Cerner's Just What the Doctor Ordered

This firm's software helps health care providers reduce errors and cut costs.
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The U.S. health care system could save as much as $162 billion annually by implementing information technology software solutions in physician clinics and practices, according to a recent study by the Rand Corporation. In addition, countless doctor errors caused by illegible and inaccurate handwritten patient medical records could be avoided by digitizing physician offices. With that in mind, we believe the growth of the medical information technology (IT) industry is just beginning.

We believe that

Cerner

(CERN) - Get Report

, which sells a variety of systems that enable doctors and hospitals to better manage information on the patients, is well-positioned to benefit from this growth. Because we already have a health care stock in the Breakout Stocks model portfolio, we are not adding Cerner, but we do believe shares are attractive at the current quote of $42.93 for investors who don't have any exposure to the sector.

Cerner could become one of the leaders in medical information technology, thanks to its large customer base and leading technology platform. The company also has a lot of other characteristics we look for in the small- and mid-cap stock universe. It has increased its revenue on a sequential basis in 10 of the past 11 quarters. Cerner's cash flow from operations has increased steadily from $37 million in 2002 to $229 million in 2005. As a result of the company's rapid revenue growth, shares have appreciated more than 400% since 2003. Even though the stock has rallied, the medical IT industry is in its infancy, and Cerner is a pure play on its growth.

Cerner is investing heavily to gain market share. The company has spent more than $1 billion on research and development over the past 10 years, and will spend another $1 billion on new products during the next five years. For comparison, competitor IDX Systems, a unit of

General Electric

(GE) - Get Report

, spent roughly $500 million on R&D over the past 10 years.

The company's fourth-quarter earnings results, reported in February, serve as evidence of its leadership position and strong execution in an industry with competition from the likes of

Allscripts

(MDRX) - Get Report

and

Quality Systems

(QSII)

.

For the December-ended quarter, Cerner reported revenue of $325.8 million, 31% higher than the year-ago period, with EPS growing 21% on a year-over-year basis to 34 cents. Its cash flow from operations of $229 million generated in 2005 marked a 36% improvement from 2004 levels, and is a sign that the company can continue to fund its growth internally without diluting equity holders with stock offerings. A good indicator of Cerner's future revenue and earnings potential is its sales bookings, which grew an impressive 58% during the quarter to a record $386.3 million.

Despite such solid results, Cerner does have its detractors. Bears cite the company's P/E ratio of 31, based on analyst 2006 EPS forecasts, as cause to wait for a pullback before buying shares. Cerner's peer group trades with an average P/E ratio in the mid-20s. Another common gripe is that increased competition -- created from investment money entering the rapidly growing industry -- will pressure margins.

However, Cerner is forecast by analysts to earn $1.35 a share in 2006 -- which would represent 22% annual growth from 2005 EPS of $1.10 -- and $1.63 a share in 2007. These estimates could prove conservative given Cerner's track record of raising its financial guidance. In addition, strong sales bookings in the fourth quarter bode well for the company's 2006 results. Considering Cerner's strong history of execution, we believe shares warrant a premium valuation, and that the potential for upside to current forecasts makes shares attractively priced relative to the company's earnings growth rate.

We believe Cerner's large customer base and strong end-market growth should leave plenty of room for the company to continue growing earnings and sales at a double-digit percentage clip. At the current quote, shares are attractively priced relative to the company's growth rate and attractive market position, and could rise above $48 by 2007.

The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please

click here.