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Merge Healthcare Incorporated (NASDAQ:MRGE)

Q4 2013 Earnings Call

February 20, 2014 8:30 am ET


Justin C. Dearborn - Chief Executive Officer, Director, Chief Executive Officer of Merge DNA and President of Merge Healthcare

Steven M. Oreskovich - Chief Financial Officer, Chief Accounting Officer and Treasurer

Steven Tolle - Senior Vice President of Solutions Management


Joseph Fadgen

Ryan Daniels - William Blair & Company L.L.C., Research Division

Eugene M. Mannheimer - B. Riley Caris, Research Division

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

Brooks G. O'Neil - Dougherty & Company LLC, Research Division


Good morning, and welcome to Merge's Fourth Quarter 2013 Earnings Call. Today's teleconference is being hosted by Justin Dearborn, Merge's Chief Executive Officer; and Steve Oreskovich, its Chief Financial Officer. My name is Colin, and I will be moderating today's session. [Operator Instructions]

Also, please consider that the comments today may contain forward-looking statements under the Private Securities Litigation Reform Act of 1995, which statements are not historical facts. Actual results may differ. Various critical factors that could affect future results are set forth in Merge'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 presented in the company's earnings release and should not be viewed as an alternative for them. For greater information regarding these metrics, please see the related discussion in the company's earnings releases.

With that, I would now like to turn the call over to Merge's CEO, Justin Dearborn. Mr. Dearborn, please go ahead.

Justin C. Dearborn

Thank you, operator, and thank you, everyone, for joining us this morning. Q4 was a challenging but successful quarter for Merge. Sales were up marginally in our Healthcare segment when compared to Q3. We increased gross margin by 3%, adjusted EBITDA by 4% to 17% in sales, and we voluntarily repaid another $9 million of debt. We continued this strategy into 2014, with an additional $3 million payment in January. However, the industry trend that drove our results during the second and third quarters continue to be present during Q4. Market uncertainty remained, and with many health care information technology imaging-centric vendors merged out the impact of provider indecision.

In both the ambulatory and the acute hospital settings, several external pressures had caused customers to defer spending. In the hospital market, the federal government sequester, which started in April, cut $11.8 billion in Medicare reimbursements to providers during 2013. Additional federal budget reductions and reimbursement uncertainties, such as the planned 2-Midnight Rule, led several large health system clients to defer making decisions on new health IT projects.

By year end, hospitals and health systems have begun to focus on 2014 mandates of ICD-10 and Meaningful Use. IT budgets and other resources were consumed by the planning and implementation of technology upgrades to billing and EMR applications to meet these mandates.

In the non-hospital or ambulatory market, the trend towards partnerships, mergers and acquisitions between physician practices and health systems continued. Unfortunately, when ambulatory providers explored deals like this, they often put technology purchases on hold.

Along with their hospital counterparts, ambulatory providers also face spending and budgetary concerns with respect to meeting the 2014 mandates, as well as general uncertainty regarding the impact of the Affordable Care Act requirements in 2014.

In addition to the observed market spending disruption in 2013, Merge faced a number of expensive legal issues. While I'll refrain from commenting on the merits of the specific intellectual property claims or the current state of IP litigation, I will note that we've put 2 very costly IP suits behind us in 2013. The first was related to our health station business and it was settled in late fall. The second was a patent infringement suit initiated by Heart Imaging Technologies in September of 2012 relating to our web-based image viewer. This past quarter, we settled the litigation and obtained a nonexclusive patent license to Heart IT's portfolio of health care information patents, including Zero Footprint technologies. This settlement should resolve any customer infringement concerns about our iConnect Access image interoperability solution.

These 2 patent infringement actions have cost the company significantly in both hard dollars and as distraction to our core business and were not covered by insurance.

In addition, as previously announced, we discovered in Q4 that a former Merge eClinical sales employee had falsified certain customer contracts. We immediately performed an internal investigation and then engaged both outside legal counsel and a forensic accounting firm to conduct an independent investigation. Both investigations concluded that the illicit activity was isolated to this one individual, and we referred the matter to the U.S. Attorney's Office for criminal prosecution.

I want to emphasize again there was no impact to any previously reported revenue results or customer billings. While we did revise our previously announced subscription backlog number, none of these changes affected our reported financial results.

