塞納 (CERN) 2006 Q2 法說會逐字稿

Welcome to Cerner Corporation's second quarter 2006 conference call. Today's date is July 20, 2006 and this call is being recorded.

The Company has asked me to remind you that various remarks made here today by Cerner's management about future expectations, plans, perspectives and prospects constitute forward-looking statements for the purpose of the Safe Harbor provisions of the Security and Litigation Reform Act of 1995. 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 heading "Factors that may affect future results of operations, financial condition, or business" in the management discussion and analysis section of Cerner's Form 10-K together with other reports that are on file with the SEC.

At this time, I'd like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation.

Thank you. Good afternoon, everyone, and welcome to the call. I will lead off today with a review of the numbers followed by sales and operational detail from Paul Black, Executive Vice President and Chief Operating Officer.

Trace Devanny, our President will follow Paul with a discussion of strategic initiatives and our global business. Neal Patterson, our Chairman and CEO is attending a client event today. Now we turn to the results.

Our results were strong across the board in Q2. Our new business bookings were another all-time record and our income statement and balance sheet also reflect very strong performance.

Starting with bookings we had a solid bookings quarter with total bookings revenue of 311.9 million. A sequential increase of 19% and 10% higher than our record Q2 '05 bookings. Bookings margin was up 13% to 273.4 million, this reflects all-time record for Q2. Our forecast for Q3, which I will discuss in a minute, is also very strong.

Moving to backlog, our total backlog increased 32% year-over-year, and ended the quarter at 2.27 billion. Contract revenue backlog ended the quarter at 1.83 billion, which is 37% higher than a year ago. The quarter revenue backlog was 440.4 million.

Moving to the income statement, we delivered very strong revenue growth in Q2. Total revenue in Q2 was 330.6 million, up 19% compared to the year-ago period. The revenue composition was 114.4 million in system sales, 84.0 million in support and maintenance, 122.2 million in services, and 10 million in reimbursed travel.

System sales revenue grew 9% over the year-ago quarter with strong software growth offsetting a slight year-over-year decline in hardware revenue. Services revenue grew 34% compared to the year ago quarter with the primary drivers including an increase in consultants during the second half of 2005 that became fully billable this year and continued improvements in utilization. Support and maintenance revenue grew 15% over the year-ago quarter.

Our gross margin for the quarter was 80.6%, which is up about 200 basis points both sequentially and year-over-year. The increase in gross margin was driven by strong levels of software and lower levels of hardware.

The strength of software specifically reflected in the strong system sales margin growth, a 15%, and a system sales margin of 64% which is up from 61% last year and in Q1. Our operating expenses before option expense in Q2 were 221.4 million, which is up 20% over a year ago. The increase in total spending was driven by growth in our services organization and an increase in global spending related to our U.K. activities.

Moving to earnings, net earnings before option expense were 27.0 million in the second quarter, which is up 36% compared to 19.8 million a year ago. Diluted EPS prior to options expense was $0.33 per share compared to $0.25 a year ago, a 22% -- or 32% increase. Operating margin in Q2 was 13.6%, which is 130 basis points higher than the 12.3% operating margin in the year-ago quarter and up 220 basis points from Q1 of this year.

This quarter our operating margin was impacted by about 70 basis points due to approximately 15 million of 0-margin revenue from the U.K. southern cluster contract. Our operating margin without this contract was 14.3%, which is up 200 basis points year-over-year.

This level of margin expansion is in range of what we expected and we continue to target 20% operating margins by 2008 excluding the U.K. southern cluster contract revenue. With a management stretch goal of achieving that level by the end of 2007.

Now I will move on to our balance sheet which remains strong. We ended the quarter with 277 million of cash and short-term investments. Total debt ended the quarter at 202 million which is down 19 million from Q1 due to a scheduled payment in Q2. Accounts receivable ended the quarter at 331 million which is up 11 million compared to last quarter.

Contracts receivable, or the unbilled portion of receivables, were 112 million, or 34% of total receivables, which is consistent with prior quarters. Our DSOs were 91 days in Q2, which is down 7 days compared to a year ago and flat compared to last quarter. The strong year-over-year decline in DSO was driven by strong cash collections of 355 million.

We view DSO in the low 90s as a good level, particularly when you consider that we have some working capital requirements related to our project on the southern cluster of England. Without the working capital associated with this project, our DSO would be in the upper 80s. Our working capital investment will continue in Q3 but a milestone payment expected in Q4 will bring our cumulative working capital investment back to a minimum.

Third-party financings were consistent with historical levels of 7% of total cash collections. Looking at the balance sheet I did want to comment on a couple of items to provide additional clarity. The inventory count increased by 5.8 million over Q1. This reflects third-party software licenses that we bought in bulk at the end of the quarter and will resell to our clients.

On the liability side we had an increase in other accrued expenses of 11.4 million which was primarily driven by the normal quarterly fluctuation in accrued income taxes which were reported on that line. The strong cash collections led to strong operating cash flow of 60 million. Q2 capital expenditures were 30 million, including 13 million of property expenditures. Capitalized software for Q2 was 16 million.

Free cash flow, defined as operating cash flow less capital expenditures and capitalized software was 14 million. Free cash flow before property expenditures was 26 million. The property expenditures were primarily related to our new data center. Net cash used in financing activities during the quarter was approximately 15 million and consisted of 4 million of proceeds from option exercises and a $19 million reduction of debt.

Looking at CapEx for the rest of the year, you may have seen some local speculation, but we are considering the purchase of an additional building in the Kansas City area. While we can't comment specifically on this speculation, Cerner's success with our ASC approach to projects has resulted in a large number of clients coming to our K.C. campus to work on projects. This has put a strain on our physical plant.

