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Merge Healthcare Incorporated (NASDAQ:MRGE)

Q1 2013 Earnings Call

May 1, 2013, 8:30 a.m. ET

Executives

Jeff Surges - Chief Executive Officer

Justin Dearborn – President

Steve Oreskovich - Chief Financial Officer

Analysts

Ryan Daniels - William Blair & Company

Chad Bennett - Craig-Hallum Capital

Deepak Chaulagai – Dougherty

Unidentified Analyst (Eric)

Unidentified Analyst (Gene)

Operator

Good morning and welcome to Merge's first quarter 2013 earnings call. Today's call is being hosted by Jeff Surges, Chief Executive Officer, Justin Dearborn, President, and Steve Oreskovich, Merge's Chief Financial Officer.

Before we get started, please consider that the comments today may contain forward-looking statements under the Private Securities Litigation Reform Act of 1995 and not historical facts. Actual results may differ. Various critical factors that could affect future results are set forth in the company's recent SEC filings and press releases. The company undertakes no obligation to update or revise any forward-looking statements.

In addition, there may be references to non-GAAP financial measures. These measures are supplemental to the GAAP financial measures and should not be viewed as an alternative to them. For greater information regarding these metrics, please see the related discussion in the company's earnings release.

With that, I will turn the call over to Jeff Surges.

Jeff Surges

Thank you Operator and thanks to everyone for joining us this morning for an update on our solid Q1 performance.

As we typically structure this call, I will provide an update on the overall organization as well as the Merge Healthcare operating group. And Justin Dearborn will provide an update on the Merge DNA side of our business.

Let me start with the fact that last week, we completed our debt refinancing, which entailed replacing our existing 11.75% notes with a new senior secured credit facility consisting of a six year term loan of $255 million and a five year revolving credit facility of up to $20 million at an initial rate of 6%. This will have a very positive and immediate impact on our business as we expect to save over $14 million on an annual basis.

Early feedback from clients and partners has been overwhelmingly positive as they have expressed renewed confidence in Merge's long term health financially and our viability.

Equally important is the fact that we expect this transaction to add almost $0.04 of GAAP EPS on a quarterly basis, a good move by the team.

Additionally in the first quarter, total Merge revenue increased to $64 million on a pro forma basis. Adjusted EBITDA was $12.5 million representing 19.5% of pro forma revenue. And subscription based pricing arrangements generated 15% of total revenue in the quarter as the subscription backlog grew 16% in both of our operating groups.

For the Merge Healthcare portion of our business, revenue was $53.6 million. Adjusted EBITDA for that group was $14.6 million or 27.2% of pro forma revenue.

While our overall Q1 EBITDA results did not meet our internal expectations, there are a few things worth noting. First, it's only our first quarter, so we remain confident that with the final three quarters of the year, we will achieve our full year goals. Second, in light of the quarter's results, we have implemented a multi-faceted plan to improve our COGs or cost of goods sold. We expect to see these results from this activity in Q2. Last, we expect that we will see more net new clients, which I'll speak to in a moment, but we'll see an increase in software revenue, which will have a positive impact.

That said, we believe our record sales combined with general trends we saw in Q1 have us off to a good and solid start. These results were fueled by three things, net new sale of iConnect, expansion of strategic client relationships, and adoption of our subscription based Honeycomb solutions. I'd like to briefly address each one of these.

First for the quarter, 11 more clients embraced an enterprise imaging strategy with our iConnect enterprise clinical platform. Even more exciting, many of these clients were net new and we welcome them to the Merge family. And they don’t currently have any Merge products within their health system. This signals that the message of an enterprise imaging strategy is resonating with the industry at large and not just with clients who already use a Merge solution.

On our last call, I eluded to the fact that we had line of sight to several net new enterprise imaging and iConnect deals that were very substantial in size. We’ve made great progress on these net new deals and still see them occurring throughout the year as well as the market continues to open up for these type of solutions.

