Analysis of a “Market Moat”: CPSI
***** EDIT: Since this article was published we added to our position in CPSI by 25% (1000 shares) with an average share price of $47.81. Purchases were made on February 2nd, 2015.***
We were recently reading “Why Moats Matter” by Morningstar’s Heather Brilliant and Elizabeth Collins and began thinking more deeply about how we see moats and their characteristics. Traditionally moats have been seen as individual corporate advantages. In their book, Brilliant and Collins explain Morningstar’s five moat categories as Intangible Assets, Cost Advantage, Switching Cost, Network Effect, and Efficient Scale.
At Nintai we take a slightly different take on moats. We don’t feel there are just corporate moats but specific “market” moats as well. While generally not as powerful as corporate moats, market moats provide selected companies with a secondary competitive advantage that can enhance performance and returns. These moats provide an environment for sustained and profitable growth to select companies. Much like evolutionary biology, not only do great companies adapt and grow but there are environments that are more conducive to feeding such change. At its essence we would argue that market moats provide an additional margin of safety as we value our investments.
As a demonstration of this concept, we thought we would spend the next two weeks articles discussing both market moats and corporate moats for our most recent investment – Computer Programs and Systems (CPSI, Financial). This week we will break down the idea of market moats and how it applies specifically to CPSI.
What is a Market Moat?
We believe there are certain market trends powerful enough to provide what we call market moats to leaders in their particular field. These are more than just industry tailwinds such as product adoption rates or rapid sales growth. These moats are driven by three key factors that provide not just a market need but a market demand and compliance. We have found these are driven by three major factors.
1. Regulatory
In some industries regulatory requirements can create a remarkably strong market moat. In the case of CPSI this is especially true. The movement to digitized healthcare is currently driven by three core regulatory requirements. First is the drive to digitize clinical care through the use of Electronic Medical Records (EMRs). It started with ARRA funding in the 2009 and requirements for 70% of all primary care physicians to utilize EMRs by 2014. Next is the regulatory requirement for adoption of Meaningful Use rules and incentive payments pertaining to meeting clinical criteria. Last is the Medicare Rural Hospital Flexibility (Flex) Critical Access Hospital (CAH) Health Information Technology (HIT) Network Implementation Program. This promotes the implementation of HIT in CAHs and their associated network of providers in states that are current Medicare Flex grantees.
Second of these regulatory changes was the passage of the Affordable Care Act of 2010. The law mandated the development of a National Quality Strategy to improve care delivery, health outcomes and population health (Section 3011). A new Center for Innovation within the Centers for Medicare & Medicaid Services (CMS) would test and evaluate innovative models of care (Section 3021).
Third was the creation of a process to reward hospitals for providing value-based care (Section 3001), and penalize hospitals that perform poorly on quality measures such as preventable hospital readmissions (Section 3025). These measures would obtain their data from the EMRs provided to rural hospitals by CPSI.
These regulatory requirements drive a market moat in which the changes are not just desired but required to meet compliance standards. You simply can’t ask for a larger moat than government regulation for the next 10-12 years. CPSI is well positioned to take advantage of these for the foreseeable future.
2. Fundamental and Sustained Shift in Capital Allocation
In conjunction with major regulatory efforts, the industry should see a significant shift in capital across the market with an emphasis towards the investment’s core competence. In CPSI’s case let’s start with the high level numbers. Healthcare data and informatics is expected to rise from just 3.4% of total spending in 1990 to 11.3% in 2020. Spending is expected to rise from roughly $1.3B in 1990 to $340B in 2020. In CPSI’s particular market – small to medium sized hospitals, spending on EMRs (including product, services, and analytics) is expected to increase from $9.3B in 2010 to nearly $44B in 2020. This shift in capital allocation is expected to increase roughly 8-10% through 2020 and roughly 5-7% through 2030[1]. This type of sustained (an estimated 15-20 years) allocation in conjunction with the dollar amount provides an enormous market moat for CPSI going forward.
3. High Profit/High Return Business Models
Once we recognize that regulatory events and influx of capital has created an opportunity, we look for the third important part of a market moat – high profit/high return business models. Let’s take a look at the field of electronic health records (CPSI’s sweet spot) and see whether the industry in itself is high profit and high return. There are currently 20 significant EMR vendors so I will look at the top 5 as examples:
| Company | ROE | ROC | Free Cash % Revenue | Net Margin |
| eClinicalWorks (Private) | 18.4% | 19.4% | 15.3% | 14.4% |
| McKesson[2] (MCK) | 15.4% | 27.4% | 11.3% | 14.1% |
| Cerner (CERN) | 14.1% | 28.1% | 11.2% | 13.4% |
| Allscripts (MDRX) | 1.4% | 5.8% | 2.8% | 2.1% |
| Athenahealth (ATHN) | 4.6% | 7.1% | 8.7% | 4.2% |
| Computer Programs and Systems (CPSI, Financial) | 46.5% | 58.4% | 17.2% | 14.3% |
With exception of Allscripts and athenahealth – which both face specific company issues – the EMR market can be a very profitable business. Compared to the older paper based management systems, the EMR market has the potential to be a high profit/high return. Most importantly CPSI has proven they can be an industry player leading in all key profit measures.
In sum, CPSI’s market has intense regulatory demands, significant and sustained capital allocation and an extremely profitable business model. We believe these – to be combined with CPSI’s corporate moat (to be discussed next week) – provide our investment with a secondary market moat and considerable downside protection.
How Do We Calculate a Market Moat?
By analyzing the markets as we just saw with CPSI, Nintai believes it can build (or reject) a business case around the fact that the industry itself provides a moat going forward. We acknowledge this process is messy. It requires an enormous effort at understanding all aspects of your investments’ markets. Deciding whether aspects of the market provide a moat is even more subjective. But it can – and should – be done. We use some critical questions to assist in this decision. These include:
- Are regulatory requirements based on industry wide mandates?
- Are regulatory requirements impacting the market for the long term (5+ years)
- Do the market dynamics (regulatory, integration, and business model) creating a more profitable environment for the investment company?
- Are these dynamics of a nature that the changes are long term or permanent?
- Do the changes create expanded or new opportunities for the investment company?
- Do the changes create new niche markets not present in the previous market? What percentage of this niche market could be captured?
- What companies – both existing and new – could compete for these new services?
- What additional events are necessary to make this investment case work out?
- What events could nullify these changes either through political or business shifts?
Conclusions
We don’t believe it’s possible to make a long-term value investment without understanding whether your potential investment operates with a market moat. Without a doubt regulatory changes offer the deepest moats simply by their very nature. The influx of capital and profitable business are the second and third leg of the market moat stool. No matter how one looks at it, the exercise itself is a valuable tool in providing downside protection to your investment. We have found investing in undervalued great companies with strong and growing market moats can provide more than adequate returns for our investors.
As always we look forward to your thoughts and comments.
[1] Research provided by Nintai Partners LP
[2] Represents McKesson Technology only