We incurred around $200,000 of legal and accounting costs in Q4 to investigate the matter with outside counsel and the aforementioned forensic accounting firm.

Our eClinical offering remains strong and I fully expect it to continue its positive growth. I, along with our board and the rest of the senior management team, take matters of corporate governance and ethics very seriously. We continue to focus on ensuring that this remains a single, isolated incident. I mentioned this today to keep our stakeholders informed, but also to provide the proper context. This was a single employee who's no longer with the company, acting alone, and committing a fraud for illicit gain. It was the company that identified the problem, investigated the situation and reported it to the proper authorities.

I assume that most of you have seen the various law firm press releases announcing an investigation of Merge or otherwise trying to solicit a lead plaintiff for purposes of commencing a class action against Merge. In fact, press releases from several firms seem to relate to a suit filed by another law firm. And just to be clear, as of today, Merge has been served with just one securities class action complaint, which is on behalf of a lead plaintiff who owns -- or owned less than 3,000 Merge shares. Other copycat complaints had been filed or may be filed in the days ahead as the plaintiff's attorneys jockey for position as lead counsel.

Simply put, we do not believe these allegations have any merit. In this instance, Merge was the victim. Merge discovered the problem and investigated thoroughly. While falsified contracts had been included in backlog reports before Merge's Board and senior management became aware of the situation, this erroneous information was publicly corrected when Merge's investigation was complete. When the time is right, we expect to file a motion to dismiss any securities law claims related to this issue for failure to meet the stringent pleading standards required by the Private Securities Reform Act of 1995. We will vigorously defend any claims that survive thereafter.

Despite these challenges, Merge has stayed on track and continued to implement plans for both short-term and long-term growth. We have invested in our core products, capitalized on new and innovative technologies and forged new strategic partnerships to support our clients with their regulatory initiatives and meet expected future market demand.

In fact, Merge was recently ranked in the top 10 software vendors overall in KLAS Research's 2013 Best in KLAS Awards: Software & Services report released a few weeks ago.

KLAS independently ranks health care key vendors based on client feedback. We take the reviews very seriously as they provide a great report card and solid third-party validation of customer satisfaction. We believe that being ranked in the top 10 and only 1 of 2 imaging-centric vendors in the group proves that our total solution is on the right path from both a technology and a services perspective.

We are listening to our customers' feedback and responding to their needs. I'm proud of our entire dedicated team of experts from solutions management, to R&D, to professional services, to customer support, for helping us achieve such a major accolade. This ranking confirms the strength of our complete portfolio of imaging and interoperability solutions.

As I mentioned previously, 2014 is a big year for government mandates. In the ambulatory radiology market, we expect our business to benefit as customers require Merge product upgrades to stay in compliance with either ICD-10 and/or Meaningful Use.

We have already successfully launched our new ICD-10-compliant billing solutions and are working to upgrade approximately 150 clients to enable testing well ahead of the October deadline.

In addition, Merge implemented a company-wide plan to certify applicable solutions for Meaningful Use Stage 2. This new phase of the MU program is particularly interesting to us, as it includes access to medical images as a requirement.

In Q4, our Radiology, Eye Care and Orthopedics PACS were all modularly certified, as well as our Merge laboratory solution. In just 2 months into 2014, we have already received certification for 3 additional products, including iConnect Access, Merge Cardio and Merge RIS.

Beyond customer preparedness and pending upgrades for ICD-10 and Meaningful Use, we see several other positive trends for sales opportunities within 3 core areas of our business.

First, in interoperability, we've seen health care organizations begin to embrace and adopt technologies with subscription-based pricing models. Merge Honeycomb, our cloud-based archive, is gaining momentum amongst both our acute and ambulatory customers. Customers have also responded well to the launch of the new iConnect Network, an advanced imaging network that provides hospitals, physicians and imaging centers the ability to exchange information electronically without having to implement costly, point-to-point HL7 interfaces.

After many months of development with our partner, Surescripts, as well as testing with 2 beta site customers, Radiology Ltd. in Tucson and Long Island Radiology in New York, we successfully completed implementation of our iConnect Network solution and announced general availability of the advanced interoperability platform. iConnect network represents a significant whitespace and recurring revenue opportunity for Merge that we are uniquely positioned to capture. We currently have 17 early adopters for this service and a large target market in our ambulatory client base.

