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Introduction

An attractive area to look for potential turnaround investments is in the software space. Along with a plunging share price, what usually grabs our attention in a depressed software equity is a steady recurring revenue base, high gross margins, a strong balance sheet, and minimal capital spending needs. Couple that with a low valuation and a fresh management team with the skills to stabilize the core business, plus the vision to lead the firm into new growth opportunities, and you’ve got a potentially attractive investment situation.

Merge Healthcare (NASDAQ:MRGE) is a pretty classic case of the above investment scenario. The firm’s ascent from late 2000 to late 2005 was dramatic, taking the share price from a touch above $0.50 to a $30 intraday peak (that equaled an approximately $1b market capitalization.). The fall, largely prompted by an accounting scandal, and new government reimbursement programs, was just as spectacular, taking the shares right back down to the sub-$1 level in 2008, equaling a market capitalization of $14m.

Despite its bruised financial reputation, however, Merge maintains a formidable foothold in medical imaging and information management software. Further, a new team has come on board, injecting both capital and relevant turnaround know-how. Most importantly, financial results have already shown a marked improvement, with the company reporting positive operating income in the latest quarter, the new management team’s first full quarter, after nearly two years of losses.

Continued positive financial results, as well as potential renewed interest in healthcare-related technology companies, given President-Elect Obama’s support for electronic medical records and other efficiency-enhancing technologies in healthcare, make Merge an interesting turnaround to watch over the next 1 to 3 years.

To get a better sense of where the company’s been and where it’s headed, we sat down recently with Justin C. Dearborn, Merge Healthcare’s new CEO. Before we get to the interview, here are some background facts and financial figures to help put the investment case for Merge in its proper context.

Merge’s Business

Website: http://www.merge.com/

Merge began life as an integrator of non-digital medical imaging devices (x-rays, CT scanners, etc.). Through a series of acquisitions, the firm moved into medical imaging and information management software, selling both directly to hospitals, imaging centers and clinics via its Merge Fusion division, and indirectly through medical device original equipment manufacturers [OEMs] via its Cedara division (now known as Merge OEM).

The basic value that Merge provides is that its imaging solutions help to reduce the film, paper, labor costs and time involved in managing and distributing medical images and information, which helps increase profitability for imaging centers and ultimately helps improve patient care.

In addition, the company’s OEM team develops custom-engineered software applications and development tools for the global medical imaging and information markets, thereby helping customers develop and launch innovative medical imaging technologies. Merge’s technology and expertise span all the major digital imaging modalities, including computed tomography (“CT”), magnetic resonance imaging (“MRI”), digital x-ray, mammography, ultrasound, echo-cardiology, angiography, nuclear medicine, positron emission tomography (“PET”) and fluoroscopy.

Though the total worldwide size of the market in which MRGE operates is difficult to estimate, Millennium Research Group, an international market research firm, has reported that in 2005, the U.S. market for Picture Archiving and Communication Systems (“PACS”), and Radiology Information Systems (“RIS”) was valued at over $1.5 billion. By 2010, this market in the U.S. was expected to grow to over $3.0 billion. This gives definition to a small part of the entire global medical imaging and information market.

The Financial Facts Behind Merge (MRGE)

(All Data is publicly available data as of the third fiscal quarter via the 10-Q: 9/30/2008)

Diluted Shares Outstanding: 57million

Options Out of the Money: 3.6 million

Restricted Stock: 0.48 million

Cash: $14.4 million

Debt: $14.1 million ($15 million senior secured term note held by Merrick RIS, due June 4, 2010, bearing interest at 13%, first two interest payments prepaid. Total yearly cash interest expense of $2.0 million)

Significant Insider Ownership:
Michael Ferro Jr., Chairman (via Merrick RIS), 49.5%

Estimated 2008 Sales: $57 million

Estimated 2008 Blended Gross Margin: 69%

Estimated 2008 (Annual Cap-Ex): $1 million

Estimated Annual Depreciation and Amortization: $5 million

Recent Quarterly Results and Implications for Future Cash-Flow:

In the latest quarter ended 9/30/2008, Merge reported positive EBITDA of $2.8 million. Subtracting interest expense and cap-ex, gets us to an untaxed free cash-flow of $2 million for the quarter, and an annualized potential free cash-flow estimate for MRGE of at least $8 million. Notably this number still includes some additional one-time legal expenses and “growth” overhead that could be trimmed to further improve cash-flow.

