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On Dec 17, 2013, we reaffirmed our long-term Neutral recommendation on Merge Healthcare Inc. (MRGE - Analyst Report) as the company’s bright growth prospects have been to some extent dwarfed by escalating costs, lower demand for advanced imaging solution and declining Medicare reimbursement.

The company has been battling losses as its strategy to grow with the AMICAS takeover came to naught due to slower-than-anticipated market growth resulting in choppy revenues and an improper cost structure. This imaging and interoperability solutions provider carries a Zacks Rank #3 (Hold).

Why the Reiteration?

Merge’s third-quarter 2013 adjusted earnings per share of a penny marked a slight improvement from the loss incurred in the year-ago quarter. Revenues declined 5.2% to $57.2 million. Dismal performance over the past few quarters and the recent exit of the company’s CEO and chairman raised our concern. Notably, the growth prospect of the company is highly dependent on the capital investment environment at hospitals and reimbursement rates.

The business of Merge Healthcare depends on the capital investments for advanced imaging solutions made by hospitals. Its business is also susceptible to the Medicare reimbursement rates for advanced medical imaging that could adversely impact hospital and imaging clinic revenues, thereby reducing demand for imaging-related software and services offered by the company.

Additionally, with its transition to a subscription-based model, Merge Healthcare has been experiencing increasing costs. Also, focus on product innovation continues to result in higher professional fees. We believe any near-term margin improvement is unlikely. But we expect the same to improve in the long run with greater adoption of the new subscription-based model.

Nevertheless, Merge Healthcare also witnessed events that favor the company. Its client wins and bookings were encouraging. With a clientele increasingly willing to adopt subscription-based model, the company is optimistic about an increase in backlog by at least $25 million or 55% by the end of 2013.

Recent findings also demonstrate an immense growth potential for the company in the U.S. and overseas markets. While its eClinical solution serves a market size of $4.8 billion, the combination of iConnect and Merge Honeycomb reflects a $550 million market opportunity.

Thus, persistent client wins and market penetration should accelerate growth. Further, Meaningful Use Stage 2 criteria and incentive payments for Merge Healthcare’s radiology clients are also likely to support positive business momentum.

Despite the lucrative market opportunity, we remain on the sidelines until we see improved execution. However, better-ranked healthcare stocks include McKesson Corp. (MCK - Analyst Report), Align Technology Inc. (ALGN - Analyst Report) and Cardinal Health, Inc. (CAH - Analyst Report). These stocks carry a Zacks Rank #2 (Buy).

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