An additional location would allow us to open up space on our primary campus to effectively host these increasing number of visits. It would not signal a significant increase in hiring, as new space would be utilized by existing associates. This would make sense where space was available at an attractive price.

I do want to point out that even if we were to purchase a building, we would still expect our total capital expenditures in 2006 to be in our previous guidance range of $150 million. This is because any spending on the building would be offset by slightly lower than expected spending on our data center.

While some of the data center spending may push to 2007 we still expect 2007 CapEx to be at least 20% less than 2006 levels. This, coupled with continued growth in operating cash flow, positions us to accelerate free cash generation to the $100 million range in 2007.

With respect to capitalized software, the 15.2 million of capitalized software in Q2 represents 25% of the 65 million of cash spent on development activities. Software amortization for the quarter was 10.8 million resulting in net capitalization of 5 million or 8% of the total.

As we discussed last quarter, our amortization will increase upon general availability of our next software release, which we currently expect to occur in Q4. That expected release time frame is reflected in our Q3 and full-year EPS guidance.

Now I will go through the guidance. Looking at Q3 revenue we expect revenue in the 330 to $340 million range. We expect 2006 full-year revenue to be in a range of 1.32 billion and 1.35 billion. Reflecting a mid-teens growth rate. Our 2006 revenue guidance still assumes 50 to 60 million of revenue and expense from the U.K. southern cluster contract, yielding no net margin as we have discussed.

The revenue from the U.K. southern cluster contract is expected to be split about 20% to system sales and 80% to support, maintenance, and services, while the expenses are expected to be split 80% to sales and client service and 20% to R&D.

We expect Q3 EPS before options expense to be $0.35 to $0.36 per share, a $0.01 increase over prior expectations. This increase reflects the strength of our bookings forecast and the fact we don't expect amortization to increase until Q4 as discussed.

The full-year 2006 we expect EPS of $1.37 to $1.38 before options expense, which is $0.02 higher than our prior guidance, and reflects 25% EPS growth. Our estimate for options expense for the remainder of 2006 is approximately $0.04 per share each quarter, bringing Q3 to range of $0.31 to $0.32 and the full year to $1.21 to $1.22.

The Q3 guidance is based on total spending before options expense of around 225 million. For bookings we expect bookings revenue in Q3 of 335 to 350 million. The midpoint of this range reflects a 14% growth over pre-southern cluster bookings in Q3 of last year which is a record bookings quarter that was 40% higher than the prior year. With that, I'll turn the call over to Paul.

Thanks, Mark. Good afternoon. Q2 was a strong quarter from a sales perspective. Here are some of the highlights.

We again had good bookings contribution from both our U.S. and global businesses with strong bookings from a wide range of solution categories including CPOE, emergency, pharmacy, physician office, and content. Our contract volume was very high in Q2 with a record 326 contracts. 13 contracts were over $5 million, 2 of which were over 10 million.

Our mix of contract bookings from new Millennium clients was 21%. Our leading indicators continue to look good. We experienced strong year-over-year increase and requests for information and quotes. And our vision center visits and site visits were at high levels during the quarter.

Our multi-billion-dollar pipeline also remains very strong with particular strength in the volume new footprint opportunities which are at a multiyear high. On the competitive front, we have seen active competitive landscape but we have not seen a major shift in the competitiveness of any particular competitor.

As reflected in our strong bookings guidance and level of new footprint opportunities, we still feel good about our ability to compete in this marketplace, and we think the favorable market conditions can support good growth for several companies.

Operationally we also had a strong Q2. During the quarter we turned on an all-time record 382 Millennium applications. This brings our total count to more than 5,500 live Millennium applications at over 1,000 facilities.

The proven nature of Millennium and our implementation abilities is reflected in the fact that we now have 22 different solutions that have been brought live more than 100 times with 10 solutions brought live more than 200 times. Our broad success in the quarter also included bringing nine additional acute care sites live with CPOE, bringing our industry leading total to 106 acute care CPOE sites.

We continue to make good progress with our efforts to enhance the delivery and operations of our solutions. We maintained high utilization of our accelerated solutions center, or ASC, Cerner's rapid delivery model that allows us to shorten implementation times while increasing the number of solutions going live per site.

We have also continued advancing our bedrock initiative. Bedrock is our wizard-like technology that automates the implementation and management of our Cerner Millennium information platform.

Q2 included more widespread use of bedrock in U.S. and global projects and progress towards expanding the number of solutions that bedrock can impact. Over 60 clients have installed the bedrock technology to assist in the design, build, and ongoing management of their Millennium systems. In addition to shorter design and build cycles, implementation projects using bedrock are already experiencing a reduction in the number of service requests per each solution by as much as 50%, which is a positive for both Cerner and our clients.

We expect to see more of these measurable efficiencies as we continue to build out this functionality and increase bedrock's use in both ASC and traditional projects. As we have said, we believe bedrock has become a competitive advantage for Cerner because of our ability to further reduce our client's total cost of ownership.

Another key element of our ability to bring down the total cost of ownership for our clients is our Cerner Works managed services business. With Cerner Works we are reducing the total cost of ownership for our clients while improving the system reliability, availability, and performance. In Q2 '06 our Cerner Works clients against experienced overall system up time of greater than 99.9%, with the majority experiencing 100% up time. Financially, Cerner Works revenue was $26.7 million in Q2 '06, which is 40% than Q2 '05 and still on a pace to be over $100 million for the year. Cerner Works also continues to drive strong contribution margins in the mid-20% range.

