Quality Systems: Quality worth considering?

Quality Systems (QSII) is one of those stocks that you rarely come across as a dividend growth investor. A technology company, paying out a dividend and still experiencing good growth. And not just a small dividend. At its current price of $17.50, QSII is trading on a 4% dividend yield. 2012 has been a rough year for the stock. I’m going to set out my investment thesis for why QSII could be quality worth considering. 

Core Business 

Quality Systems (QSII) is a company operating in the fast growing Electronic Medical Health Records space or (EMR).

For YE 2011, QSII did $430M in revenue, with a 65% gross margin and net income of $76M. QSII has a market capitalization of ~$1B.

QSII is focussed on helping doctors and hospitals digitize their medical health records. EMR is a big deal to health care providers. Most health records at doctors offices are still handwritten. It creates major inefficiencies in trying to index and search for patient records.

Health care providers haven’t in the past been incentivized to move to EHR. For the doctors, the office managers and the health care administrators, moving to an electronic system means means additional staff training, additional record entry and changing the way they need to do things. That’s traditionally proven to be a major barrier for adoption of EMR.

Quality Systems develops and markets these software support systems which allow medical health records to be digitized. It sells into the individual physician and dental markets (ie to individual doctors and dentists) as well as the hospital market.

Quality Systems also provides maintenance and support for the software systems that it installs, collecting a recurring revenue fee for ongoing maintenance. It’s Next Gen business, which provides electronic records and financial management for small physician practices, accounts for the bulk of QSII revenue (almost 75%). Sales to hospitals and dental practices are a minority of revenue.

Recurring maintenance revenues for providing support for installed systems make up almost 50% of total revenues (slightly higher in 2012 as a result of lower product sales)

Quality Systems has a dominant EMR product for the individual physician market. It has been struggling to make inroads into the hospital market (reflected in its relatively lower revenue contribution in this segment). Competition is increasing in the space with a number of competitive solutions in market from players like Allscripts, Athena, Cerner and McKesson.

Where’s the growth?

The Obama administration has recognized that there are huge benefits to the health care system overall in moving to EMR. It’s been offering financial incentives to Dr’s and hospitals to digitize their electronic health care records. Almost $20B of incentives.

But it doesn’t end there. If health care practices fail to convert to EMR by 2015, they will be penalized (including losing ability to claim Medicare reimbursements). So the health care sector is incentivized to move to EMR. This should contribute to an acceleration towards EMR over the next few years.

My overall thesis is that Quality Systems is a business in a rapidly growing market which will be further incentivised by government programs to drive EMR. This should create a nice tail wind for the business over the next few years to drive profitability.

What do the numbers say?

10yr /5yr revenue growth

The analysis will be done on a 9 year view given data is only available for 9 years for QSII

Quality Systems compound revenue growth over a 9 year period (2003-2012) has been an impressive 26% p.a, quite extraordinary growth.

Both “halves” have had good revenue growth. 2003-2007 revenue growth was an impressive 30% p.a. 2007 to 2012 has been an equally impressive 22% p.a! While growth in the 2007-2012 period has been decelerating, a 22% p.a growth rate is fairly good over a 5 year period.

10 yr / 5 year operating cash flow growth

QSII operating cashflow over a 9 year period has also been a very impressive  22% p,a.

There’s not much to differentiate the two periods here. 2003-2007 increase in yearly cashflow was 23% p.a for the period. while 2007-2012 was 21% p.a. Again, pretty stellar numbers

Dividend Growth Rates

QSII has only has a dividend in place for the last 5 years. During this year period, dividend growth has averaged 9% p.a over 5 years. While this rate is reasonable (without being spectacular), the fact that it is lower than the operating cashflow growth rate suggests there may be scope for QSII to increase dividend growth over time, as operating cash flow growth increases.

QSII’s dividend payout ratio for reported 2011 was around 55%, fairly comfortable in my view.

So QSII’s numbers and growth all seem to be humming along well ? Unfortunately there is a postscript to this story. The QSII stock price has been demolished in 2012, losing almost 50% of its value from $35 down to $17.50. What’s behind this?

2012 performance

QSII has faced a year of consistently missed estimates and suspended revenue and profit guidance due to some of these misses. While missing analyst estimates and guidance doesn’t concern me terribly, a major slowdown in the business is more of a problem, and QSII revenue has been flat to slightly down for the first 2 quarters of the year. The full picture though is that maintenance and recurring revenue is strongly up, while new product sales are down.

My view here is that this represents deferred (rather than cancelled) orders. The QSII pipeline is still robust, its just that closing some of these deals is taking longer.

Wrap Up

I recently initiated a $7000 position into QSII stock at $17.50 for the Integrator $50k fund. I may look to slightly increase this position by another $3000 if the price drops below $15.00.

I view QSII as a an opportunity to enter a business that has experienced solid growth, in a sector that I expect will have some favorable tail winds over the next few years as the digitization of electronic medical records continues at pace. This presents an opportunity to grab a rising dividend stream over time.

QSII has experienced some lumpiness in its growth over 2012, with sales revenues and pipeline activities not meeting expectations. I view these as short term impediments that the business will ultimately resolve.

Caution: As QSII is a small cap dividend stock, it warrants caution, and i will be monitoring its business performance over the course of this year for any changes in the thesis or impacts to the dividend.


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