With Department of Defense contracts up for grabs and hi-tech medical reforms being implemented, the healthcare IT world is a red-hot opportunity for investors.

While the big-name companies are earning the major contracts on these multibillion-dollar modernization efforts, should investors keep an open mind to the little guys in the space or are their chances of survival in this nascent market all an IT fantasy?

A full transcript follows the video.

 

Kristine Harjes: Healthcare goes hi-tech. This is Industry Focus.

Hi, everyone! Welcome to Industry Focus, healthcare edition. I'm your host Kristine Harjes, and I'm joined today by Motley Fool healthcare contributor Todd Campbell. Today, we're going to talk about healthcare IT. Information technology in the healthcare sector. When I think about big trends going on in healthcare right now, there are plenty that come to mind, but one of the really huge ones that I think about is IT.

This is an absolutely ginormous thing to watch going on right now because you've got the government pushing for it. Back in 2009, as a part of the stimulus bill, we had this HITECH Act that was passed and it basically said, "Here's $25 billion. With this, we want to promote the expansion and the adoption of health information technology." Of course, that's a pretty vague term right there, but one of the really big efforts within health IT is the establishment of EHRs.

EHRs are your Electronic Health Records Systems, where you essentially have everything you need to know about a patient stored electronically. You've got their patient demographics, their progress notes, drugs they're taking, problems they're having, vital signs; I could go on and on. Allergies, immunization dates; any sort of medical history or something that a doctor might want to know in a clinical setting.

EHRs automate and streamline provider workflow to get all this information together, have it in one place, have it digital, and be able to work with it that way. To me, this seems like an absolutely huge initiative. Todd, where do we stand on it?

Todd Campbell: It's a mammoth initiative. If you think about this, healthcare is being dragged kicking and screaming into the world of information technology. It's one of the last major sectors that are a holdout on embracing these computerized systems. Not that long ago, we would go into a doctor or dentist's office and there would still be rows and rows of file cabinets behind the desk.

You look at that and say that's from the 1970s, but there were a lot of reasons for it. There weren't any financial incentives for doctors and hospitals to embrace technology because if they have a paper record, they'll invoice Medicare or Medicaid or a private payer like an insurance company and they don't need to have a lot of bells and whistles. Why would they spend the money?

Harjes: It would be a huge effort for any single provider to totally reform and not be incentivized to do so.

Campbell: You're basically taking a car that's not as fast, but it's going 60 miles per hour and you're pulling up the emergency brake and telling the car to go into another direction. I think that's one of the reasons the HITECH Act was so important to create both a carrot-and-a-stick approach to getting providers to embrace these health IT systems.

You've got the carrot side of things in which doctors and providers can receive tens of thousands of dollars for multiple years for bringing in these health IT systems. Then you've got the stick approach, which kicks off very soon and that's going to start dinging providers on the amount of money they receive back in reimbursement for Medicare if they haven't adopted these systems.

Harjes: Basically, you've got these players that, as a practice, if you decide you don't want to implement EHRs, your option is to either face these penalties, which will get bigger and bigger each year, or stop accepting Medicare. Both of these are going to absolutely kill your business.

Campbell: Right. You can't. You can make a decision knowing that you get X amount of money from Medicare in the practice and consider if they ding 1% that might not be a lot. Maybe it's a lot relative to how much it would cost to institute the health IT system from one of the many providers that have popped up and race to capture part of this money that's being given out or has been given out by the government as part of the incentives.

Harjes: At the same time, you're just delaying the inevitable there. This is a reform that is going to end up being ubiquitous.

Campbell: Technology is going to happen. Evolution happens. There's a lot of argument and studies have been done and released this year saying that the HITECH Act was great; it really was. All of this is pulling things forward. If that never existed, then doctors and hospitals would still embrace these systems. It would have just happened two to three years later.

Two to three years is still substantial. When it comes to technology, if you can shorten the curve, it's almost exponential. The next advance will come quicker and the advance beyond that will come quicker. There's also a lot of debate right now with EHRs questioning if the systems are really doing what they were supposed to do when they were first conceived.

Are they really communicating across different doctors and providers? Can a specialist really pull up my record? Can a hospital then pull up my record, make changes, and have it go back to notify the primary care? There are a lot of challenges here.

Harjes: Yeah. That raises the issue of interoperability, which is healthcare-speak for saying that these systems don't speak the same language right now. Your biggest provider -- Epic Systems and they're a privately held company -- they have this closed-box system that won't play well with others. They also don't have any incentive to play well with others.

They've got half the market share in hospitals, and there's no reason why they would make a system that can nicely communicate with all the other systems because they're trying to leverage their size and drive everyone else out of this market.

Campbell: Right. It's the race to the top. You want to squeeze out all of these small players who came in during 2009 and 2010. There's a high level of dissatisfaction due to the interoperability issue. Most of the major hospitals either have systems in place either from Epic or from Cerner (NASDAQ:CERN) and those are not going to communicate with these other smaller systems that have been put in place.

A lot of people are now saying, "I'm going to have to toss out the one I just spent all this money on and replace it with this other system. Who's to say I even like the system? Who's to say if I get one of these other systems that it's still going to be able to communicate with Epic?" Like you said, Epic has no interest and no incentive.

A lot of people will then say "The HITECH Act is flawed because it didn't mandate that it should be built around a common code. Then you're getting in a muddily area. How much do you want to stifle market ingenuity and innovation by mandating a certain approach?

Harjes: The other side of that coin is one of the reasons these systems don't talk to each other is security. You're talking about people's health records. That needs to be on lockdown. If you're Epic, you don't want to open up your system where anyone can talk to it because all of a sudden you could be compromised that much more easily.

Campbell: Right. Someone uses a backdoor through another company to get into your system and then guess what? The press release is "Epic's System Has Been Hacked."