In addition to our broad-based success at improving our inpatient implementations we also made significant progress with our physician office implementations. We have been able to improve these implementations by applying a more systematic approach to the projects simultaneously implementing EMR and practice management solutions and using web-based training modules.

One example during the second quarter involved a small internal medicine physician practice in which we implemented both practice management and EMR solutions in seven weeks from contract signing. Just a year ago, a similar implementation would have taken 26 weeks. In the second half of the year we will be leveraging bedrock functionality for physician office implementations which is expected to further improve our productivity.

Before turning the call over to Trace, I'd like to comment on our life sciences strategy with the recent acquisition of Galt Associates which we announced in June and closed at the beginning of July.

Many of you know that Cerner has been in the life sciences business for four years providing valuable insights to our health facts data warehouse and have set a specific strategic professional services designed to assist the pharmaceutical and medical device industries in making strategic decisions in both marketing and in their R&D investments. The goal of Cerner's life science division is to become a meaningful player in the $250 billion pharmaceutical industry.

Broadly, Cerner life sciences helps pharmaceutical companies answer medicine's most vexing problems. Pharmaceutical companies develop drugs through a highly regulated process that requires very large bets on compounds, hoping that just 1 in 10,000 become commercialized. Scientists and business managers at these companies continually analyze the viability of their compounds, making go or no-go decisions throughout what can be a ten-year process. Cerner's healthcare databases are invaluable assets to help solve these challenges.

For example, Cerner's industry leading Health Facts solution had more than 35 million clinical encounters that can help draw meaningful relationships between pharmaceutical therapies and the resulting clinical outcomes. This knowledge can be used to highlight the efficacy, cost, and compliance implications of existing medicines.

In addition to Health Facts, Cerner life sciences has other healthcare databases focused on extracting proven development approaches for clinical literature as well as deep patient data focused on specific disease states. The Cerner life sciences team utilizes this data to perform highly customized research that helps drug companies better assess the market potential for compounds in their initial phases of development.

The acquisition of Galt, a leader in the pharmaceutical drug surveillance industry, adds an important capability to our life sciences arsenal. Galt focuses on pharma co-vigilance helping drug companies better understand the performance of their compound through surveillance of adverse drug events, which allows them to more effectively manage the safety of the products they bring to market. Galt also brings to Cerner an excellent client base including seven of the top ten global pharmaceutical companies.

We are excited by the potential created by the combination of our companies.. We now offer the most comprehensive solution to improved safety and reduce the risk throughout the entire pharmaceutical development, commercialization, and administration processes. With that I will turn the call over to Trace.

Thank you, Paul. Good afternoon, everyone. Today I'm going to begin my remarks with a discussion of our global business. Our second quarter again included very strong results from around the world. The broad strength of our global success is reflected in the fact that our bookings this quarter included strong contribution from Australia, Canada, the Cayman Islands, the Middle East, France, and nonnational health service related United Kingdom contracts. In England, as reported by the NHS Connecting for Health program, momentum is building with the rollout of Choose and Book, the national appointment schedule system we are delivering with partner, Atos Origin.

On July 10, there were nearly 11,000 appointments made, marking the highest number in a single day to date. This compares to an average of about 6,000 appointments per day at the beginning of May and 2,000 per day in January. To date over 685,000 appointments have been made using the Choose and Book service.

At the beginning of July, Choose and Book was being used to manage over 20% of total NHS referral activity from general practitioner surgeries to outpatient appointments. Currently 100% of acute trusts in England are now live with Choose and Book, and over 70% of GP practices have used the service.

In addition to Choose and Book we continue to make progress as a software supplier for the Fujitsu consortium in the southern region of the Connecting for Health program. As we announced last quarter, we expect several additional go-lives in the last half of the year and look forward to creating future success stories for the NHS in the months to come.

On another note, I'm sure many of you would like us to comment on the speculation that a software supplier in another region may be replaced by Cerner. However, please respect the fact that we are not able to comment on this speculation. I will only say that we continue to be very supportive of the Connecting for Health program. We're very proud of our role in the National Health Service and we hope that our execution will lead to further opportunities.

Looking at other areas of global opportunity, we continue to believe we are well positioned to participate in the increased levels of HIT activity that is expected to occur in other European countries. For example, France and Spain both have country-wide and regional initiatives that should lead to procurements over the next 6 to 12 months. As we have mentioned in previous calls we are working hard to successfully position ourselves in these markets. We also continue to see opportunities to expand our business in the Middle East and other countries in the Pacific Rim.

Finally, the healthcare challenges of cost, friction, and quality we face in the U.S. are equally daunting around the world. We believe we are building a very strong global resume that should position us for continued long-term success.

Moving to the U.S. market, we also continued to enjoy strong healthcare IT environment in the United States. As we've discussed, the financial health of acute care hospitals remains solid, and a recent report by Fitch ratings gives hospitals increased support for making investments in healthcare IT.

In a May 2006 report Fitch concluded that investment in capital related to quality and patient safety will be a differentiating factor in credit quality going forward. Fitch also believes that CMS will move to a reimbursement system driven by quality and patient safety outcomes, which highlights the need for systems that can not only report on these key metrics, but also guide clinicians toward providing the safest possible care. With a report by Moody's in 2005 that came to similar conclusions, it is clear that the rating agencies understand the importance of strategic healthcare IT investments.

The second quarter also included progress on the legislative front. The week of June 5, was National Healthcare IT week, and highlighted a variety of advocacy efforts currently underway in Washington.

