The EHR Landscape Report 2010: Its Only the Beginning

September 21, 2010

The EHR Landscape Report 2010: Its Only the Beginning

Research Conducted By: Waco Hoover, CEO The Institute for Health Technology Transformation BenjaminHarding, MBA The Institute for Health Technology Transformation Todd Brockman, MBA The Michael Bass Group Publication Date: September 10, 2010 Published By: The Institute for Health Technology Transformation

September 21, 2010

EXECUTIVE SUMMARY
The purpose of this report is to take a more in depth look at the emerging (EHR) electronic health records landscape. It has been forecasted that this area of health information technology is poised for the most rapid growth as healthcare providers begin to adopt these EHR technologies. It is estimated that 10-15% of healthcare providers are currently using an EHR system. Many of these EHR companies revenues will expand dramatically as the government stimulus incentives are spent to implement electronic health records software and the industry more broadly adopts EHRs. Our research uncovered approximately 400 companies doing business in the EHR space. The EHR landscape is still in its infancy and is primarily dominated by approximately 30 companies in terms of revenues. It is a very fragmented market with the remaining 370 small players servicing the space. As more information becomes available through our research we will update our report accordingly. According to research firm Frost & Sullivan, the U.S. ambulatory EHR market is expected to double from $1.3 billion in 2009 to $2.6 billion in 2012. 1 Due to a number of changes resulting from health care reform and financial subsidies from the HITECH Act, adoption rates among U.S. physicians are expected to increase significantly over the next 2-5 years. The report suggests that HITECH will indirectly stimulate the health care market by encouraging providers and other stakeholders to finally adopt information technology in their organizations. As the market matures, year-over-year shifts in revenue are expected as a result of increased competition causing a decrease in pricing models. As has been well documented in some circles and woefully underreported in others, the Federal Government is spearheading a massive national effort through the American Recovery and Reinvestment Act (ARRA) to modernize healthcare in the United States. As often is this case, this will be effectuated by a carrot and stick 2 method of providing grants to healthcare providers for becoming what is called a meaningful user of Healthcare Information Technology (HCIT). However, while it is fashionable to discuss HCIT as an industry in its infancy and this incentive program as being in a similarly nascent form; this is simply no longer an adequate description of this segment of American healthcare, government, or finance. A salient example of this new phase in the HCIT market came in July when the Government, after much deliberation and delay, defined both the meaningful use standards that will guide stimulus spending in the space as well as the certification standards for Electronic Health Records (EHRs). 3 As the more seasoned reader will know, the EHRs are nothing less than the foundation of all government activities in the HCIT space. This is the case because near universal adoption of standardized, portable EHRs is predicted to drastically curb healthcare expenditures by as much as $81 billion annually 4 through reducing duplicative treatment while naturally winnowing opportunities for fraud and abuse. Additionally, this EHR grid will be the infrastructure on which more advanced HCIT services, such as healthcare exchanges or results-base care, will be effectuated. Because of this centrality and primacy, this class of software services is the central focus of ARRA spending. As recent equity research reports to this effect have well documented, the HCIT space has been very resilient through the financial crisis both in terms of issuance of public equity and M&A activity. 5 This financial market stability, coupled with the advancing sophistication of government policy, lends credence to the argument that HCIT should now be viewed as a more mature, diversified market than most information sources have traditionally conveyed. It is this maturity and diversity viewed from both the business and capital markets perspective that we will now examine further.

