Health service provider iSoft moves on to critical list after latest setback

ISoft, the beleaguered healthcare software developer, moved on to the critical list yesterday as an overhaul to its accounting policy sent its shares plummeting to a record low. The accounting shift, which some critics said should have happened long ago, has forced a restatement of profits and thrown the future of the company into question.

The company, which has issued two profits warnings this year, now needs to renegotiate its banking covenants. It is in talks with its banks and expects to end those discussions within a month - but investors will not welcome such uncertainty.

This year has already proved disastrous for iSoft which has lost almost 87 per cent of it market value. Two years ago, it was celebrating winning the lion's share of software contracts in the massive upgrade to the NHS's information technology systems and looked to be one of the few UK technology success stories to emerge since the dot.com bubble burst. Yet delays implementing and delivering systems to the NHS have slowed down the project, hampering iSoft's financial performance.

The situation is so severe that the company's broker, Morgan Stanley, has suspended its recommendation on the stock and shockingly argued the equity could be worth anything between 60p a share and nothing. The shares closed at 51p yesterday, a 39 per cent decline and a record low.

It is a stunning fall from grace for one of the UK's brighter technology companies. Founded in 1994 by the consulting firm KPMG, iSoft listed in July 2000 before making a series of acquisitions. It merged with its UK nemesis, Torex, in 2003 as the two joined forces to take advantage of the multibillion-pound NHS upgrade. That deal created a clear market leader in healthcare solutions and put the combined company in pole position to win contracts to supply software to the NHS.

After winning three out of the five contracts on offer, iSoft looked in rude health. It picked up the 2004 TechMark technology company of the year award and seemed set to join the FTSE 100. Tim Whiston, the chief executive, looked to other parts of the world where healthcare systems would be upgraded.

But the Manchester-based company seems to have contracted the financial equivalent of MRSA since the start of the year. The NHS project has been held up by delays in installing and implementing the systems and the cost of the upgrades has spiralled out of control. The negative sentiment around the project appears to have infected iSoft's prospects.

There could be more pain to come with the impending renegotiation and rescheduling of the NHS contracts, key to iSoft's future. It appears unlikely the company will be dropped from the programe, but until there is clarity many investors may assume the worst. Frustratingly, there is no indication when the renegotiation will be complete.

ISoft's decision to change its revenue recognition policy is not unexpected after consistent criticism that its accounting was too aggressive. Previously, the company booked all the licence revenue from a large contract when the healthcare system was delivered. Now it will phase the recognition of licence revenue over the life of the contract, in line with industry standard practice. The shortcomings of the previous policy are illustrated by the revelation iSoft booked £40m in revenue in 2003 relating to deals not yet fulfilled.

Its accounting shift eliminates £165m of historic revenue. According to Numis Securities, iSoft has never made a profit using the new accounting policy. In the fiscal year 2006, iSoft expects to record profit before tax of £3m to £7m on revenue of £200m. That compares to guidance given in April of profit before tax of £17m to £22m on revenue of £210m to £215m.

The revenue that has been removed from previous accounts will be accounted for in future years. That has implications for the company's cash flow as it has already booked the cash related to the eliminated revenue. ISoft expects to report that it had £15m of cash at the end of April, but cash flow is likely to be negative over the next few years. Numis estimates the total cash outflow over the next four years could be £115m. That raises the possibility that iSoft may need to raise funds to service its obligations.

As a further kick in the teeth, investors are acing the prospect of a goodwill write-down. The software developer has £500m of goodwill on its balance sheet.

The company says the decision to change its accounting policy is a result of it winning larger, more complex deals where customers pay licence fees on an annual basis. Yet amid the turmoil of the NHS upgrade delays, iSoft could not have picked a worse time to bite the bullet.

Predictably, it has sharpened its cost-cutting knife to offset the reduced profit. As a result, 15 per cent of its UK staff - 150 people - will be shed. ISoft intends to cut its annual operating cost base to £180m from £210m by the end of fiscal 2007.

The NHS project has proven a burden for the Government and the companies involved. Not long into the project, the government body charged with implementing the multibillion-pound upgrade - Connecting for Health - fined BT for late deliveries of infrastructure. With little evidence of successful implementations of iSoft's advanced "Lorenzo" system across the NHS, some observers started to question whether it would lose its key selling point.

In January, iSoft admitted it did not expect to recognise any revenue from delivering new software into the project in the second half of fiscal 2006, resulting in a £55m revenue shortfall. The warning wiped 40 per cent off the company's share price. In March, Accenture, a key partner to iSoft in the NHS upgrade, booked a $450m loss on the project. It pointed its finger at iSoft, arguing the loss was a result of late deliveries of software. Yet Connecting for Health defended iSoft, saying it was Accenture's responsibility to ensure delivery.

But another warning in April, coupled with yesterday's accounting change, have raised significant questions about Lorenzo. Numis noted news that some NHS departments are struggling with older iSoft systems and have reverted to paper-based solutions. Steady criticism of the project from politicians and medical staff has led to calls for an inquiry into the upgrade. Numis says there are questions over the scale of iSoft's involvement in the project once the renegotiation is complete with the previously exclusive contracts potentially opened up for competition.

The future of ISoft's management has also been called into question. After presiding over such a precipitous collapse in the share price, it has been accused of poor communication. Seven weeks before its January profits warning, the company had reiterated its bullish guidance for the year. Some observers have asked whether management should hand back £2m bonuses paid in the past three years, based on the old accounting policy.

Analysts said the change in revenue recognition was the right move. But to resurrect the business, management must restore credibility in the balance sheet, management and its product.

There is also a chance that with shares at record lows and iSoft's credibility in tatters, a buyer may emerge. Analysts mentioned the UK's Misys, and US software companies including Cerner and General Electric.