Recently, the Center for Diagnostic Imaging, a long-standing Merge customer, and one of the largest national networks of outpatient imaging centers in the United States, became an iConnect Network customer.

In addition to CDI, we also completed a new strategic partnership with athenahealth to help us grow the iConnect Network. Recently named the #1 overall software vendor by KLAS in the 2013 Best in KLAS report, athena is a leading provider of cloud-based services for electronic health records, practice management and care coordination. Under our partnership agreement, athenahealth will integrate iConnect Network with its national cloud-based platform, enabling athenahealth clients to receive and view exam results, diagnostic quality images and other critical patient information within the athenaClinicals EHR workflow. This collaboration is significant to both the adoption and future growth of the iConnect Network, as it further expands our customers' options, allowing them to leverage a solution to reduce operational bottlenecks, improve physician satisfaction and ultimately, enhance the patient experience.

And this is just the beginning. We will continue to grow iConnect Network in 2014 as we bring additional services to market, sign up new strategic partners and expand the service into other verticals in which Merge has a strong customer base, such as orthopedics.

After being named the Best in Interoperability by Frost & Sullivan in Q3, Merge was also able to secure several interoperability customer wins in the fourth quarter, including a win with Blanchard Valley Health System, a nonprofit, integrated health system serving 8 counties in Ohio. Blanchard Valley selected Merge's vendor-neutral archive, image-sharing and cardiology solutions to fulfill 3 main objectives: Enable a seamless flow of image information across its enterprise, help meet Meaningful Use Stage 2 imaging requirements and develop a disaster recovery program.

As a first step, Blanchard Valley will operate its existing Merge PACS and will also implement Merge Cardio and Merge Hemo. Those solutions, combined with iConnect Enterprise Archive and iConnect Access, will provide Blanchard Valley with an imaging interoperability platform that eliminates its departmental silos and leverages intelligent rules to manage data and reduce the cost of storing imaging procedures. I am very happy to announce that Blanchard Valley has also, this week, signed a 5-year contract to utilize our Honeycomb Archive solution.

Another very prominent IDN that has been recognized for high-quality patient care more often than any other academic medical center in the nation chose Merge's integrated suite of interoperability, cardiology and radiology solutions to form an innovative cardiovascular image management, data management and clinical reporting system that extends throughout and beyond the hospital walls. This is a long, competitive sale and our win displaced a large modality vendor. These 2 significant contracts, totaling over $3 million in sales, along with the expansion of Merge Honeycomb and iConnect Network subscription-based product offerings, further position Merge for long-term success in the interoperability market.

The second area of the business where we've seen success is our cardiology, and we recently announced very exciting news about our market position. Merge Cardio received the Best in KLAS honor in the cardiology category, and Merge Hemo held on to its #1 spot as a KLAS Category Leader in Cardiology Hemodynamics for the third year in a row. This is a major achievement, as it marks the first time that KLAS is giving top honors to the same vendor in both cardiology categories.

As highlighted in the Q4 wins, our cardio imaging solution continued to be a key enabler of our enterprise imaging strategy. In both wins, our ability to bundle cardiology and radiology imaging offerings allowed us to deliver superior value to our customers.

The third area, where it's seen solid year-over-year growth, is our eClinical business. Over the past year, we've successfully completed a strategic migration to a SaaS business model and platform with Merge eClinical OS and have seen a 4.5x increase in eClinical OS revenue over 2012. To date, there are 267 active trials being conducted, with 225,000 study subjects using the platform. And we expect to see these numbers to continue to grow as the solution offering expands.

Overall, when I look back on 2013, I am disappointed with the status of the industry as a whole, as well as our top line performance. However, as I just mentioned, we continue to invest in our solutions at a high rate, while lowering our annualized cost structure in excess of $20 million. Despite the difficulties that face the imaging industry, Merge signed 515 customer contracts greater than $25,000, not including maintenance renewals. While that took a lot of hard work, we clearly need to do better to meet our internal and external goals.

Finally, I'll provide some context regarding the 2014 guidance that was included in our earnings press release. We expect pro forma revenue of between $212 million and $225 million and adjusted EBITDA of between $40 million and $45 million. On a continuing business basis, we expect our pro forma revenue to be plus or minus 2% to 3% compared to 2013. The EBITDA range provided represents between 8% to 21% growth over our 2013 results.