As the week came to a close, representatives, Paul Ryan of Wisconsin and Dennis Moore of Kansas introduced the Independent Health Record Bank Act in the House. This bill is the companion bill to the legislation introduced by Senator Brownback of Kansas earlier that same week which will allow Americans to carry their electronic health records with them in a debit card fashion connected to a lifetime patient account. This account would then be available to provide critical health record and payment information where it is needed the most at the point of care.

This bipartisan legislation was a positive capstone to a National Healthcare IT week, and we are pleased to see continued momentum on the Legislative front. Another recent development impacting the healthcare IT landscape is the certification process being driven by the Certification Commission for healthcare information technology or CC HIT. CC HIT is the recognized authority in the United States for certifying electronic health record products.

They are an independent nonprofit public/private organization that sets the benchmark for healthcare information technology. On Tuesday it was announced that our Cerner PowerChart electronic health record solution is CC HIT certified and meets CC HIT ambulatory electronic health record criteria for 2006. As a CC HIT certified product, PowerChart was tested and passed inspection of 100% of the comprehensive set of criteria for functionality, interoperability, and security.

This certification process sets the stage for interoperability, and for widespread adoption of electronic health records. Being among the first companies to be certified is an important step for our growing position in the physician office practice marketplace. As we mentioned on our last conference call, our approach to addressing this market is leveraging our proven hosting capabilities to provide low-cost, high-value services to physician offices.

We offer both CHR and practice management solutions with low up-front costs and a reasonable recurring subscription fee. The level of interest in this model has exceeded our expectations for the first six months of 2006 with over 90% of new footprints and migrations choosing a subscription model. In addition we are beginning to see positive results from our efforts to leverage our strong inpatient presence to generate new opportunities for our physician practice offering.

Now I'd like to provide with you a quick update on some of our regional network activities. Through our Tennessee initiative with our partner Shared Health, 1.1 million Medicaid recipients in Tennessee now have a community health record, or CHR, that is accessible by their personal physician in the many emergency departments across the state.

In addition, we expect to add nearly 600,000 commercially insured citizens in the third quarter. Through a similar pilot program in Kansas, which we mentioned last quarter, we already have a CHR for 200,000 people in the greater Wichita area and we're optimistic that the scope of this important initiative will continue to expand.

I'm also very pleased to announce we've signed contracts in Florida and Oklahoma for new CHR initiatives during the second quarter. In Florida we are building the community health record for managing the uninsured population for the Palm Beach Community Health Alliance, which is a coalition of more than 20 healthcare sites. In Oklahoma we are facilitating a health record data exchange for 14 counties in northeast Oklahoma.

Finally, we continue to advance our first of its kind employer driven approach to care coordination in greater Kansas City. This initiative called Healthy mid-America will provide employees of participating companies a portable personal health record that holds the promise of improving the quality and completeness of care they receive in venues across the Kansas City Metropolitan area.

During the second quarter, the Federal Reserve Bank of Kansas City became a founding member of Healthy mid-America joining other founding members such as American Century Investments, Applebee's International, Sprint Nextel and YRC Worldwide. In summary then, we believe our progress on these initiatives solidifies our leadership role in creating systems that will continue to coordinate care across all parts of our fragmented healthcare delivery system. With that I will open it up for questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Steve Halper with Thomas Weisel Partners.

Relative to the growth in the services line you talked about consultants becoming -- the consultants maturing and getting up to being fully billable. Given the growth that you've had in bookings and backlog, is it possible that you are going to have to ramp up the number of consultants again, thus at some point dragging down the growth in the near term, to satisfy that growth in systems?

This is Paul. We've actually, through the efficiencies of bedrock and ASC and other things we've done internally, we're not seeing a one to one relationship between the growth in the top line on the services business and the need for that to have an accompanying growth of the associate.

We've been focusing over the last three to four years, as you well know, on different approaches and methodologies so that we're more efficient in that regard and we're very pleased with the progress we're making there, and we expect that we are not finished with those efficiencies at this stage.

And one quick follow-up. On the 106 acute care sites using CPOE, does that include ambulatory groups associated with acute care hospitals, or is that just inpatient use of CPOE?

That's just inpatient use, Steve.

What's the ambulatory number?

Hang on. It's over 400.

Thanks.

You bet.

Your next question comes from the line of George Hill with Leerink Swann. Please proceed.

Good afternoon guys. I'm wondering if we can drill down into the system sales and software numbers a little bit more. I recognize that the Q2 number is, the growth rate is down a little bit on the change in hardware mix, but can you give us a little more color on maybe what domestic software sales the change was or the increase year-over-year, maybe first half over first half compared to last year?

Hey, George, this is Marc. I'm not sure that I've got that detail right in front of me. The high level answer is, as we said in the script, that hardware, which had been increasing, especially last year, on a year-over-year basis, basically declined a little bit while we had strong software performance both domestic and global. So we had actually performance across the board from our business in that space.

In looking at the increase in that line, as most of you know, we focus more on the margin line because that equalizes the mix relative to hardware and software. We were pleased with the growth that we realized in that space of about 14 to 15% on the system sales margin line.

And I imagine hardware is down because you're selling more hosted solutions?

Yes, we had a -- keep in mind that that initially hit us very hard in '04, reducing hardware sales, but we have been focused on reselling hardware back into our client base. We just didn't sell quite as much of it in Q2 as we had in the year-ago quarter.

I guess a quick question for Paul. You spoke briefly to the domestic competitive market and there being room for multiple players to grow. I'll just say through what me and a lot of investors have discussed it, it seems like one competitor in particular seems to doing well lately.