Harjes: Exactly. There are these really high profile acts that have happened. There was one in August of 2014 that I remember, with Community Health Systems. They had this hugely public breach that involved 4.5 million patients. That just looks bad. Even if you don't end up getting penalized by HIPAA you are still getting all that bad publicity.

Campbell: Absolutely. This is very different than putting a system in place at any one corporation. Its' all about silos versus non-silos. If you've got a grocer, even if its system is opened up to all the different grocery stores and all the different distributors, it's still a closed system to that grocer. You don't have competing grocers having access to your systems.

This is a new animal because you're really trying to create something that is open to all that should get it, but closed to all that shouldn't. Trying to figure that out is a magic bullet.

Harjes: I think one of the questions we've danced around is: is this a 'winner takes all' type of game, or is there room for some of these smaller players like Athenahealth to come in and develop a really niche-y type of business and survive in the face of Epic?

Campbell: I think one of the things that's interesting about all of these different companies -- Cerner is obviously a huge player in acute hospitals. Athena is a big and growing player in primary care practices that wants to get into that hospital market. There are different ways that you can attack this market. For that reason, I think you can have huge players like Epic and Cerner and small players like Athena surviving and possibly even thriving.

However, beyond those leaders in these respective niches it's very hard to argue that an upstart would jump in or that some of these other players like Allscripts, who's another big player, but it's hard to imagine that over time they're not going to continually lose ground. The reality is, you've got to go with whatever system is installed by the most people if you truly want interoperability.

Harjes: I would agree there. There are only 10 EHR vendors that account for 90% of the hospital EHR market. Meanwhile, in 2014 there were only three vendors that actually posted a gain in market share. Those were Epic, Cerner, and Athenahealth. Athenahealth actually doubled its market share in 2014. They're a smaller player, but I'm personally rooting for them.

Campbell: They're a smaller player. You could take that information with a grain of salt. They've made a big acquisition this year with Razor Insights that really launched them into the hospital acute care market. They're definitely one to watch. Cerner is probably the most compelling, from an investment stand point because they're big, they're growing, they're profitable, and their valuation is far more reasonable than Athenahealth.

Harjes: They're still high though.

Campbell: Yeah, it's still high for the space. You have to look at this as a technology company, not an insurer or drug maker which will have relatively low valuations. Other parts of healthcare will see P/E ratios in the 10 to 20 range fairly commonly, but you have to look at this almost like it's a software company where you can really get valuations that go in the forward P/Es of 30s.

Harjes: Yeah. That's a good point. You can't talk about Cerner without talking about the Department of Defense contract.

Campbell: I remember having discussions about this contract in 2014 here on Industry Focus and chatting a lot about who would be the big winner. What you've essentially got here is the Department of Defense with a massive job in caring for all the people that receive healthcare because of their service.

You've got 55 hospitals, 100s of clinics, plus you have all of these former service men and women who are getting civilian care. Trying to get all of those records together to communicate has been a nightmare. You've got legacy old systems that have been patched here, patched there, tried to be connected, and nothing is talking together.

The DOD finally said "Let's scrap this and start over. Let's do a major modernization effort and get it the way it should be. Initially, when this was first talked about -- to put this into perspective you're talking about a 10 year contract that could be worth as much as $10 billion. That's massive. It's actually larger than the amount of spending that will be spent on healthcare IT without it in any given year.

This is a big deal and a lot of people wanted this contract, but the ones who came out on top were Cerner, and then a partnership that orchestrated with Accenture -- which is another name that The Fool happens to talk about and like -- and another prime contractor by the name of Lidos. They're a spin-off, but a big player in government contracts.

They won this contract for the first two years, it's a $4 billion contract initially, but if they continue to do well and win the contract extensions this could be worth up to $11 billion possibly. Who knows with government contracts? They tend to grow, not shrink.

Harjes: One of the interesting parts about this story, I think, is how fierce this competition was and what it did to that estimation. Originally, this was an $11 billion contract, and I'm seeing estimates that have now dropped down to $9 billion. That is the effect of competition.

You had Epic teaming up with IBM. Talk about a powerhouse. You had another power team of AllScripts with Computer Sciences Corporation and HP. A lot of big guys were fighting for this contract so the fact that Cerner was able to pick it up is a huge deal, and it's certainly part of the investing thesis for the company.

Campbell: Everybody wanted a piece of it, and we have to remember as investors that this contract is big. It could be $9 billion, it could grow. They're saying $9 billion now, but they said $11 billion last year. Let's call it $10 billion. As an investor, you have to remember that not all that money is going to go to Cerner. It's split among the three companies that big on it.

Regardless, this is a needle moving deal. It should certainly help earnings over the course of the next two year at least -- conceivably much further beyond that.

Harjes: Exactly. Before we wrap up, I want to ask you: Between the two companies that we've talked about today -- Athena Health and Cerner -- which one would you want to add to your portfolio today?

Campbell: Personally, it's Cerner. If I have to pick one, it's Cerner because you've got a company that's growing as quickly, or quicker than Athena that is profitable, and has a lower valuation. Athena has a monstrous short position. It's probably best suited only for the aggressive investors. I like it, but of the two, I like Cerner more.

Harjes: You bring up a good point. Different companies are suited better for different people. As always, you want to do your own research. Todd and I could have interests in the stocks we talk about. The Motley Fool has a disclosure policy. The Motley Fool could have formal recommendations for or against these companies.

Long story short, don't buy or sell based solely on what you've heard today. Hopefully, this provides some good information about a really exciting space within healthcare. Go forward with that. Do some research, dig in, and definitely keep your eyes on these stories that are developing because this is the future of healthcare. Thanks for listening, everyone. 

Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool recommends Accenture, Athenahealth, and Cerner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.