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On Apr 2, 2013, we reaffirmed our long-term Neutral recommendation on Merge Healthcare Incorporated (MRGE - Analyst Report) as the company’s bright growth prospects are to some extent dwarfed by escalating costs, lower demand for advanced imaging solution and declining Medicare reimbursement. This imaging and interoperability solutions provider carries a Zacks Rank #3 (Hold).

Why the Reiteration?

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 the transition to a subscription-based model, Merge Healthcare has been experiencing increasing costs. Also, focus on new product innovation continue to induce higher professional fees. We believe any near-term margin improvement is unlikely, although 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 growth was 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. Because of the length of sales cycles under this model, Merge expects this arrangement to turn more prevalent in 2013 and beyond. The company expects more than 60% of its revenue to be generated from the subscription based model in 2013 and reach about 80% in a couple of years.

Recent findings also demonstrate immense growth potential in the U.S. and overseas market for the company. 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 signs of improved execution. However, other healthcare stocks such as Cepheid (CPHD - Analyst Report), Medical Action and Given Imaging are worth considering. These stocks carry a Zacks Rank #1 (Strong Buy).

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