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Merge Healthcare (MRGE - Analyst Report) reported net loss of 4 cents per share in the third quarter of fiscal 2012, worse than the year-ago net loss of a penny per share. After adjusting for certain one-time items, the company reported breakeven earnings per share (EPS), in line with the Zacks Consensus Estimate. The results, however, are considerably lower than the year-ago adjusted earnings of 5 cents per share.

Although total revenue during the quarter edged up 0.5% year over year to $60.4 million, it was down 3.9% sequentially. Total revenue also missed the Zacks Consensus Estimate of $64 million. The company noted that its latest subscription-based pricing model, which was launched in the first quarter of 2012, generated 15.1% of total revenue in the reported quarter with a 62% year over year increase in subscription backlog.

Merge primarily derives revenues from three segments – software and others (35.1% of total sales in the quarter), professional services (18.7%), and maintenance and EDI (46.2%). Barring software and others, which recorded a year-over-year increase of 5.5% to $21.2 million, the   professional services, and maintenance and EDI registered annualized decline of 6.0% to $11.3 million and 0.5% to $27.9 million, respectively, during the quarter.

Total cost during the reported quarter (excluding depreciation and amortization) increased 5.6% year over year to $22.9 million. Gross margin during the quarter was 62.01%, down 183 basis points (bps) compared to the year-ago quarter.

Sales and marketing expenses during the quarter were up 5.6% (to $10.8 million) with a 14.9% jump in product research and development expenses (to $8.3 million). General and administrative expenses were up 3.7% year over year ($7.8 million) during the quarter. The adjusted operating margin declined to 17.5% from 22.3% in the year-ago quarter.

Merge exited the quarter with cash (including restricted cash) of $42.2 million compared with $39.3 million at the end of fiscal 2011. Year-to-date, operating cash flow was $5.1 million as against $5.9 million in the same period last year.

Our Take

Although the company’s subscription-based model is improving gradually, a sluggish second-quarter performance disappoints us yet again. During the quarter, the company acquired 15 new iConnect(R) contracts with some big healthcare systems. Moreover, it received contracts to store more than 3.65 million studies in the Merge Honeycomb Archive via subscription-based models. We still believe that Merge has the potential to expand in the huge and growing market for diagnostic imaging, especially with government’s emphasis on HIT and an aging population.

However, Merge’s growth prospect is highly dependent on capital investments by hospitals for advanced imaging solutions, which in turn are linked to the general economic conditions. Also, the presence of big players like General Electric Co. (GE - Analyst Report) and McKesson Corporation (MCK - Analyst Report) has made the diagnostic imaging market highly competitive. Presently, Merge retains a short-term Zacks #3 (Hold) Rank. Over the long term, we are Neutral on Merge.

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