Second, in addition to adding net new clients in Q1, we had great success in the expansion of current client relationships. Two examples are Ascension Health and the Centers for Diagnostic Imagings, CDI. Both of these organizations are growing dramatically and decided to expand their relationship with Merge in Q1. Ascension provides care at more than 1,500 locations in 23 states. And has renewed their contract with Merge as well as expanded the services and solutions that it will be purchasing from Merge. The Ascension agreement not only secured Merge's existing relationships for another five years, but provides us with confidence in our ability to expand our relationship across additional product lines.

Due to the structure of this agreement, this opportunity is not currently contemplated in our non-recurring or subscription backlogs. But we are very excited about the opportunity to work with Ascension and support their growth initiatives for years to come, Enterprise Imaging.

CDI, which recently expanded after a major merger is now one of the nation's largest medical imaging service providers. CDI has selected the Merge radiology suite to serve as the platform for their newly merged company and for all future acquisitions, which is positive now and into the future. These are two great examples.

Last, this quarter, we saw seven new clients adopt Merge Honeycomb, our cloud based archiving solution for their long term image storage needs.

To reiterate the model for those of you who are new to the call, when customers purchase Merge Honeycomb, they contract to pay a per-study fee for every image they store into the cloud plus a small monthly archiving fee. These arrangements are generally three-year agreements. And each client agrees to a minimum annual study volume. Just like you buy songs from iTunes and then store them in the Apple cloud, Merge Honeycomb allows clients to store imaging studies for a per-study fee in the Merge cloud. This quarter demonstrated that this model continues to gain traction.

While we are proud of these Q1 achievements, I also want to remind you that the second and fourth quarters are generally the strongest in the healthcare IT space as they are tied to hospital's budgets and buying cycles. That's the way our industry works. We feel that we are off to a strong start as we work to achieve our full-year guidance.

With that, I'd like to turn it over to Justin Dearborn.

Justin Dearborn

Thanks, Jeff. I am happy to share an update on the Merge DNA business.

From a financial perspective this quarter, Merge DNA generated $10.4 million in pro forma revenue with an adjusted EBITDA of $1 million or 9.6%. Subscription revenue comprised to 74% of total revenue for this operating group.

While we are pleased with the 30% plus revenue growth quarter-over-quarter and year-over-year, our margin was negatively impacted by a high mix of hardware sales and one-time deployment costs we expense as occurred in the quarter, which we don’t expect to continue.

Backlog at March 31st grew from $34.9 million to $40.9 million and is 100% subscription revenue based. In the past year, subscription backlog has grown by more than 100%.

Sales within our e-clinical group continued to grow aggressively both from new and existing customers. And new system capabilities continued to increase total contract value. We saw our average selling price increase by 21% over the prior quarter. We continue to be extremely positive in the revenue and margin growth within this group.

Now I'll let Steve provide additional comments on the quarter's financial information.

Steve Oreskovich

Thanks, Justin.

As Jeff mentioned, we are extremely pleased to have completed the re-financing of our existing debt in the past week. Before I provide the highlights of the new credit facility, I would like to review the operating results for the first quarter of 2013.

Total pro forma revenue of $64 million was a record for the first quarter of any year for Merge and an increase of 4% over last year's $61.6 million. We believe that we are on track to deliver on 2013 guidance of $265 to $275 million of revenue.

Revenue generated through subscription and other highly predictable sources continued to approximate 60% of total revenue, similar to the latter half of 2012. Specifically, subscription revenue is 15% and maintenance and EDI was 45%. We again experienced strong growth in subscription backlog of $7.2 million in the quarter to $52.8 million, which is easily on pace to achieve the guidance of an increase of $25 million for 2013.

Further, subscription backlog grew in both segments with the clinical trials platform leading the growth. What was particularly encouraging was the adoption of Merge Honeycomb, which is a 100% subscription based offering and added $1 million to our subscription backlog in healthcare. We expect to see these trends continue to grow in future quarters.

Revenue generated through perpetual license agreements also referred to as non-recurring revenue contributed the remaining 40% of revenue in the quarter.

Non-recurring backlog decreased to $23.8 million in the first quarter, which is typical in the healthcare IT industry as the fourth quarter is generally the strongest bookings quarter. We expect the non-recurring backlog balance to increase in coming quarters.

