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Merge Remains at Neutral

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Recently, we reiterated our Neutral recommendation on Merge Healthcare Inc. with a target price of $2.75.

The company’s third quarter 2012 adjusted earnings per share (EPS) remained at breakeven level, in line with the Zacks Consensus Estimate but lower than the year-ago $0.05. Revenue edged up 0.5% to $60.4 million but missed the Zacks Consensus Estimate of $64 million.

Merge witnessed 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. During the reported quarter, subscription revenue was approximately 15% of total net sales. The shift to a subscription-based model is clearly reflected in the company’s continued backlog generation in both healthcare and DNA compared to the year-ago quarter. The company expects about 80% of its revenue to be generated from the subscription-based model in the next couple of years.

Currently, with the greater adoption of electronic health records (EHRs) in doctor’s offices, hospitals and imaging centers, Merge’s iConnect platform is becoming significant, since it is a vendor-neutral archive. According to Frost and Sullivan and Merge’s recent research report, the global market for imaging software and services, healthcare IT interoperability solutions and EHR solutions for radiology, cardiology, ophthalmology and orthopedics is worth $7.5 billion annually.

In the third quarter of 2012, the company added more than 15 clients for its iConnect solutions. These include global contract research organizations (CRO), and large IDMs (identity managements) to community hospitals.

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 - Free Report) and McKesson Corporation (MCK - Free Report) has made the healthcare solutions and services market highly competitive. We have a Zacks #3 Rank on the stock, which translates into a short-term ‘Hold’ rating.

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