Can you talk about, I guess, can you just provide a little more color on the competitive environment, especially as greenfield opportunities present themselves and how the Company feels positioned as the bigger academic med centers come up and the multihospital contracts become available.

Over time we have had quite a bit of success, depending upon what markets you're talking about. Whether it's a large lab system or a large pharmacy system or a large CPOE system, or mid market, so in any given different marketplace there's a different competitor quite frankly that we are competing against. Overall our competitiveness has been quite good over time.

So as an example, there are three different competitors that we always compete with and laugh. There are three different competitors, and none of which are the same that we compete with when we are working in the pharmacy area across the multi, let's say IBN, or the multi academic, or the multi pediatric space there's usually a short list of people that we are used to competing with, and we're doing quite well in that regard also.

And I'd reference just our results on the new business sales that we had being 20% of people who report, no one else in the marketplace reports a number that is that high. I will also tell you, that having just sat through, there are two days of forecast feedings for Q3, Q4, Q1, and Q2, there's nothing that's going to lead me to think that our competitiveness has taken a hit here. So we're still very bullish about our ability to make the numbers and continue to make them and continue to grow that very robust marketplace. Not only in the U.S. but worldwide.

Your next question comes from the line of Atif Rahim with JP Morgan. Please proceed. Your next question comes from the line of James Kumpel with FBR. Please proceed.

Good evening. Marc, can you comment a little bit on the incremental increase in amortization of capitalized R&D that you expect in fourth quarter relative to the third quarter?

Sure. Based kind of on our guidance, we're looking at somewhere in the neighborhood of $2 million as an increase to that capitalization expense. So that's what we -- if we were modeling out, that's what I would recommend people look to model an increase in that expense of 2 million.

And would it be reasonable to expect that fourth quarter is kind of the quarter that you will be rolling out new products in general to basically trigger that? On an ongoing basis?

On a going forward basis, the reason that we made the change was that our development cycles will actually vary over time. So based on the amount of feature and functionality that's going out in the release will determine the date of the release. So it could -- the development cycle could vary. So December is not necessarily or not December, just Q4 is not necessarily when we would expect to roll things out. It could be any quarter. We'll try to give people as much visibility as we can once we start those projects. It just happens that this year has come out in Q4.

Can you talk a little bit about -- or actually anybody, can any of you talk about your capacity as a company to handle potentially two or three massive contracts? If some of the rumors are true, in the U.K., what's your capacity to handle two or three contracts simultaneously? And would that require some of your resources in the U.S. to be to be redeployed overseas if that were the case?

This is Paul. The capacity that we have to be able to go and work on additional work, should we be lucky enough to get it, in one specific instance that I think you're referring to, just broadly if we back it up to the top, today there's about 10% of the workforce in the Cerner Corporation is in the global business. That 10% reflects all geographies. So it's not just the U.K. So having the benefit of a big contract in some other location would not require us to have a student body left to go accomplish that. We will be, as we are today, we're a subcontractor, so we're not the prime contractor.

The prime contractor, you would be accountable for performing 100% of the work effort and that is not a position that we will find ourselves in. So in both of those scenarios we are confident that we can take on more work from an engineering perspective, and we're also confident we can take on the work from a deployment and development standpoint to be able to meet the obligations that we have signed ourselves up for on behalf of the citizens.

Just, Paul, I think you mentioned some of the growth drivers in the quarter of bookings, this will be my last question. Can you comment on Probe Fit, and can you comment on some of your business in the tax area?

Yes. On Probe Fit specifically, we sold two more systems this last quarter, and we turned on another one. We have 29 Probe Fit clients in total and we have 9 of those projects that are in process. So that's the Probe Fit update. Probe Fit making great progress there.

We're getting our clients updated to the latest release of our IP there. That is feeling very good, the trajectory there is very good, and the feedback we're getting back from our clients is that we're making substantial progress on AR days, on collectability, on customer satisfaction, and client service because our ability to generate a single bill is meeting some pretty interesting market demand out there. That's just on the revenue cycle piece.

On the tax piece, what we've got, 66 clients, I believe we also sold two more clients last quarter, excuse me, we sold five more tax clients last quarter, and we're making good progress there as well. That is a marketplace that we're excited because the worldwide acceptance and the worldwide interest in that. Probe Fit, obviously, is designed domestically, has unique attributes that are -- state by state that are different. On a global basis the revenue cycle piece is being met with wide receptivity as well.

Thank you very much.

You're welcome.

Your next question comes from the line of Steve Unger with Bear Stearns. Please proceed.

Hi. Could you provide an update for us on the number of contracts or the percentage of contracts that are implementations that are fee for service versus fixed price?

Yes. I think that trend has been fairly consistent over time. It's been about 20% fixed fee versus fee for service, and within a range that's kind of what we've been seeing. So it's -- we expect that to increase at some point as we do more of the bedrock system improvements and utilize that more in our projects, but today that's a pretty good estimate of the approach. Obviously our accelerated solution center and ASC is also prime user of a fixed fee contract.

And then do you consider that to be a competitive advantage in contracting situations, having a fixed price implementation?

Absolutely, because one of the things the clients want to know is total cost of ownership and they love it when they have a guarantee of what they're going to go pay for the solution as implemented.

So where we can go and offer a fixed fee price, especially when the implementation is very well defined, that is a differentiator in the marketplace. Having our own implementation resources to do that in a very controlled and consistent manner is huge when you compare that to our competitors who often have to use third parties to install their systems.

That's what we believe over time will continue to be a competitive advantage. By going fixed fee we are able to meld all the elements, value and come discerner where as third-party contractors have to get their money out of their services alone.