You should recall that in the second half of 2013, we exited certain low- to negative-margin businesses that contributed about $14 million to 2013 pro forma revenues. Our 2014 guidance takes into account these exits.

As we discussed in the prior call, we took these steps, including beginning to wind down our health station business to focus Merge on 2 core areas: Imaging interoperability and clinical trial software.

The health station business would have required a great deal of capital that Merge could not access under its current credit agreement. Given the competitive pressures and other uncertainties in the kiosk market, the Merge Board determined that trying to raise tens of millions of dollars in new capital to deploy a new generation of kiosks was not prudent. As a result, Merge chose not to bid on renewal opportunities and will continue to exit this business line in 2014 as our existing contractual obligations expires.

Now I'll let Steve Oreskovich provide additional comments on our financial information.

Steven M. Oreskovich

Thanks, Justin. Like many other imaging software providers, the market conditions Justin discussed had a significant impact on our 2013 results, most notably, nonrecurring revenue, which comes from perpetual license deals, has lagged since the second quarter.

Merge has differentiated itself from others in that we have focused our efforts not only on cost containment, but also investing in continued product development. We have introduced products such as iConnect Network, ECOS and Honeycomb, which is why R&D continues to remain at the high end of the industry at 14% of net sales over the last several quarters.

We have also tightly controlled our expenses, resulting in the adjusted EBITDA margin increasing from 15% in Q2 to 17% in Q4. And on a GAAP basis, we were essentially breakeven in the fourth quarter. We also continued to deliver strong customer collections, which enabled us to pay another $9 million of principal, ahead of schedule in Q4, and $3 million more at the end of January, bringing our total principal payments in the first 9 months of our new credit facility to $19.3 million, or 8% of the initial loan amount. We believe that our efforts over the last few quarters are starting to bear fruit and put us in a good position for 2014.

As it relates to the comparable, quarterly, year-over-year results, total pro forma revenue was $53.9 million in Q4 compared to $64.7 million in the prior year. Revenue generated through subscription and other highly predictable sources accounted for 65% of total revenue in 2013, up from 58% in the prior year.

On the backlog front, subscription backlog was $55.3 million at the end of the quarter and grew 39% in the last year. Nonrecurring revenue backlog increased 9% in the quarter to $24.2 million, which is typical of the fourth quarter.

Gross margin on a pro forma basis was 57% in Q4, up from 56% in Q3 and compared to 59% in Q4 2012, excluding some onetime charges that occurred in that quarter.

Gross margin is affected by the mix of software and hardware sales on a quarterly basis. That said, hardware revenue was 15% of overall pro forma revenue in the quarter, which is consistent with the long-term average.

Costs associated with sales, R&D and general and administrative expenses, decreased to $24.1 million in the quarter compared to $28.9 million last year, excluding certain onetime items. This illustrates the savings obtained from the cost alignment actions undertaken in 2013.

As defined in our press release, adjusted EBITDA for the quarter was $9 million or 17%, compared to $700,000 or 1% in the prior year. Adjusted net income was $0.04 per share in the quarter compared to a loss of $0.13 per share in the prior year.

On a GAAP basis, we were essentially breakeven, a $300,000 loss in the fourth quarter of this year compared to a loss of $17.2 million last year.

Cash generated from business operations was strong again during the quarter at $14.2 million, while our cash balance remained relatively flat and ended at $19.7 million. This was a 51% increase over the $9.4 million generated in Q4 of last year. Collection efforts and lower operating expenses drove the significant cash generation.

I would like to thank the entire finance and accounting team for their effort in both areas and look forward to continued focus in 2014. As a result, we feel very comfortable increasing our voluntary loan repayment to $9 million in the fourth quarter.

Further, the aging of our accounts receivable balance continues to improve, as over 65% of the net balance at year end is aged less than 60 days.

I want to highlight that while our collection efforts during the quarter generated cash, there was not a significant change in the primary accounts impacting working capital, as both our accounts receivable and accounts payable decreased by $3 million in the quarter.

On last quarter's conference call, I addressed our philosophy regarding cash and debt. I would like to again touch on a few important items. First, we believe that reinvesting cash into the business and making voluntary loan repayments are the best ways to use cash generated from operations. We expect to continue this approach in 2014, as noted by the $3 million voluntary loan payment already made in January. We are also comfortable operating with about $15 million of cash on hand and don't currently foresee the need to use any of the availability under our $20 million revolving facility.

