Quality Misses 1Q Est; Profit Dips

Quality Systems (QSII - Analyst Report) reported first quarter fiscal 2013 (ended June 30) adjusted (excluding one-time items other than stock-based compensation expense) earnings per share of 26 cents. It missed the Zacks Consensus Estimate of 36 cents and fell short of the year ago earnings of 32 cents per share.

Net income dropped 18.4% year over year to $15.5 million primarily due to increase in incurred costs in the first quarter.

Revenues

Revenues were up 17.8% year over year to $118.3 million in the first quarter. In spite of registering record revenues in the quarter, the company missed the Zacks Consensus Estimate of $121 million.

Segment-wise Results

System sales amounted to $37.9 million, up 10.2% year over year. Revenues from the two subcomponents were $25.8 million (down 10.6% year over year) from Software, Hardware and Supplies and $12 million (more than double on a year-over-year basis) from Implementation and Training Services.

Maintenance, Electronic Data Interchange Services (EDI), Revenue Cycle Management and other Services revenues amounted to $80.4 million, up 21.7% year over year. Segment sales were reported under four separate headings. Maintenance revenues were $38.6 million, up 22.4% year over year. Electronic data interchange services sales were $13.8 million, up 14.3% year over year. Revenue Cycle Management sales increased 21.2% year over year to $14.4 million and revenues from other services amounted to $13.6 million, up 28.6% year over year.

Margin

Gross margin declined to 59.1% in the first quarter compared to 65.2% in the prior-year quarter. The decline in margin is due to reduction in the high-margin System sales in the reported quarter.

Operating margin dipped to 19.9%, from 28.7% in the year-ago quarter. The selling, general and administrative expenses increased 24.8% year over year to $36.7 million in the quarter while research and development expenditure edged up 25.6% year over year to $8.6 million.

Balance Sheet

Quality Systems ended first quarter with cash, cash equivalents and marketable securities of $129.9 million, up 4.7% year over year.

Our Take

Quality Systems runs a pure-play business model in an attractive industry with a large number of catalysts, which provoke frequent speculation about mergers and acquisition. On the positive side, we observe the high proportion of recurring revenues. Of late, however, growth of its pipeline metric has seen a falling trend along with progressively fewer signed deals on a quarterly basis.

The company has made multiple acquisitions to bolster organic growth. Its acquisitions are expected to facilitate its entry in the small hospital segment. We are concerned about execution risk emanating from Quality Systems’ entry into the rural inpatient market.

Moreover, competition is intense from well regarded players such as Athenahealth (ATHN - Analyst Report), Allscripts Healthcare Solutions (MDRX - Analyst Report), Cerner Corporation (CERN - Analyst Report) and others. Price discounting is frequent, particularly at the lower end, and Software as a Service (SaaS) based model appears to have exacerbated pricing pressure.

Quality Systems has traditionally focused on providing solutions for physician practices. However, core ambulatory EHR providers such as Quality Systems will find that opportunities for product sales will shrink, as physician groups are increasingly absorbed into hospitals.

Our long term ‘Neutral’ recommendation is supported by a short-term Zacks #3 Rank (Hold).