Gross margin on a pro forma basis was 56% in the first quarter compared to 59% in Q1 of the prior year. The decrease in gross margin is driven by hardware sales, which accounted for 16% of overall sales. This amount was slightly greater than prior periods. And the hardware was sold at a slightly lower margin. We do not expect this trend to continue during 2013. Please recall that the mix of software and hardware sales will continue to fluctuate and may impact our gross margin on a quarterly basis.

Offsetting the lower gross margin was an improvement in operating expenses. Cost associated with sales, R&D, and G&A decreased to $26 million in the quarter compared to $27.2 million in Q1 of 2012. Also we continued to monitor these highly controllable expenses.

Adjusted EBITDA for the quarter was $12.5 million or 19.5% compared to the same dollar amount for the first quarter of 2012. We continue to expect adjusted EBITDA of 22% to 24% for 2013. As it pertains to adjusted net income, a significant reason for the $0.01 per share loss in the quarter is attributed to the timing of recorded income tax expense under GAAP. While we expect $5 million of tax expense during the year, of which only $1 million is cash taxes, $3 million of that expense was recorded in the quarter. As a side note, only $250,000 of this total was cash taxes. If the timing of cash expense during 2013 was similar to 2012, Merge would have generated adjusted net income of $0.03 per share in Q1, 2013.

Another area of continued improvement is the cash generated from operations, which was $9.2 million in the quarter, an increase of $6.7 million compared to Q1 of 2012. As a result, the cash balance increased by $8.7 million in the quarter. To add to this momentum, the debt refinancing is expected to result in over $14 million of increased cash from operations annually starting in the third quarter purely by cutting our interest rate in almost half.

While all the details of the new credit facility exists in the 8-K filed earlier this week, I want to highlight some of the notable items as well as speak to the impact on the income statement going forward.

We replaced $252 million of public bonds at an interest rate of 11.75 with a $255 million six-year term loan at 6% interest. We obtained a new $20 million five-year revolving credit facility. The term loan was issued at 99% OID, which means we received $252.5 million of cash, which we used to pay off the old debt. The old debt also had a regular semi-annual interest payment due in the quarter and required a 5.875% penalty, same as one-half year of interest to retire at this time.

As a result, we will use cash of no more than $36 million to pay for not only the $31 million of interest and penalty, but transaction costs as well. Of that total, we have already paid $34 million.

The interest rate on the new debt is technically variable. But we have the ability to hedge this rate, which is why we are comfortable calling it 6%.

As a result of all this work, the second quarter P&L will have some noise in it. Most notably, the captions below net income from operations are expected to have approximately $24 million of one-time additional expenses.

Starting in Q3, we expect total interest expense and related expenses of approximately $4 million on a quarterly basis going forward.

While none of these charges will impact adjusted EBITDA in the second quarter of 2013, the positive news is that starting in the third quarter, we expect this transaction to add almost $0.04 of GAAP EPS on a quarterly basis. The end result is an expectation for the company to deliver both net income and EPS on a GAAP basis for the third quarter.

To provide some additional context, this transaction means an increase of $0.15 EPS annually compared to analyst consensus for adjusted EPS in 2013 of $0.19 per share.

With that, I'll now turn it over to the operator to open the call up for questions.

Question-and-Answer Session

Operator

(Operator instructions). Ryan, your line is unmuted.

Ryan Daniels - William Blair & Company

Yeah, guys, can you hear me?

Jeff Surges

Hi, Ryan. Good morning.

Ryan Daniels - William Blair & Company

Hey, sorry about that. Let me give you a couple of questions on the numbers first and some big picture. First, Jeff, you mentioned some steps you’re doing to reduce your cost of goods sold. So two questions there; one, does that relate to the modest restructuring charge you took during the period? And number two, can you just give us a little bit more color on what you’re doing there to control COGs?

