactSet

Epic Systems Corporation

Epic is a privately owned company, headquartered in Verona, WI,that specializes in mid to large hospitals and integrated healthcare organizations. As such, the company focuses on providing enterprise-wide solutions for their clients. Epic leads its competitors with 97% of hospitals attesting to Stage 2 and is second in physician attestation at 26%. 15 Epic is well-positioned in the industry with an estimated 22% of market share. 1 In 2014, Epic made significant gains by winning new contracts at the expense of their competitors including McKesson, Cerner, and Allscripts. Epic focuses on many of the key industry drivers listed above. Specifically, they provide interoperable solutions and have a strong hold on the large hospital market. Epic has the best opportunity to increase their market share and they pose the largest threat to the industry's publicly traded companies.

Data Source: FactSet

McKesson Technology Solutions ( MCK )

McKesson, located in San Francisco, CA, operates in two major segments. The first, McKesson Distribution Systems, focuses on the distribution of pharmaceuticals for biotech and pharmaceutical companies. The second segment, McKesson Technology Solutions, "delivers enterprise-wide clinical, patient care, financial, supply chain, strategic management software solutions, as well as connectivity, outsourcing and other services, including remote hosting and managed services, to healthcare organization." 16 Their 2014 annual revenues were $137.6 billion, with $3.18 billion coming from the McKesson Technology Solutions segment. They also reported an operating margin of 1.2% and R&D expenses of $456 million in 2014. 16 Finally, MCK has a higher portion of debt compared to their peers, which will put them at a disadvantage if they wish to increase their market share through debt-financed acquisitions. McKesson's market share will not increase significantly, and I do not see them as a positive investment opportunity in this industry. Their strengths and efficiencies lie in their distribution business segment, which is a significantly different business model from the typical HCIT company.

Cerner Corporation

Cerner, headquartered in Kansas City, MO, provides HCIT solutions to healthcare providers of all sizes, including hospitals, ambulatory facilities, and small physician practices. The company provides cloud-based systems and statistical algorithms aimed at improving patient outcomes. They also provide software that improves billing cycle management, helping hospitals collect payments more effectively. Cerner's 2014 revenues were $3.4 billion and operating margins were 22.4% . 17 They accomplished this high margin due to their popular brand name, successful performance with large hospital systems, and comparatively large-scale operation. While CERN is able to compete for major contracts within the United States, it has also seen significant growth in the United Kingdom, Middle East, and Australia. Cerner is the best-positioned publicly traded company in the HCIT industry because they also focus on many of the drivers identified above. Cerner's low debt level enables them to finance any future acquisitions with debt, even though previous deals were financed with cash. CERN may be stuck at the number two position, because of the positive outlook for Epic, the current industry leader.

Data Source: Company Financials

CareFusion Corp (CFN)

CareFusion, located in San Diego, CA, focused on "areas of medical management, infection prevention, operating room effectiveness, respiratory care, and surveillance and analytics." 18 CareFusion operates in a slightly different environment than Epic, Cerner, and McKesson by providing products that improve efficiency and medical performance, where their competitors look to provide enterprise-wide EMR solutions. CFN has a market share of 11% and revenues of $3.84 billion, and their operating margins are about 18%. 18 While CFN presents an appealing opportunity for growth based on their niche offering, the trends towards an enterprise-wide HCIT solution give their competitors a better long-term strategy. As hospitals merge, they will force their smaller components to adopt their HCIT system. This could decrease CareFusion's market share while strengthening their competitors'.

Data Source: FactSet

Catalysts for Growth

The main growth factor in the HCIT industry is the HITECH Act and the increased focus on reducing healthcare costs. The incentives and penalties will continue to drive investment into IT solutions. When new software or system sale growth slows, HCIT companies will be needed to transition to a maintenance-based model.

The other important growth catalyst is the trend towards reducing healthcare costs, while improving patient care. With the use of data analytics, increased communication among providers and patients, and ability to remotely diagnose and treat patients, the HCIT industry will help achieve both of these goals.

Investment Positives

· The HCIT industry will continue to benefit from an increased awareness of healthcare costs in the United States. As pressure is applied to healthcare providers to become more efficient, they will seek HCIT companies to help improve their business model.

· The implementation of new IT solutions will generate immediate and long-term revenues for HCIT companies. As they transition from installing new systems to improving and maintaining those systems, they will continue to generate profits.

Investment Negatives

· As important as the HITECH Act was in spurring a growth opportunity in the HCIT industry, a change in legislation could significantly affect the industry. A change in the incentive/penalty policy would reduce the demand for some healthcare providers, changing the outlook for industry.

· Cloud storage is widely regarded as a more secure storage system than the previous, paper copy system used in hospitals. However, the threat of a data breach is very real; any significant events in this regard would cause Americans to reexamine the industry.

Valuation

In the coming years, there will be transition in the industry towards system improvement and maintenance. I expect current growth rates of 6-12% to continue until 2017, when many healthcare providers will meet Stage 3 requirements. Beyond 2017, growth rates to slow to around 6%.

Companies that focus on large hospital systems, interoperable products, and improving additional revenue streams are best positioned to take advantage of industry trends. Companies like Epic and Cerner will increase their market share as hospitals merge and look to reduce costs. Epic and Cerner will grow closer to 12% per year through 2017, but even they will be subject to increasing pricing pressure and declining demand in the long-term. In 2018 and beyond, Epic and Cerner will slow to 6% annual growth.

References

1. "Electronic Medical Record Systems in the US" IBISWorld. 2014.

2. NCHS Data Brief, 2013:

http://www.cdc.gov/nchs/data/databriefs/db129.pdf

3. Barr, James. "Healthcare IT Systems Market Leaders" Faulkner Information Services. 2015.

4. Centers for Medicare and Medicaid Services: http://www.cms.gov/Regulations-and-Guidance/Legislation/EHRIncentivePrograms/index.html

5. The Office of the National Coordinator for Health Information Technology:

http://www.healthit.gov/providers-professionals/how-attain-meaningful-use

6. Keston, Geoff. "Electronic Medical Records: Trends" Faulkner Information Services. 2013.

7. Wayne, Alex; Webb, Alex. "Cerner to Buy Siemens Health Data Business for $1.3 Billion" Bloomberg. 06 August 2014.

8. Herper, Matthew. "Cerner to buy Siemens Health IT for $1.3 Billion" Forbes. 05 August 2014.

9. Mead, Charles; Rana, Anurag. "Cognizant's TriZetto M&A Feeds Fastest-Growing Health-Care Unit" Bloomberg. 15 September 2014.

10. Boulton, Guy. "Mayo Clinic picks Epic Systems for Electronic health records" Milwaukee Journal Sentinel. 21 January 2015.

11. Armour, Stephanie. "Accenture Wins New HealthCare.gov Contract" The Wall Street Journal. 29 December 2014.

12. "Health IT Law & Industry Rep.: Elsewhere in the News" Bloomberg. 15 January 2015.

13. IBISWorld - Hospitals in the US, 2015.

14. Hirst, Ellen Jean. "Hospital mergers continued to create larger systems in 2014" Chicago Tribune. 10 February 2015.

15. "Epic and Athena distance themselves in stage 2" Wells Fargo Equity Research. 03 February 2015.

16. McKesson Technology Solutions 2014 10-K report.

17. Company press release, 10 February 2015:

http://www.cerner.com/erner_Reports_Fourth_Quarter_and_Full_Year_2014_Results/

18. CareFusion Corp 2013 10-K report.

19. "Total health expenditure" IBISWorld. 2014.

See also W.R. Berkley ( WRB ) Q1 2015 Results - Earnings Call Webcast on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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