Analyzing Cerner
From the "For Future Reference" department
A few days ago, Wall Street Journal has accused Cerner (CERN) of accounting irregularities. I’ve never heard of the company before, as it didn’t show up on my stock screener. However, the article, full of pointers to bad accounting practices has sparked my interest, so I conducted a quick and dirty analysis of the company. For that, I used only the company’s SEC filings, and yet a simple analysis has revealed so many red flags that I’d never end up investing in that company. This entry does not serve as a recommendation to purchase or sell the stock, only to show that such articles like the one in WSJ shouldn’t have to exist if the investors and investment analysts did their job properly and actually read annual reports.
For my analysis, I took the financial statements as reported for the past few years. I adjusted them by accounting only for recurring accounts, as they can be expected to grow in the future. I did so for the income statement, left the balance sheet unchanged and recalculated a new cash flow statement. The article mentioned possible creativity in creating the cash flows statement, which is why I recreated it myself.
In the next step, I looked at the company’s software capitalization methods. Cerner states in its annual reports that it expenses software after its technological feasibility is proven, and then it capitalizes it. While this is permissible under accounting standards, many companies, including Microsoft, never capitalize its software development costs (insert jokes about the technological feasibility of Microsoft’s software here). However, for an useful comparison for Cerner’s financial statements with other firms, I recalculated the company’s financial statements (in this case the income statement and balance sheet), as if it expensed all software.
Altogether, I found the following irregularities:
- Software amortization period has been around 7.4 years over the past few years. The company claims an amortization period for software of 5 years, which by itself is longer than the industry standard, but in fact it amortizes only about 13.5% of its gross capitalized software cost every year. As a result, I expect a write-down of capitalized software soon, which will impact shareholders’ equity. To get in line with a 5 years amortization period, the company would have to write down a significant portion (I expect around $100 million) in capitalized software, which would result in a similar decrease in shareholders' equity.
- The CFI profile of the company has significantly changed. Cash Flow to Income ratio is one of the best, yet much underused indicator for possible troubles in the analyzed company. Usually, one calculates it after adjusting the operating cash flow and income for non-recurring items, which is what I did, but I also used the numbers provided by the company. In both cases, the ratio has been below 1 until 2002; by 2003 it shot upwards significantly, and remained at roughly that level in 2004. This signifies that the company generates plenty of more operating cash flow than income. While this is quite possible, such a change comes gradually, not so suddenly. This has been achieved primarily by falling net income in 2003, the tightening in accounts receivable in 2003 and the loosening of accounts payable in 2004. Still, the level of change is highly disconcerting.
- Free cash flow is negative. The first indication I got of this was when I ran a cash variance report, trying to see how much cash is being generated by the company’s growth. I found that discounting for changes in taxes payable and receivable, the company’s growth in 2004 has cost it $4,000. This is an immaterial amount, but stark in contract with the company’s $54.5 million reported free cash flow. Consequently, I recalculated FCF expensing all software and removing all non-recurring items.
- The company is recognizing reimbursed travel expenses as revenue. Comparing older financial statements with new ones, I found that these show no gross margin at all. In other words, the same amount is included in sales and operating costs. This has only two effects: it inflates the company’s revenues and gross margins. While the increase in revenues is only 3.5%, I still took this amount out when recalculating the financial statements.
All things considered, I have recalculated the company’s net income, operating cash flow and all important financial ratios. I present my results in the two tables below. As you can see, the results are significantly worse, with the exception of the Return on Equity (ROE), which benefited from a lower equity numerator after taking away the capitalized software. I was not interested in this investment when I saw the reported ratios, and with the adjusted ones I will steer clear off Cerner.
Note: Per share ratios use Friday's share price and 2004 annual report financials, and are to be used only to illustrate the significance of differences between the reported and calculated financials.
That said, I do have a few positive things to report:
- The company doesn’t seem to become too reckless in new customer acquisition. It has kept a growing allowance for doubtful accounts, both in absolute numbers and the percentage of sales. I always like to see that.
- The company still looks healthy, just overpriced. In fact, adjusting the net income yielded positive income throughout the years, including 2001, when the company reported a net loss of $42 million, due to a non-recurring impairment of investments charge.
- The company is very good at reporting. Despite the irregularities, I found the annual reports to be very informative, even fun to read. Cerner has been very diligent in reporting everything and went into such details as enumerating and dissecting all its acquisitions.
This article is serving only one purpose: to show what can be done with annual statements. I didn’t need any investment reports or news articles about the company; if it came up in my stock screener and I found it attractive enough, I would have done the same, hopefully with different conclusion. I would expect anybody who is willing to wager their own money in individual stocks and especially those who advise other investors to do the same.
December 18, 2005 at 9:22 pm GMT by Jozef
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