Jeff Surges

Yes, so again, I think one of the graphs we’ve talked about over time is that we have been able to run our product portfolio and road maps in a way that have digested what we’ve acquired over time and have now single platforms for say our PACS product versus multiple. Honeycomb is now live and operational versus purely R&D and iConnect, both from an access share and archive is up and running and all on a single platform.

So as we look at development as a percentage of overall – of the overall operations, that continues to go down though we’re still able to fund and fuel what we need to. Sometimes some of those products do have third parties that we were using for either analytics or software development resources whereas we get to one product and go forward, we’re able to eliminate and cut those out.

In the quarter, we released our PACS 6.5 release, which was a very big release and migrates a number of those products into one and we’re able to shed off now in the going forward quarters a number of third-party and other costs that will start to strengthen. So that’s number one.

Secondly, as we start – as I talked about in the net new clients versus existing clients, it’s a much better software services and maintenance mix for us. And as we start to talk about net new, we can see a bigger expression. So lower our costs on the operating side, improve our margin on the net-new deal and I think that could have expressed itself even more so had we continued to pull in one or two of those larger deals that we see happening throughout the year.

Ryan Daniels - William Blair & Company

Okay, that’s helpful color. And then in regards to, maybe for Justin in the DNA business, the 2.1 million in non-recurring sales, did that have to do with the kiosks and is that the hardware commentary you’re referencing with the – somewhat of the margin pressure in the quarter?

Justin Dearborn

Yes, it’s a combination, it is hardware sales, it’d kiosk sales and those go to the retail channel as well as corporate customers for wellness programs. But really, the margin pressure there was around deployment costs on the lease side, so the combination of selling units out right and leasing them, we take the expense of shipping and deployment up front so it’s been a one-time hit for the more funds that we do under lease, the more pressure the margin is going to come under.

Again, I think that’s a – Q1 was a huge deployment. We don’t expect this net margin hit to continue.

Ryan Daniels - William Blair & Company

Okay, perfect. And then maybe one big picture one for Jeff. I know last quarter you talked about not only the bigger deals in the pipelines to look forward to, but also more market activity around the VNA deals. I think you thought maybe, you know, upwards of 50 versus the teens last year. Can you talk a little bit about how we are looking through the first third of the year and kind of what you’re doing from a sales perspective to make sure you guys capitalize on the big market opportunity ahead of you? Thanks.

Jeff Surges

Thanks. So again, this, to me, was a great opportunity that we likely could have really had an exciting start to the year [inaudible] came into the quarter. The way I think about it, you know, Ryan, Q4 of last year with all the noise around the PE stuff, we delivered our record quarter of 65 million plus. 90 days later in Q1, after refinancing this debt, we’re at 64 million and a number of those deals, as you know, the buying cycle for hospitals is Q2 and Q4, that’s when budget years go. So we tried to pull one or two of those in, we were successful with current clients, like Assention and CDI, which are very large and significant for us, but we have existing contracts there and the renewal is much different than a net new.

On the sales side though, we continue to see growth. There are more activity at what I call the large end, higher end health system level for image and interoperability. We’re seeing that our larger, more experienced sales executives, which we continue to top grade, not add net new, but continue to top grade, we’re seeing more and more activity there and I would say a good chunk of my time is in the CEO, CFO and CIO space, which I think a year ago or two years ago would have been in maybe the director level trying to climb that ladder.

So that visibility and the sales seasonality of Q2 and Q4 have us really poised as an opportunity to, what I think internally, I call it a missed opportunity where externally I think Q2 provides that opportunity to jump the curve.

Ryan Daniels - William Blair & Company

Okay, great. Thanks again, guys.

Operator

Chad, your line is unmuted.

Chad Bennett - Craig-Hallum Capital

Good morning, guys.

Jeff Surges

Hey, Chad.

Chad Bennett - Craig-Hallum Capital

So just kind of going back to the prior question on hardware sales, Justin, should we expect, you know, was this more of a one-time deal or was this a reorder from some retail clients? Should we expect the hardware kiosk business to be a consistent contributor at some amount quarterly throughout the year?