Interview with Merge CEO Justin Dearborn

Envoy Global Research (EGR):

So what went wrong at Merge over the past few years?

Justin Dearborn [JD]:

Not long after the company’s merger with Cedara Software in 2005, accounting problems began to surface. A delay in providing 2005 audited financial information in early 2006 snowballed into a series of financial restatements, delisting notices, and management shakeups that culminated with two shareholder lawsuits (both settled in 2008) and a formal SEC investigation. Litigation became a significant drain on both financial and other corporate resources. Our competitors certainly capitalized on these distractions, which led to missed sales opportunities.

A more recent business issue was prior management’s entry into the teleradiology service business. In the simplest terms, this means transmitting a diagnostic image from virtually anywhere in the world to be interpreted and returned. This potentially put Merge into direct competition with some of our customers. We viewed this as an untenable position. Additionally, we saw the space beginning to commoditize and become very price sensitive.

In addition to these self-inflicted woes, the Federal Deficit Reduction Act of 2005, which started to take effect January 1, 2007, has also hurt our business by reducing procedural reimbursements from Medicare and Medicaid for certain types of medical image-based procedures. This led to a reduction in revenue for our end-user customers, namely the imaging centers, which caused these centers to cut back on all investments. These cutbacks affected many of our OEM customers as well.

As great believers in the ROI that our offerings provide, however, we view this scaling back as only a temporary setback. The imaging centers were and still are faced with increased competition, lower revenue and increased costs structures, and will be required to make the necessary technology investments to improve workflow. Additionally, as health care consumers become better educated they will demand quality services regardless of federal reimbursement levels.

EGR:

What has changed at MRGE in the past year to improve the outlook for the company?

JD:

A great deal has changed in a short period of time.

For one, there was the entry of Merrick Ventures (http://www.merrickventures.com/), as both an investor and a new managerial team, in June 2008. Michael Ferro formed Merrick after selling Click Commerce for nearly $300 million. He’s now Chairman of Merge and the company’s largest shareholder. I served in a number of roles during my nine-plus years at Click Commerce, including serving as General Counsel and Director of Strategic Alliances as well as leading the company’s largest business unit. Nancy Koenig, the current President of Merge Fusion, also contributed immensely to our success at Click Commerce and was the President of Click at the time of sale.

Once the Merrick team took control of Merge, we initiated major reorganizations within the company. Within the first week, we halted the sale of Merge’s European operation that had been scheduled to close in June. Our Europe, Middle East, and Africa business has been folded into the two remaining divisions, Merge Fusion and Merge OEM and has been performing very well.

In addition, the failed Teleradiology Services has been shut down, though we retained certain technology that was developed via that initiative. We also shed our offshore custom engineering subsidiary. On the positive side, we’ve also reversed former management’s disposition of our Chinese operations, which we believe is key to our international expansion strategy.

These changes and others have enabled us to re-focus on our core business, and to better serve our customers. Equally important for shareholders, due to our decisive actions, we’ve quickly returned Merge to profitability for the first time in several years. Given the difficult macro environment, we are very proud of these early results.

EGR:

What are some of Merge’s financial strengths and business advantages?

JD:

Financially, we of course benefit from the high margins that software sales provide. Even our lower-margin services and maintenance segment generated 65% gross margins in the third quarter. Combined with very low capital spending needs, this business can generate strong cash profits, now that exceptional expenses such as legal and severance have dropped away.

In addition, Merge possesses a strong, core base of customers that provide recurring revenue on both the Fusion and the OEM side. We can also boast of strong global brand recognition, as demonstrated by both our eFilm Workstation product, the most-downloaded diagnostic imaging software in the world and our MergeCOM3 DICOM toolkit. We also have a strong IP portfolio, with 29 patents granted and another 37 applied for.