Is there a way to give us some color as to how your implementation profitability is improving?

Yes, I think the best answer there is to continue to look at the contribution margins that we're driving out of our professional services organization. So we delineate that on a periodically kind of on an annual base, and I think that you've seen us pushing those into the upper 20% levels. We absolutely expect that as we continue doing the fixed fee implementations, pulling those into -- to get on, to go over 30%. Currently we are on track in '06 for our contribution margin improvements in that space.

Okay. Lastly, Trace or Marc, could you comment on the economics associated with the CHR initiatives? What do those programs mean for the Company financially?

I can give you an idea of what the -- economically. Currently Tennessee is our biggest contract, biggest client out there. Those are fairly significant revenues. Driving out pretty reasonable margins. We're talking just that contract can be 6 to $8 million coming through on a year. I think we're -- as you see us continue to -- the thing we really like about that model is per member, per month.

We expect all of those to grow. We expect our Tennessee experience to grow as we start adding some of the core profits from the insured covered lies to that. And you'll see us, not only the recently announced Kansas pilot, but you'll start seeing us announce additional pilots and additional states. As those continue to grow it is very nice subscription type, per member, per month revenue stream that has high levels of visibility and good profitability.

So that's all recurring revenues, then?

Yes.

Great. Excellent quarter. Thanks guys.

Thank you.

Your next question comes from the line of Richard Close with Jefferies. Please proceed.

Yes, thank you. Congratulations. I guess a follow-up to a question that was asked before with respect to if you secure any additional contracts in the global marketplace, I guess the U.K., let's say, does that make you wary of spreading yourself too thin with respect to France or Spain or any other additional countries?

Richard, this is Trace, frankly, we have been in the global market for going on 20 plus years in various capacities. We have planned very carefully to scale our abilities in the various markets around the world. And couple that with the fact that we've struck some very important multinational global relationships with people such as Fujitsu, that really does position us, I think, just to bring in the expertise, to bring in the end user solutions, and work with partners to build out a successful deployment. So we're very comfortable that we're growing the business and scaling our business on a country by country basis. We've -- I think our partners would tell you the same, and as we look to expand our abilities in other parts, perhaps the NHS, but certainly the other parts of Europe and the Far East we will continue that strategy and it's working very well so far.

Then maybe if you could talk a little bit more about the physician marketplace, ambulatory. How are you going out and selling that -- those products? Do you have a dedicated sales force for that? Maybe if you could provide additional details there.

Sure. Well, we're first of all, very excited with the record top-line performance of our physician group in the Q2. In the first half, frankly, and the subscription model has led the way as I indicated in my comments. So we're doing it the old fashioned way with people actually making the most of a face to face encounter, as a sales -- as a bag carrying salesman, but more importantly we're being very efficient because we're using telemarketing, telesales to make sure when these people show up they have a chance to make a very good impression and maximize their ability to get business closed.

So that's been very effective for us. We're also using the web to do a lot of our demonstrations. So our cost of ownership is a model for all of Cerner, and the cost -- excuse me, the cost of sales is a model for the rest of Cerner, and we're very, very pleased I think with the progress we've made. And we are just beginning to light up the fact that we have a great inpatient presence as you know, and that's beginning to give us great leverage in the market as well.

Then, one final question I guess for Marc. Looking at the operating margin improvement year-over-year I was wondering if you guys have been able to dissect that a little and really break out how much of that was contributed by ASC and bedrock and maybe the percentage of Implementations using those systems.

Yes. It's not at that discrete a level. It's not really a, from our standpoint, a good analysis. What you're seeing is pretty much across the board professional services are doing a good job of increasing their contribution margins. They're a third of our revenue. So them increasing is just a natural benefit to the bottom line. You've seen us a little bit better mix of hardware, which is lower margin and we've had some very good strength in the software space which is higher margin. So it's a little bit of the business mix.

It's a strong contribution from professional services, which is related a little bit to the ASC and to the bedrock today, but there's plenty of room for that to continue that growth. So there's no one piece of the business that I would say is necessarily driving forward. If you look at our slides that we present as we talk to investors, they're on our website, there's several areas that we're looking for to generate our margin growth and all of those cylinders are really being driven effectively based on that plan today.

Do you have any other productivity plans to talk about now, other enhancements?

Nothing. We've tried to be very transparent about what we're doing relative to increasing margins, so I think that slide is a pretty good indicator of our current thinking of what we're going to do. Clearly that's not everything we currently have on the drawing board, but at this point that's -- that clearly is what we're sharing with everyone.

Thank you.

Your next question comes from the line of Anthony Vendetti with the Maxim Group. Please proceed.

Thanks. Just a couple questions, mostly for Marc, I guess. The operating margin, Marc, you said was 14.3% without the 0-margin southern cluster.

Correct.

And the goal of 20%, is that the average for '08 or is that what you expect to exit '08? And that also, I'm assuming, excludes the southern cluster?

The 20% is for all of '08. It's an annual number and it excludes the southern cluster.

Okay. Capitalized software, can you just go over that number ago impawn for quarter?

Yes. Let me just--.

As you're looking for that, that number has come down as a percent of earnings, as a percent of operating earnings. Why is that continuing to come down, and do you expect that to bounce up in the fourth quarter? Is that what you said?

The amount of amortization or the net impact of the cap?

Well, I know you said the amount of amortization is expected to go up but what about the net? Is the net expected to also go up a little bit?

It should actually go down.

It should go down? Continue to go down?