Justin Dearborn

So a margin contributor, definitely. So the margin pain in Q1 is around deployment costs, which we will not incur the same level of deployment costs in Q2 or Q3. So that was the big hit. It has been a margin contributor over the past six quarters, so we expect that to continue in Q2 and Q3 and Q4.

Chad Bennett - Craig-Hallum Capital

Do you expect more kiosk sales?

Justin Dearborn

No, higher margin.

Chad Bennett - Craig-Hallum Capital

Okay, but the…

Justin Dearborn

From the falloff on the deployment side.

Chad Bennett - Craig-Hallum Capital

Okay.

Justin Dearborn

So looking at it for 2013, don’t expect an increase from where we’re at right now. It’s, you know, like any other transaction, they’re fairly large and long. We do continue to sell kiosks into both retail and corporate markets, but Q1 was abnormally high.

Chad Bennett - Craig-Hallum Capital

And this transaction had nothing to do with Michael?

Justin Dearborn

Correct.

Chad Bennett - Craig-Hallum Capital

Okay. And Justin, on the subscription side of the DNA business and the clinical trial side, backlog growth sequentially was really strong and it has been to some extent the last few quarters. Is that business, and I know, I think from an operating income standpoint it generated about a million, is that at enough scale where we should expect kind of growing operating income or EBITDA contribution from that business throughout the year?

Justin Dearborn

Yes. It is generating and being coupled with the kiosk business in Q1, it’s massive, but it did have its highest margins ever and we don’t see why that wouldn’t continue. We do have the scale, the platform is complete, [inaudible] around the PACS refresh we did in the platform, it is complete and we’re starting to see the margin as you expect from a SASTs offering.

Chad Bennett - Craig-Hallum Capital

And how should we – should we think about the growth rate of that business being, you know, it grew 30% this quarter, is that about the right way of looking at it for the year?

Justin Dearborn

On an annual basis for us, but not quarter over quarter. So the spike from, you know, this is been a nicely-growing quarter-over-quarter business, but its subscription revenue so it’s not going to spike 30% quarter over quarter. So some of the 30% growth came from the kiosk side of the business, but the clinical trials group is growing at a great pace quarter over quarter and then annually it will be up a significant number.

Chad Bennett - Craig-Hallum Capital

Okay. And then, Jeff, can you give us a sense of how we should think about, you mentioned in your script that the June and the December quarters, obviously being the strongest quarters of the year. When you think about, you know, you were on the road a lot, you know, for the debt refi and kind of the whole management team, I imagine, was kind of focused on that for the last portion of the quarter, not to mention other things. Do you think the quarter was negatively impacted at all? I know you talked about the large enterprise deals that may be you thought you could get one this quarter, that – how much of an impact do you think that had on the business this quarter, the healthcare side?

Jeff Surges

Yeah, again, I appreciate the question. Again, I want to reiterate 64 million in a quarter where Q4 was 65 million, I don’t know any of the peer group in healthcare IT that Q1 exceeds Q4. So I’m sitting here saying, you know, one or two enterprise deals that we have our hands under, pull that in, high margin software, boy, a few points would materially make an impact here. But it’s Q1, so even if those did come in, I don’t know if my comments would be changed. I’d say, we’re still being operationally focused, we want to control EBITDA, lower our costs, we want to continue to accelerate and see.

The debt refinancing, while it took time, it was an efficient process. And most importantly, it took away the number one competitive reason our competitors talk about our company. They say, wow, look at that debt, could they ever make it? I said that last time, Chad. So when I talk about our clients and our partners who, in addition to our shareholders are our big three, we got strong momentum from the C-suite of our clients and partners who said awesome, congrats, 14 million a year, you know, you could either service the debt, you could invest it in the business. My view is we’ve invested in the business. We need to execute and keep that cash and potentially service the debt. And as Steve said, get to the EPS number by Q3.

So again, I’m not going to, in Q1, you know, look at the results and say, holy cow, we were really close to beating Q4, that would be like the first time in my 15 years in healthcare, so I feel good about it. That said, Q2, budgets end at the end of June and they start new in July, so we’re right in the middle of a number of these deals that could positively impact at the size we are, you know, they could sway – they could move the meter meaningfully in a positive way once we bring a couple of them right into the barn. And I feel that the visibility we’re at and the focus on where we’re at gives us that opportunity. I expect you and the rest of the group to wait to see, that’s okay. But I see the momentum and I see it – it’s our turn to execute on it.

