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Recently, we reiterated our Neutral recommendation on Merge Healthcare Inc. (MRGE - Analyst Report). Shares of the company surged 9.95% yesterday to close at $3.54 with the announcement of the company’s plan to evaluate strategic alternatives including the sale of the company or its merger with another. In this regard the company appointed a New York based investment bank Allen & Co. LLC to explore options.

In the second quarter, Merge reported a loss of 6 cents per share, greater than the year-ago loss of 4 cents per share. Adjusted earnings per share (EPS) came in at 2 cents in the reported quarter, considerably down from the year-ago adjusted EPS of 6 cents. Nevertheless, the adjusted EPS for the quarter was ahead of the Zacks Consensus Estimate of break-even. Total revenue during the quarter stood at $62.9 million, up 16% year over year and above the Zacks Consensus Estimate of $60 million.

Mergewitnessed a significant addition to its client list with the recent transition of its pricing arrangements to a subscription-based model from the traditional perpetual software license arrangement. The company made this operational alteration to better focus on its two primary served markets: providers and consumers.

Though this model has generated lower upfront revenues, thereby impacting performance in the near term, it has higher longer-term potential and lends visibility to the revenue stream. During the second quarter of 2012, subscription revenue was approximately 15% of total net sales with a subscription revenue backlog of $34.1 million as of June 30, 2012. The company expects about 80% of its revenue to be generated from the subscription based model in a couple of years.

Currently, with the greater adoption of EHRs in doctor’s offices, hospitals and imaging centers, Merge’s iConnect platform is becoming significant since it is a vendor-neutral archive. In the second quarter of 2012, the company signed several new contracts, including major healthcare systems such as Franciscan Alliance with a network of 14 hospitals in Indiana, Children's Hospital and Research Center in Oakland, California which is a level one trauma center and Our Lady of LourdesHospital, which was formed by Ascension Health.

Additionally, St. Vincent's Hospital, a member of the Hospital Sisters Health System and the largest hospital in Wisconsin has developed a new partnership with Merge to implement the company’s complete cardiology solutions suite.

We also believe that Merge possesses strong growth potential in the Radiology Information System/ Picture Archiving and Communication System (RIS/PACS) market. There is immense potential in the diagnostic imaging market, especially with the government’s emphasis on health IT (HIT) and an aging population.

However, in recent years, Medicare reimbursement for advanced medical imaging has declined significantly. This remains a matter of concern as it could negatively affect hospital and imaging clinic revenues, thereby reducing demand for imaging-related software and services offered by Merge.

Moreover, Merge’s growth prospects are highly dependent on capital investments by hospitals for advanced imaging solutions, which in turn depend on the general economic conditions. Furthermore, the presence of many big players like General Electric (GE - Analyst Report) and McKesson Corporation (MCK - Analyst Report) has made the healthcare solutions and services market highly competitive. We have a Zacks #4 Rank on the stock, which translates into a short-term Sell rating.

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