1 http://www.healthcareitnews.com/news/ehr-market-projected-double-2012 2 http://www.chita.org/downloads/Rose_Kanvik.pdf 3 http://www.hhs.gov/news/press/2010pres/07/20100713a.html 4 http://www.rand.org/news/press.05/09.14.html 5 Christopher McCord. Healthcare Information Technology and Related Services, Quarterly Market Report. April 2010

EHR LANDSCAPE
First, as alluded to in the summary, the EHR industry remains fragmented and opened to further consolidation. A recent search of publicly available materials shows that at least 400 EHR companies have recently reported some form of revenues through public filings, consolidated databases (such as capitaliq.com), or traditional private company reporting tools like Hoovers or Dun & Bradstreet. Players are generally divided by at least three discrete criteria: market segment by size, practice specialization, and geography. Specifically, the largest hospitals have IT needs similar in scope and scale to similarly-sized corporations, including the need to retain dedicated IT staffs to ensure the functioning and upkeep of these highly specialized systems. Midsized hospitals have more in common with large hospitals and institutions than individual medical practices; however, their solutions can be more customizable and required less ongoing service. By nature, the individual practice segment is the most fragmented and specialized. These solutions often take the form of software suites that are purchased by the doctors themselves and serviced remotely. Additionally, a key decision facing this industry is which products and services will gravitate toward a traditionally licensing format versus the Software as a Service (SaaS) business model. Probably the most common examples of the licensing system are the operating system and the productivity suite stalled on a machine where it resides. Alternatively, the SaaS model is built on remotely-hosted software that utilizes the principles of cloud computing and remote storage. 6 Practically, for a healthcare provider, this is the difference between purchasing a license where you have a larger, upfront expenditure capitalized on a balance sheet and amortized over time versus paying for a SaaS solution as a recurring operating expense. It is important to note, however; that while SaaS products require less capital outlay, such solutions often are more expensive over a healthcare providers horizon of product use. 7 Finally, as an important addendum to any discussion of the current EHR landscape, it is important to remember that the unprecedented amount of government involvement in this space will continue to shape the EHR and HCIT landscapes; perhaps more than any industry besides healthcare and financial services. As we have seen with the evolution and ultimate definition of EHR certification and meaningful use, there are still many questions left to be answered making fluency with the process necessary to any interested party either as a service provider or market participant.

6 http://it.toolbox.com/wiki/index.php/SaaS#Saas_-_Examples_of_SaaS 7 http://www.hispanicbic.org/index.php?id=16108&lang=en

INVESTMENT OPPORTUNITIES AND OPINIONS CONCERNING FUTURE CONSOLIDATION

A natural analogy for a foreseeable future for the EHR space is the software industry itself. What this means is that many argue that the relatively sparse number of software providers and even sparser universe of operating systems are a natural outgrowth of the need of compatibility and portability to maximize software utility. In business strategy terms, this is an economic moat referred to as increasing returns to scale i.e. the enviable position where a product becomes more valuable when more people start using it. In essence, this argues that it was natural for Microsoft and Apple (or any small number of competitors) to dominate personal computing or productivity suites because software must work on virtually everyones computer to maximize its value. It is currently unclear if we will someday make a parallel argument that it was natural for Cerner and Allscripts to become the dominant EHR platforms. Additionally, as the recent approval of the Allscripts merger with Eclipsys suggests 8, it is even conceivable, however unlikely given the fragmentation in the physician space, that in 40 or 50 years we feel it was inevitable for EHRs to coalesce around one dominant platform because of compatibility requirements with government mandates. This will bring us, shortly, to empirical clues on the near future of EHR consolidation. However, it is important to stop here and briefly address the general consensus on EHR equity prices, i.e. the shared belief that expected stimulus spending is fully factored into industry equity prices. Vivid illustrations of the expected impact of stimulus spending on equity values can be seen across the space. Take Eclipsys, an industry stalwart considered the market leader in servicing middle market hospitals, as of July 8, 2010 Eclipsys is trading at approximate 123.91 times trailing P/E and 21 times forward PE 8. While some financing decisions may be involved, this is simply, unequivocally suggesting that Eclipsys earnings will increase six fold over the next twelve months due to government mandated and subsidized spending by healthcare providers. Of further relevance is the resilience of these equity valuations even with abnormally high trailing multiples. As has been reported in several competent and illuminating analyses, EHR equity prices have been almost impervious to overall market volatility. While it is counterintuitive for equity values based on an expected 600% increase in earnings per share to be stable, the market clearly believes the governments dedication to this program and remaining undaunted ability to finance itself makes such increases a nearly sure bet. In the near term; however, it is likely that extreme fragmentation and existing opportunities for strategic vertical or horizontal integration is that this process will take longer to play itself out and follow more of a condensation pattern. That is, with business units forming more unpredictable combinations while getting steadily larger and ultimate consolidation a much longer term process.