Chad Bennett - Craig-Hallum Capital

Okay, great. And then last one for me for Jeff. You know, the iConnect suite, or enterprise platform, specifically VNA, and I know industry people look at it differently, but what do you think your win rate has been in VNA or broader iConnect opportunities out there in the marketplace?

Jeff Surges

Yeah, so remember, our iConnect solution and enterprise imaging stack is being provided by one provider, Merge. When we go up against our competitors in this space, it takes two to three of those companies to patch together a solution design that sticks against us. So right off the bat, Chad, we get a high degree of win because we’re just easier to do business with, right. One implementation one contact, one integrated platform versus three. So in that standpoint, we are clearly ahead of our competition.

The big question that is coming is, we are now in circles where we are talking on the largest PACS, the largest providers of imaging, the GE, the Philips, the biggest guys who forever have had a dominate position at the largest health systems, we are positioned as, you know, here’s another company at a significantly reduced price point than that uber premium from those guys that could positively generate a return on investment, be nimble enough to implement.

So we’ll track both iConnect but we’ll also track specifically VNA since that’s the mother ship of the stack and that’s the one that we think, we’re in the street fight with as it comes to either dethroning the existing guys because that’s net new, you have to take out the existing guy, and two, a win there is a great opportunity for our entire portfolio. So you know, continue to stay very focused on that and, you know, again, if you think about Assention and if you read about Assention, Chad, they’re buying 10 to 15 hospitals a year, we’re the recipient of that. CDI buys 40 imaging centers, we’re the recipient of that, so again, lining up against those opportunities where we’re completely now focused, right, refinancing’s over. We closed down last quarter that noise, we are very focused now and we are one or two deals away from a few of these digits looking differently, but I’d still have the same commentary. It’s Q1 we were pretty darn close to beating Q4 and I’m pretty optimistic about our opportunities for the rest of the year.

Chad Bennett - Craig-Hallum Capital

Yep, I hear you. Nice job on the quarter.

Operator

Deepak, your line is unmuted.

Deepak Chaulagai – Dougherty

Good morning, guys. Thank you for taking my questions. Jeff, just to start, a big-picture question for you. What would be the number one or number two growth driver for you? Would it be a secular trend where hospitals are now past the EMR implementation? Would it be meaningful use to regulations where now providers, some who might not have been focused on imaging are focused there? What would you say are the two or three top three growth drivers going forward?

Jeff Surges

Thanks, Deepak, and good morning. I think when we positioned iConnect a year or two ago, we talked about simple iConnect access, simple iConnect share and that the driver would be the vendor neutral archive. And so what is present today, the denominator today is the VNA, vendor neutral archives because that allows all of their images to get into one solution, readying them to attach those images to their EMRs. And you are correct, we are past EMR. AS I read, our other companies in the healthcare space, their reports, you know, not seeing a lot of strong growth in those EMR-only businesses. That signals we’re past that. So when we talk to the CIO he says, I’ve got a number of ailing imaging systems, I’ve got to get all these images into one and attach them up for the – into the medical record.

There’s really two drivers there. Revenue opportunity as they go to their referring physicians, they want to be easy to do business with and then the CFO is pounding the table saying, I need to save money, I’ve got four different systems for imaging, I’ve got four different storage components Let me look at Honeycomb as a repository, a cheaper way to store and let me look at the iConnect stack as a more effective way to keep all my images in one location. Those two drivers are clearly leading the day for us.

I think then what also comes along with that is a continuation of the cardiology stack of solutions, which is the evolution of the hospital health system wanting to get cardiology aligned with radiology and that’s where our class rated number one product starts to really show up. We have good strong clients with great strong reference ability with proven results, that comes together.