Finally, I would mention that our work with major OEMs keeps us firmly in touch with customer demands and assures that we will continue delivering useful, innovative products into the medical imaging market.

EGR:

What growth opportunities do you foresee for Merge?

JD:

I mentioned our moves to terminate the disposition of our foreign subsidiaries. International expansion is critical to our growth strategy. Although the U.S. market for digital medical imagery is far from reaching a saturation point, the international markets are dramatically under-penetrated. Places like China offer the most room for growth, so that is a major focus for us, which is why we reacquired our operations in China.

Furthermore, even though we acknowledge that this is a very competitive industry, our software is already out there, being used in over 70 countries. Specifically, we have a very extensive database of all the folks out there who have downloaded the eFilm Workstation. That’s an extremely valuable tool for acquiring sales leads and ultimately new enterprise customers.

Finally, in my former experience with Click Commerce, I was part of the team that built Click through the integration of a series of successful accretive acquisitions, and you
can expect to see us utilize a similar strategy at Merge.

EGR: What makes you confident in current management’s ability to execute on a profitable organic and acquisition strategy for Merge and to enhance shareholder value?

JD:

We can first point to our track record with Click Commerce. While that story ended well, there was a definite rough patch when the dot-com bubble burst and the tragedy of 9/11 occurred. Our business was cut in half overnight with our stock price following.
We cut our expenses significantly, and were able to ride out the storm. We also made some very accretive acquisitions during that period. Ultimately, the stock returned something like 2500% in a little over a three year period of time up through our sale. So, we provided very attractive results for the shareholders who hung in there.

Second, as I’ve mentioned, we have already delivered initial profits at Merge, proving that the business is viable. As we maintain profitability and grow both organically and through smart, opportunistic acquisitions, the intrinsic value of this business will become clearer to investors, and we believe the stock price will follow.

EGR:

What major challenges does Merge face?

JD:

Obviously, the macro environment is unpredictable right now and it of course weighs on our customers’ purchasing decisions, as it does for all other businesses.

We’ve also worked hard to rebuild Merge’s reputation, which suffered as a result of all the negative, litigation related press, not to mention viability questions.

However, Merrick’s capital infusion along with our Q3 results should have resolved any viability concerns. Now the new management team, free of past distractions, has a great opportunity to leverage Merge’s core strengths, continue to regain our customers’ confidence, and win new customers.

EGR:

What major factors should investors focus on when evaluating Merge’s performance over the coming few years?

JD:

Look for continued financial stability and profits. A steady, dependable top-line is a critical platform for future growth.

In terms of business developments, keep an eye out for new product announcements, such as our new Merge Mobile iPhone application, and partnerships, such as our recently announced initiatives with IBM (NYSE: IBM), SIIA and Robarts Institute.

Finally, while acquisitions are hard for investors to evaluate until they’ve been properly integrated, expect us to be thrifty and opportunistic in this area. As significant equity owners, the Board and management team has every interest in pursuing only accretive M&A.

EGR:

Justin, thank you for your time and best of luck.

Envoy Conclusion:

While Merge still has some work to do in terms of regaining both customers’ and investors’ trust, we see plenty of reasons to be optimistic here.

The firm’s revenue base has proven to be very resilient even in the face of some stiff headwinds. Furthermore, the rapid return to profitability under this new management team, which is well-incentivized to turn this business around, is very encouraging and displays the free cash-flow potential of the business.

Financial risk also appears minimal, since the balance sheet is stable, and cash-flow easily covers any interest expense. Furthermore, Merrick is the firm’s creditor as well as its primary shareholder. Incidentally, Merrick continues to be a large buyer of MRGE stock on any correction. In short, the business downside — which is always our primary focus when dealing with turnaround situations — appears limited from here.

Meanwhile, we see plenty of room for this management team to engineer significant growth at the company, as they did with Click Commerce, a software firm that saw its own share of struggles. Continued positive financial results could lead to a significantly higher share price over the next 1 to 3 years.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in MRGE.

Source: Merge Software: A Turnaround to Watch in Medical Imaging Software Space