8 http://www.healthcareitnews.com/news/allscripts-eclipsys-merge-13-billion-deal 9 finance.yahoo.com

INVESTMENT OPPORTUNITIES AND OPINIONS CONCERNING FUTURE CONSOLIDATION

With the origins and stability of current HCIT equity valuations established, it is hopefully now a small step, both for the initiated and new reader to see a near future with greatly increased consolidation in the EHR space. However, as the before-mentioned Allscripts/Eclipsys merger portends, the financial realities at play imply that this wave of consolidation will be an almost ipso facto process of strategic consolidation not financial consolidation. This is important to note because larger HCIT players are still trading at the before mentioned inflated multiple and smaller players are trading on similar inflated valuations or, sometimes, for the option value of their intellectual property. This means that there are very few accretive (or significantly accretive) transactions where companies can trade expected money (high multiples) for realized cash flows in stock-based transactions. In such an environment of strategic consolidation with few big players and a high reliance of valuations based on intellectual property the analogy, parallel to our above use of the software industry, becomes the internet industry. Specifically, large swaths of companies and services will be marketed, positioned, or developed solely with the goal of being acquired by one of few industry goliaths (for the internet, this consists of a triumvirate of Google, Yahoo, or Microsoft). Our colloquial conversation with industry contacts suggest that profitable companies with revenues of $10 million and above are particularly well suited to take part in this industry roll-up. This is both from the perspective of acquiring smaller players and positioning themselves within a market or geographic niche to, ultimately, be an acquisition target. Particularly if future cash flows reach market expectation, we may soon see a reflection of the internet space where dedicated players (Cerner, Allscripts /Eclipsys) and diversified market participants (McKesson, GE) are the preferred destinations for entrepreneurs and innovation is geared toward augmenting or improving their core products. In the near term; however, it is likely that extreme fragmentation and existing opportunities for strategic vertical or horizontal integration is that this process will take longer to play itself out and follow more of a condensation pattern. That is, with business units forming more unpredictable combinations while getting steadily larger and ultimate consolidation a much longer term process.

8 http://www.healthcareitnews.com/news/allscripts-eclipsys-merge-13-billion-deal 9 finance.yahoo.com

SUMMARY AND CONCLUSIONS

As argued, historical examples suggest that it is natural for portability and compatibility needs to push the EHR industry to coalesce around a few dominant formats and players. For all of those interested, the question remains what, specifically, will this look like? This question is currently muddied by the presence of so many unknowns, i.e. government intervention, a fragmented industry, the fundamental instability of technology, willingness to consolidate, and the prevalence of strategic acquisitions that can remake the industry. However, there are still time honored principles of the free market at work as well as some concrete, educated deductions we can make about the industrys near future. First, transaction volume should increase. As stated before, we have seen an increase in M&A volume during the most difficult economic environment in recent economic history. As the economy has recovered, larger mergers such as Eclipsys / Allscripts suggests this will be a strengthening trend. Second, the evolving business model will be crucial for what both HCIT and related M&A look like. As we have mentioned, there are several other HCIT products and services that are much more in their infancy than EHRs. If one of these products or services becomes successful or valued, it could reshape industry influence and players very quickly. Third and finally, public financial markets double as our best predictive tools and they have given us an unqualified prediction; near term EHR business performance should play out as currently predicted with wide-scale adoption and increased use of HCIT. Strategic decisions for investment that are congruent with this prediction simply make the most sense at this time.

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