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Merge Disappoints in 2Q

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Merge Healthcare reported net loss of $5.9 million or 6 cents per share in the second quarter of fiscal 2012, a disappointment from the year-ago net loss of $3.3 million or 4 cents per share.

After adjusting for certain one-time items, the company reported net income of $1.7 million or 2 cents per share, considerably down from the year-ago adjusted net income of $5 million or 6 cents per share. Nevertheless, the quarter’s adjusted EPS is 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 up 3.1% sequentially. Total revenue also surpassed the Zacks Consensus Estimate of $60 million. The company noted that its latest subscription-based pricing model, which was launched in the earlier quarter, generated 15% of total revenue in the reported quarter.

Merge primarily derives revenues from three segments – software and others (40.2% of total sales in the quarter), professional services (15.7%), and maintenance and EDI (44.2%). Barring professional services, which recorded a year-over-year decline of 6.3% to $9.9 million, the software and others, and maintenance and EDI registered annualized growth of 43.2% to $25.3 million and 1.2% to $27.8 million, respectively, during the quarter.

Total cost during the reported quarter (excluding depreciation and amortization) increased 54.9% year over year to $25.4 million primarily due to significant jump in costs associated with software and others group. As a result gross margin was 59.6%, substantially down from 70.5% in the year-ago quarter.

Sales and marketing expenses during the quarter were up 36.8% (to $10.7 million) with a 20.4% jump in product research and development expenses (to $8.4 million). However, general and administrative expenses were down 10.3% year over year ($7.4 million) during the quarter. The adjusted operating margin declined to 14.3% from 24.7% in the year-ago quarter.

Merge exited the quarter with cash (including restricted cash) of $33.7 million compared with $39.3 million at the end of fiscal 2011. Year-to-date, net cash used in operating activities was $3.1 million as against operating cash flow of $1.4 million in the same period last year.

Our Take

We are disappointed with the second quarter performance of Merge and remain uncertain about the impact of operational changes the company made in the earlier quarter. Moreover, 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.

The presence of big players like General Electric Co. (GE - Free Report) and McKesson Corporation (MCK - Free Report) has made the diagnostic imaging market highly competitive. However, 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.

Presently, Merge retains a short-term Zacks #4 (Sell) Rank. Over the long term, we are Neutral on Merge.

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