Merge Healthcare & the Stimulus

Merge Healthcare Inc.'s (MRGE - Analyst Report) cost-cutting initiatives continued paying off for the 2nd consecutive quarter. The company reported a net income for the 4th quarter of 2008, driven by higher margins on lower sales. Sales for the quarter declined by 3.5% y/y due to economic weakness.

Customers continue to proceed with caution as they still have going-concern issues. Margins have been helped by substantial headcount reductions, some of which were in sales. With a smaller sales force and weak economic environment, sales are unlikely to make much progress over the coming year. The company should continue treading water until the current economic crisis passes.

As we point out in our report, "earnings driven by cost cutting as a business withers away only reflects an effort to stay alive a few quarters longer and does not reflect a true turn around." At this point, our primary concern is how will the company's income statement look after they resume operating at full-speed. The company will need to add back substantial headcount in order to compete in this highly competitive industry. As such, margins will be pressured back to historic levels.

We think it is too early to celebrate the government stimulus spending when the company competes against 35 stand-alone operators, not to mention the larger OEMs that produce their own software.

The stock has gained momentum, benefiting in recent months from the approval of more than $20 billion in spending on health-information technology. The majority of the spending will be felt between 2011 and 2015. Starting in 2011, physicians who use electronic records will be eligible for more than $40,000 in Medicare incentive payments. Payments will be made over several years. With 2 years to go, there is a lot of uncertainty remaining here.

We continue rating this company a SELL and advise investors to look for further proof that the ship is turning around is not just hanging around.