Now, package those three things together, we are several million dollars plus in the offering and that’s going to take a committee or two at the hospital side to purchase, which is why I talked about Q2 and Q4. In any given quarter, you can move a few $100,000 deals through any hospital or through any ambulatory imaging center. The several million dollar ones are going to have to really line up and go through their process, which lines up to the way we talked about the seasonality of our clients.

Deepak Chaulagai – Dougherty

That’s perfectly understandable and makes sense. On the competitive front, you talked about you are now having the confidence or the ability to go up against the big players. We’re aware that in the marketplace, you know, Philips and others are also very aggressive in that positioning. So you think it’s a matter of pricing that you can come in at a lower price point? Why couldn’t they come at a lower price point? And I have another follow up on the competitive front as well.

Jeff Surges

Yeah, so I think this is one where we stand as “Switzerland”, right. We don’t sell magnets or scanners, our business key drivers is not selling imaging equipment where then we would throw in the imaging software. All of our data say hospital’s capital budgets are not being spent on million-dollar-plus CT scanners and MRI machines, they are making do with what they have. So when that stalls, the rest of those large guys stall the rest of their world. Right, the rest of their P&L gets hurt. Merge comes in and says, look, we can consolidate all of your imaging silos into one system. So Deepak, I can consolidate all of the songs on all of my kids’ telephones into one iTunes library, it’s the same thing for the hospital. And I can store it. One of the things I want to make sure is clear is with Honeycomb up and running, our subscription growth, while it’s only $1 million, should signal that we are selling Honeycomb to places where there’s lower cost basis to store in the cloud than on premise by buying more hardware. And that will continue to grow and that demonstrates those are all subscription and that will demonstrate that we’ll tag on Honeycomb to large iConnect deals as yet another ROI.

So that type of discussion, number one. Number two, remember, all of these large, large systems that expect to receive millions of dollars through Meaningful Use haven’t received it all yet. They’ve only received stage one, which is 18,000 per physician and not the 44. So they’re still operating very nimbly. I haven’t had a meeting yet where the CFO says, you understand, we’re down 2% because of the sequester. Immediately, every hospital is down 2% because of the sequester. They want to know, what can you do to help me save that? And I think that’s where our portfolio, that’s where our ROI comes into play. You say, well, what are you paying for storage, right out of the gate, what are you paying? And then we can provide that solution in the offering there. So those are some of the highlights that we see when we are table to table with many of our prospective clients. And it’s about executing and bringing them in on our timeline and taking advantage of that market opportunity, which is no longer stalling because we’re going to buy an EMR.

Deepak Chaulagai – Dougherty

And then, I guess, what’s the – what are some of the puts and takes in expanding with a large entity like Assention or CDI? I mean, you’re expanding some of your solutions there, I assume you’re giving up some on pricing as well.

Jeff Surges

So in both of those cases, they’ve been existing clients for a long time and some of our larger clients on an annualized basis. So we have the strength of history and demonstrating our results, so when we get into a pricing discussion, we’ve got proven results that offset any negotiation, number one.

Number two, it’s like I talked about net new gives us more upfront revenue, right. When you’re selling to the same client, your right, they do expect a little bit of a discount. So while we may get strength in professional services and maintenance, it’s the net new products where we’ll see strength in the software. So those two examples were excellent for the business long term and will provide consistency as they roll out new hospitals and new products.

What I think is important to note too, because of the nature of those deals and not a net new agreement, we are not recognizing that model in any of our subscription or non-recurring backlog though internally, we have a great trajectory of what they’re strategic growth plans are and we’ll just keep adding to that each quarter as we talk about it.

Operator

Eric, your line is unmuted.

Unidentified Analyst (Eric)

Thank you. Good morning. One of the issues in the past from folks not buying into the Merge story was a belief that with all of VNA, say – kind of circa 2008 and ’09 through 2011 and ’12 the revenue growth reports were not really organic revenue growth reports and as I look at this now and correct me if I’m wrong, is it true that there’s only one very small acquisition that has yet to annualize in your reported results?

Jeff Sturges

That’s is correct, Eric. There was on small acquisition back in Q1 of 2012 but from the perspective of going forward, it’s all like for like comparison and that as very small. So the impact, if you’re looking at Q1 ’13 versus Q1 ’12 was insignificant at best.