Right. Because the net difference between -- as my amortization expense goes up in Q4, my capitalized software amounts should remain fairly consistent. 16.2 during this quarter for capitalization.

So you expect that to stay relatively consistent.

That should stay fairly consistent with a -- at least in that range. And then as I said, Q4 we're looking for an uptick of about 2 million over the 10.8 million we had this quarter.

2 million uptick in amortization. Lastly, you said that CapEx should come down at least 20% from the '06 level. You gave -- did you give the free cash flow number for '07?

What we indicated was, if you do the math and take -- map out where you would expect us to end this year, and then you add a benefit of basically 20% lower CapEx next year on 150 million of this year which is a $30 million benefit.

Right.

Then you add in basically the net income increase based on your estimates from '07 versus '06, those two numbers add about 55 million to cash flow depending on where your numbers are at. As long as -- if you're modeling free cash flow this year of 40, 45 million you're going to end up in the neighborhood of 100 million of free cash flow for '07.

And lastly, I know you guys have talked about this, I guess, a couple of times already on the call, but do you have an actual number for the number of employees you have located in the U.K. working specifically on the southern cluster? You said 10% of all your employees are located globally, but do you have a number?

It's about 4, 450 right now.

400, 450.

Yes. So it's a sizeable workforce.

And the southern cluster contract, if I remember from Audiex, was about $1 billion over ten years or so and they as the software component were I think approximately 400 million of that 1 billion, or 1.1 billion. Is that pretty much the range for what the southern cluster contract is worth to you over that time period? And then from what I understand the London contract would be slightly smaller than that. Is that accurate?

I can tell you that on the Fujitsu contract that we've talked about it being in the 4 to $500 million range relative to Cerner Corporation, and I certainly wouldn't have any idea of any other contract as we only have one contract in the U.K. other than the Choose and Book contract.

Great. Thanks.

Your next question comes from the line of Sean Wieland with Piper Jaffray. Please Proceed.

Thanks. With you guys touching just about every segment of functionality in the market I'm wondering if you can give me your perspective on what you see as the fastest -- the segment or the market that is in the best position to drive software sales? For example, is it enterprise software sales to large health systems versus the departmental sales to maybe existing customers? Is it the ambulatory market? Is it the international market? What should I think of as having the greatest impact on the software sales line?

This is Paul. As I mentioned in my comment there's a number of different elements that are pretty hot, if you will, right now. The entire physician office marketplace is going quite well. The CPOE marketplace we have not seen any backing off of that. The what I would call the acuity, high acuity marketplaces. So the surgery, intensive care and the emergence room are all going really well. We're somewhat uniquely positioned from other people who talk to you from the standpoint that we also have the breadth to be able to compete in some of these marketplaces on a global basis.

So the software sales and the overall top line of the Company are being risen -- or being driven by many different elements and it's our ability to be able to execute and turn systems on and have people talk about us in the marketplace, and have those people pay us faster that are helping with the top line, helping with the referenceability, and helping with the DSOs. So we're -- we always see room for improvement, but we're very pleased with the market outlook that we see and we're very pleased with our ability to execute and deliver value because at the end of the day that's what our clients want is for us not only to sell these things, but to turn them on, and we're not aware of many other people out there who are turning systems on as effectively and as consistently as our company has done over the last five years.

If I were to go back in time and ask that question say a year ago would that be a pretty similar response or how has that response changed over time?

I would say that the response would be similar last year.

And then relative to the international opportunity, can you talk about how that business is tracking relative to your expectations? You've made some bullish comments on it in the past and on this call. Is it on track, ahead of schedule?

We had a very, very solid quarter across all of our markets in the global business. I would tell you that it's exceeded our expectations, as you know, and as you probably follow, the healthcare is not a U.S.-based problem or challenge. It's global challenge. The difference is often times in these other countries they make decisions at a government level, primarily single payer systems that have huge impact, or could have a huge impact if you're positioned with the depth and breadth of solution to be a player. So I would tell you that we've been -- it's exceeded our expectations and we expect that it continues to do so.

Great. Thank you very much.

Your next question comes from the line of Sandy Draper with JMP Securities. Please proceed.

Thanks. I must have slow fingers. A couple quick questions. Marc, I missed your comment about the guidance or operating expense guidance for the third quarter.

Around 225 million.

And that excludes or includes the option expense?

I'm sorry, it excludes option expense.

Which would be around that similar 5 to 5.25 million?

It's $0.04 per share.

Then the second question I guess is for Paul. In looking at your bookings guidance for the third quarter, as you pointed out, if you take the middle of the range you're looking at a slightly higher or accelerating in terms of growth rate. You've given some good color around the broad view of that, but could you maybe look at, when you look at -- is it the pipeline that's getting bigger or your confidence of closing deals in terms of why you think that number looks like it's going to probably be a better growth rate? Or is it maybe just quarterly fluctuations and it's hard to really say it's a better pipeline or a better close rate?

It's -- just within 90 days we now have real good visibility as to what we expect to close, by name, serial number, by zip code, and we feel it's pretty good given our historical ability here to get stuff done. Within 90 days, our visibility as you know is as high as it's ever going to be. That is something we feel quite good about. The other thing is that we've got some, as I talked about earlier, there are some newer contracts and some large contracts that are out there that we are moving through the pipeline and that pipeline over the course of this year has increased from the first two quarters at an accelerating rate.

Okay. Would you categorize -- are you sort of more bullish about where you are today than you were 90 days ago, or 180 days ago, or is that really just reflective of maybe some of the -- again the quarterly fluctuations? I'm just trying to get a sense for with the growth rate accelerating, is it something better or is it really just on a quarterly basis you're going to see some bouncing around?

