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We recently downgraded our recommendation on Quality Systems (QSII - Analyst Report) to Neutral. The company reported earnings per share in third-quarter fiscal 2012, which matched the Zacks Consensus Estimate.

Quality Systems offers an electronic health record (“EHR”) product and is benefiting from the migration of ambulatory and inpatient practices to EHR under the federal Stimulus. The company has made multiple acquisitions to bolster organic growth. Its acquisition of IntraNexus, in early 2011, is expected to facilitate its progress in the small hospital segment.

In recent times, Quality Systems has not only well managed its ambulatory clinical deals but, in addition, it has nicely executed several enterprise contracts. The company is winning traction with its inpatient package for small hospitals. In the end, however, we believe that Quality Systems’ success on the inpatient side will be limited to a relatively small number of hospitals.

Revenue growth was impressive in most segments and was driven by the growing client base. Quality Systems continues to expand its recurring revenue stream (estimated to be slightly over 60% of total revenues), which provides further room for encouragement.

We believe the company is in a strong position to undertake merger and acquisition (M&A) activity. We also believe that the company’s dividend record, unusual for growth companies, holds some promise for investors. 

The business is crowded with many players operating in the upper end of the market where Quality Systems has traditionally been strong. We harbor doubts about the company’s ability to penetrate the low end of the EHR market where it faces competition from lower-priced, cloud-based EHR models.

We are concerned about execution risk emanating from Quality Systems’ entry into the rural inpatient market. Also, on the negative side, it competes in a fragmented market with larger competitors. The market is price sensitive, and vulnerable to price cutting. The company competes with Athenahealth (ATHN - Analyst Report), Cerner (CERN - Analyst Report) and Allscripts Healthcare Solution (MDRX - Analyst Report), among others. Our Neutral recommendation is supported by a short-term Zacks #3 Rank (Hold).

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