Unidentified Analyst (Eric)

I think I had a couple hundred thousand at the most. So it’s all organic number starting in Q2.

Operator

Gene, your line is unmuted.

Unidentified Analyst (Gene)

Thanks, good morning and congratulations on a good quarter. Question on the DNA backlog. Obviously impressive, grew again over 100%. Justin, can you tell us what that – whether that backlog is a reflection of expansion, of existing customers and studies or weighted more towards greenfield clients?

Justin Dearborn

So a little heavier weighted to expansion within existing customers. If you looked at some of our CRO clients, they are the largest in the world, so to get additional mindshare with them and bid additional phases has been the strategy. We did sign 37 net new clients in the quarter, so a huge uptick there a well, but you know, what we’ve seen, and I think – and I know, Gene, you’ve follow many solutions, you’ll see the same things there. The CROs are winning a lot of business right now and that channel has been very strong for us. So to grow with [inaudible] for example is a great thing for us. Love the net new accounts a well but love the large multinationals a little bit better.

Unidentified Analyst (Gene)

Very good. Okay. And then Jeff, on the healthcare segment, you know, you talk about some of these large deals in the pipe. Can you share with us at least what the status is? Are you vendor of choice in these deals and it is a matter of going through the committee and board approvals or where are you in the process?

Jeff Surges

Thanks, Gene. So the process that most hospitals go through when they run their selection criteria is you know, they go to market, there’s an RFI or an RFP and then you go through the selection and then they whittle it down and then they name the VOC and at that point they have funding and then you enter into, from a net new client, you enter into the contract process which can add a few months, quite frankly. And so in many of these, we are VOC and we are in that process and it’s a timing question, right. So as I talked about in some of these deals we are whale hunting not bass fishing. So getting them close, we’ve to pull them in and you’ll see the reflection of that due to our size and the impact those can have. So encouraged by it, again, Q2 should be, as it always is, a good selling quarter and it should help us, you know, kind of throttle the rest of the year but it’s about executing and bringing them all the way into the boat versus getting them along side of the boat.

Unidentified Analyst (Gene)

Okay, great. Thank you, Jeff. And then just stepping back, you know, I can appreciate the notion of stage 2 meaningful use and how image sharing is taking more of a front seat. So when I think about the timing of when this will play out, given that adaptation for meaningful use Q2 doesn’t really begin until October of 2014, would we expect your adoption here to be a gradual phased approach or more of a 20-14 event?

Jeff Surges

Great question and again, I want to start with kind of the end question from the last call. You know, we are making great progress on these metrics that if you’ve been following over time, you’re seeing things like, you know, pay taxes and positive EPS and this debt. And so what is not contemplated in it is the positive nature that for the next two years plus we’re going to see more importance on the hospital side to lower their costs and to streamline their process. One of those processes is imaging because of the cost, right?

So as you look at the size of that industry, where everybody does imaging, non-profit, for-profit, chain, community, rural, urban, everybody does imaging. You’re going to see that those that have been already past phase one, the large academics where there was deep pockets are moving forward. So we don’t see this as a one-time event but a gradual over the next few years continuation and adoption of this strategy we’ve been putting together. And as we’ve strengthened the balance sheet now, as we’ve strengthened the message and have brought these products to market, Gene, we really feel like we’ve entered this enterprise sales solutions selling at a tier level that we haven’t been at a year ago. And so that should bear out with the meaningful use regulations whether it’s 2, 3 or finishing, whether it’s the ICD10 which is going to drive more change, cloud-base for lowering their costs, all of those things resonate in the discussions and the overall simplification of they don’t want to have nine imaging vendors, they would like to have one over time.

Unidentified Analyst (Gene)

Okay, very good. Thanks, Jeff.

Jeff Surges

Okay, well, thanks to everybody for all those questions. I’m glad we took the time to answer them.

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Source: Merge Healthcare's CEO Discusses Q1 2013 Results - Earnings Call Transcript

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