I feel as good today as I did 90 days ago, and as probably good as I'm going to feel October when we have the call again, from the standpoint of there's a lot of activity in the marketplace. We have very good solutions on a global basis. The markets are becoming more predictable for us, and all of those lead to numbers that we feel pretty good about, Sandy. It's not really anything other than that. It's a good marketplace. We've got a very solid team. We've got a very solid set of solutions. We've got a very robust solution out there called Millennium that a lot of people are looking at and we're turning them on which is probably one of the most single most important things that we can do is install this stuff, turn it on, and have more references out there.

Great. Thanks for the color, Paul.

Given the time why don't we take one more call.

Your final question comes from the line of Duane Pfennigwerth with Raymond James. Please proceed.

Wonder if you could comment on how you're structured from a sales perspective internationally and what overlap there is between the two markets?

We have a country by country approach and based on the emerging opportunities clearly we have more attention in England than we would have in, say, perhaps Spain. That will change as these market continue to evolve. But we use a country model that I think is built on our synch model here in the U.S. Clearly in these single-payer types of markets we don't have the requirement, the infrastructure of sales because you have fewer places in which to call. Typically the decisions were made of -- typically decision were made at a government level. So we're able to leverage our investments in R&D and Millennium. We're able to leverage our service organization with the help of other partners and the folks that we have that are calling on the actual opportunities, it doesn't have to be nearly as many, and therefore we've had great leverage and great success to date.

But it's a country by country basis. Not everyone speaks every language in Europe, so we have to be very careful in how we line up and make sure that we're bringing people in that speak the language, that are native, understand the work flow, and therefore -- and then, frankly, live there. So it's a slow process. We've been doing it for a long time, and we're pleased with our progress.

Great. What level in the organization would you say is reviewing pipelines from both international and domestic markets?

Every level of the Company reviews every line item of our business every month, every week, and every quarter. So it's -- you can't scale -- there are not many companies in the world in information technology that have the ability to scale as successful as we have across a wide continuum of the healthcare landscape. It's something we're very conscious of and we work on it very hard every day and I think it's paying off.

Okay. I guess what I was trying to get at, to what extent do you have domestic sales people focused on international opportunities?

Zero. I'm sorry. My point earlier, was it's all native speaking in-country sales forces that understand the work flow, understand the language, and understand the healthcare system.

Great. Thank you. Marc, could you just remind us, what was the initial CapEx to start up the southern region and the U.K.?

You talking about the initial working capital?

Correct.

It was minimal. The pay -- until we really rolled into '06, payments we were receiving were basically offsetting the costs we were incurring. In '06 the payments are -- the next payment scheduled for Q4, so there will be some investment in working capital for Q4 then, then we'll be back to basically zero, or a very minimal amount, which was our plan.

I understand from a financial statements perspective you're not going to realize margin in the near term here, but is there an economic margin that you could realize sooner than when you've communicated?

The cash will be spent once we get through these initial bills which will, as I said, kind of track our working capital. So cash will actually be similar to the revenue stream. It will kind of offset our expense for a period of time, then it will get to a -- kind of a steady state, slightly increasing over time as our cost kind of flatten out and the margin starts getting recognized on that deal. So in this case, cash and revenue are somewhat linked.

Great. Thanks. Wonder if you could just comment on what the contribution from the physician office market was this quarter?

Once again, it's a fairly new business for us, so it's not a material contribution to the Company. It's probably going to be, for an annual basis, it runs about 70 million in revenue, so on a quarterly basis it's doing about 17, 18 million in revenue, and it is profitable, so we are -- it is contributing to the earnings, but as we roll out the subscription method it will be a little time before we -- it has a material impact on the bottom line.

Great. Then is there any potential or historically have you seen any revenue pull through associated with new product releases? So is there a maintenance renewal event or an up-sell opportunity that could trigger in the fourth quarter with the release of your new version?

Our support is basically -- entitles all of our clients to an upgrade of their software at any point in time. So unlike some of our -- the other people in our industry, we don't recognize a one-time bump from people moving to the next release. We will have maybe some service revenue but there isn't a one-time license fee. We think that's the smart way to do it. We charge a premium for our support, our clients understand that, lets them get on the most current release. That reduces the cost it takes to support those clients, so we think it's a good model, so you won't see a bump from the release.

Okay. Thanks very much.

Yes, I think -- this is Trace, I'll make just a couple of closing comments. First let me thank you all for joining us this afternoon. As you can tell we're very, very pleased with the strong results of the Company across the board both from the U.S. marketplace and the global marketplace. But we're particularly pleased with the strength of our market. I don't think there's any company in this business that has the depth and breadth that Cerner can offer across the continuum of healthcare from physician office to life sciences to the global markets, emerging regional networks where we've begun to get good rate traction, and, of course, our traditional U.S. business. So our ability to scale both on the people and the solution side of the business has been something we've worked very hard to maintain and I think the numbers would indicate that we're able to do that successfully.

We're also pleased to see the government legislation is beginning to catch up with the marketplace. We think that only means good things for our business going forward. And as we said in our comments there is room for a number of players in this business to be successful. There's no one that offers the scale that we bring so we like our position better than anyone else as you would expect us to say, and particularly bullish on the markets outside the U.S. So we expect to have a very strong finish to a very strong start in the first two quarters, and we think Q3 and Q4 look equally good, if not better, and we're very bullish on our ability to close here. So thanks for the time today, and I wish you a good evening.

Thank you for your participation in today's conference this concludes the presentation. You may now disconnect. Good day.