Last week's column, EMR: Electronic Medical Revolution, generated a good amount of reader feedback (which I greatly appreciate!). Clearly, there's a lot of excitement out there about bringing doctors' offices into the 21st century.

No one who wrote disagreed that old-fashioned, paper patient charts are bound to eventually give way to the efficiencies and quality-of-care advantages afforded by electronic medical records (EMRs). But for all the enthusiasm, there's just as much skepticism.

Most of the email I received was from practicing physicians, who raised a number of important concerns, including the following: constrained ability to invest in IT due to shrinking medical-care margins; lack of comfort with new technology; fears of inflexibility in taking a software approach to recording patient data; and general fears that the "right" EMR solution hasn't yet come along.

Does this mean EMR adoption is still a long way off? For smaller practices, perhaps; but overall, it just goes to show how fragmented and nascent this market is. For physicians in smaller practices (less than five docs), EMR is a much tougher sell because of the costs. And considering that something like 90% of all doctors' offices fall into this "small practice" category, you can see why there's widespread skepticism out there.

But a good number of larger practices (10 to 75 docs) have sufficient financial resources to make EMR a compelling investment. Not surprisingly, Quality Systems (NASDAQ:QSII) finds its sweet spot in this group.

Happy client earning accolades
You'll recall from last week's column that Quality Systems is generally thought to be the leading EMR vendor among the larger medical practices. These practices comprise only a small portion of the overall physician practice market, but it's a sizable enough market for Quality Systems to build tremendous value.

Today, I want to take a closer look at some of Quality Systems' recent achievements and their underlying drivers.

Let's start with a specific client example. One larger practice using Quality Systems' software with tremendous success is Southeast Texas Medical Associates LLP (SETMA) of Beaumont, Texas. Last month, SETMA was named Clinic of the Year, one category of Microsoft's annual User of the Year awards program recognizing the most innovative health-care organizations that use Microsoft-based technology. SETMA's electronic patient management solution documents almost every aspect of patient care, both inside and outside the exam room. Tangible benefits included:

  • Transcription costs declined from $5.93 per visit to $0.25 per visit;
  • More accurate coding and charge capture increased revenue per patient visit by 20%; and,
  • Overall operating expenses declined by over $2 million per year.

White-hot demand
With success stories like SETMA's, Quality Systems is starting to generate a lot of buzz among potential clients. On the latest earnings conference call in January (courtesy of Fair Disclosure Financial Network), management said client interest is actually overwhelming the sales force: "We have the fortunate, or unfortunate, situation of having more interest than the current sales force can handle. We have more leads than our sales people can possibly follow up."

When was the last time you heard a company talk about demand outstripping available supply? At Quality Systems, demand has been quietly growing hotter and hotter, with sales in the medical software division (NextGen) accelerating over each of the past five quarters:

  
    Quarter    Year-Over-Year  EndedGrowth 12/02          49.9%  9/02          37.0%  6/02          23.0%      3/02          22.7% 12/01           6.9%

Obviously, that kind of growth acceleration can't continue much longer, but the important thing to note is this: In spite of all the skepticism swirling around EMR, there's an increasingly large wave of investment already taking place. The debate may continue to rage, but the buyers are speaking. And my money is betting that today's skeptics will be tomorrow's buyers.

Driving demand: HIPAA and strong competitive position
So, what's driving this upward demand for Quality Systems? Last week, I told you about the economic and quality-of-care benefits of EMR software. Let's now discuss two additional factors: 1) a rush by physician practices to comply with regulations imposed by the Health Insurance Portability and Accountability Act (HIPAA); and, 2) a favorable competitive landscape. On these topics, Quality Systems' January conference call included several key quotes which I'll share with you.

First, there's the HIPAA factor. HIPAA, as I mentioned last week, is a series of health-care regulations on patient privacy, medical record security, and electronic transaction standards. The first deadline for these regulations hit in October of 2002, but this was something of a "soft deadline" due to various extensions and later deadlines. Medical practices are scurrying to prepare for the inevitable requirements. The January conference call included some very illuminating comments on this subject:

It [the impact of HIPAA] has started to kick in, but I think it will continue to be a driver over the next couple of years.... Before October 2002, the federal government allowed people to file an extension, so, in effect, granting them until this coming October to comply. But it's something that practices are out there thinking about and needing to comply with. Many of them are not compliant at this point. In fact, better than 50% of them, in our estimation, are not currently compliant, and in fact [the lack of compliance] goes beyond the medical practice into the payor community, and hospital community, and many of the covered entities [i.e. those required to comply with HIPAA].

Did you catch that? Fifty percent of medical practices may not be HIPAA compliant. That's huge.

Also driving demand for Quality Systems is a lack of strong competition. This may come as something of a surprise. While it's true that a lot of competitors are going after the smaller medical practices, only about five major players are competing for the larger practices' business. As management stated on the call:

On the EMR side, we're selling into a relatively unpenetrated market, where fewer than 5% of the medical practices in the country have electronic medical record systems. And typically, the competition in that market is pretty weak: a lot of small companies, a lot of regional companies, a few larger, well-established legacy system players. But their product offerings -- I'm generalizing -- their product offerings don't stack up to NextGen EMR.

By these comments, you can see that NextGen's real strength is in their EMR product. But when clients install an EMR system, they're also likely to upgrade their administrative software package. And what makes more sense than to utilize NextGen's EPM (electronic practice management) system, which is of course designed for ideal compatibility with NextGen EMR.

During the December quarter, about 60% of NextGen's clients purchased software that included both the EMR and EPM modules. This is especially impressive when you consider that the EPM market is much more saturated than the relatively unpenetrated EMR market. On the conference call, Quality Systems management had the following comments about EPM sales:

On the practice management [EPM] side, we're selling into a market that is about 95% saturated, but there's a reasonable turnover in that market because of all the legacy systems that are out there and customers wanting to move to new technology with better return on investments and technology that will help them meet the HIPAA regulations that have started to go into effect....

Let's wrap this up. We're dealing with a lot of acronyms here, but hopefully you see how HIPAA is driving sales of both EMR and EPM software, which helps pave the way for success stories like that of Southeast Texas Medical Associates. And as the word gets out, more and more large medical practices are knocking on Quality Systems' door.

Next time: Quality Systems' growth potential and valuation
Unfortunately, that's all the space I have today. Sorry I wasn't able to get into Quality Systems' growth potential, as promised last week. But come back next Monday, and I'll examine the company's growth potential en route to estimating what's a fair value for Quality Systems' stock.

Matt Richey (MattR@fool.com) is a senior analyst for The Motley Fool. At the time of publication, he held shares of Quality Systems. For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select , which is where Quality Systems was originally presented in June 2002. The Motley Fool is investors writing for investors.