Volatility for Quality Systems

We are optimistic about Quality Systems Inc.’s (QSII - Analyst Report) earnings growth as a result of the continued strong revenue growth and improvements in gross margin. Sales growth continues to be driven by the strength of the NextGen division. However, with gross margin and operating margin at significant highs, substantial further improvement may be difficult. Our rating is Hold.

The acquisition of Healthcare Strategic Initiatives expands the company’s presence in the revenue cycle management market. The QSI division market, largely mature dental practices, is undergoing consolidation and this group pulls down overall growth of the company’s topline.

The risk to earnings growth is the continued strong investment emphasis in research and development and increase in selling, general, and administrative expenses. Historically, the company has expended a significant percentage of revenue on product development and management believes that significant continuing product development efforts will be required to sustain growth.

After declining in fiscal 2008, gross margin may expand once again in fiscal 2009. The product mix of the higher-margin NextGen sales and a lower-margin hardware and third party software sales which drives this positive trend can fluctuate from quarter to quarter.

At its current price of $31.25 per share, QSII is trading at roughly 19x our fiscal 2009 EPS of $1.67 and our calendar 2008 EPS estimate. Despite solid market fundamentals, we think the lack of operating visibility will also play a role in limiting multiple expansion.

Also, since the management does not provide quarterly or annual guidance, that contributes to near-term volatility. The stock is trading at roughly a 0.8x P/E/G on calendar 2008 EPS, at a discount to the group calendar 2008 P/E/G of roughly 0.9x. Our target price remains $35.

Read the full analyst report on QSII