Historically, our adjusted EBITDA amounts, calculated with respect to compliance under our credit facility, have tended to be greater than the adjusted EBITDA publicly reported. Further, we can positively affect our credit agreement compliance calculation by voluntarily paying down principal or through the use of equity cure provisions on our credit agreement in the event of an EBITDA shortfall.

Now I would like to turn to 2014 guidance. As Justin indicated, we expect revenue of between $212 million and $225 million and adjusted EBITDA of 19% to 20% for the year. After adjusting 2013 revenue for the exit of nonprofitable and low-margin products, our 2014 revenue guidance is essentially flat. This reflects the fact that our last 3 product innovations are subscription-based, and therefore, revenue from those products will be recognized ratably over a longer period and also our current expectation on when the market, the larger perpetual license software products, will improve.

Our adjusted EBITDA expectations imply a growth rate of 8% to 21% from 2013. We believe this is achievable based on the efforts taken during 2013 to rightsize our cost structure. In addition, we expect to capitalize approximately $2 million to $3 million of software development costs as a result of enhancements to our product development and quality assurance processes.

I would also like to point out that there are 1.2 million shares of currently in-the-money stock options held by officers that are set to expire in Q2 and Q3 of this year. We anticipate that all of these options will be exercised before they expire, which impacts the estimated share count for 2014 provided in the press release.

We are also providing this information so investors understand the context of stock option exercises that may occur in the next few quarters from reporting officers.

As it pertains to the other items reconciling GAAP net income to adjusted EBITDA, the expected amounts are contained in our earnings press release. And speaking of GAAP net income, our bottom line has improved during the last 4 quarters, from net losses of $6.5 million to $4.3 million, excluding $24 million of debt refinancing costs in Q2, to $4.1 million, to less than $300,000 in the fourth quarter. Given that Q4 was our lowest revenue quarter in that span, we view this improvement as evidence that our business is headed in a healthy direction long term.

I'll now turn it over to the operator to facilitate question and answers.

Question-and-Answer Session


[Operator Instructions] Going now to our first caller.

Joseph Fadgen

So Joe Fadgen here, on here for Chad today. A couple of questions. First one, on the guidance, the EBITDA guidance in particular, I think going back maybe a year or so, I think you guys had kind of targeted a low- to mid-20% range. I think it was -- you had always kind of targeted maybe 22% to 24% margins. I think your guidance now looks like around 19% or 20%. I guess looking out even beyond maybe 2014, is there any reason to believe that if you get back, the EBITDA margins couldn't move maybe north of 20% again? Or is 20% kind of a new range to think about with your model, if that makes sense?

Steven M. Oreskovich

Yes. Joe, this is Steve. That makes sense. The range that we have for 2014 includes ongoing litigation and other cleanup work that we anticipate during 2014. But longer term, we would expect those margins to increase and even above the low 20%, especially as the revenues build from iConnect Network and Honeycomb, as well as ECOS continues to generate forward -- at the nice projections it's had over the last couple of years.

Joseph Fadgen

Okay. And then on the cash, so I think you had, in the press release, estimated that cash flow for the year, $18 million to $23 million, let’s take the midpoint of that. I know you guys are -- $20 million. I know you guys are looking to repay debt. But assuming you hit, say, $20 million, about how much do you think you would put towards debt repayments? I guess, as a percentage or out of that chunk, how much would you target?

Steven M. Oreskovich

Great question. I'd say a vast majority of that, our 2014 costs anticipate what we're looking to put back into the business. So as you look through that table, the money going back into the business is already reflected into that from a cost structure in 2014. So unless there's something else out there that we foresee the need to invest in from a business perspective, let's say, the vast majority of the cash flows generated will come from -- or will be used to, pardon me, repay the debt. The other thing to note in that table is that it's assuming a no capital or no change, pardon me, to working capital. I would say that if you look at our current receivables and payables balance, we still have an opportunity to, again, leverage our accounts receivable balance and drive that down further, while the accounts payable balance is about right for what we would expect long term now. So there exists the ability to be above those amounts if we continue to drive down that receivables balance.

Joseph Fadgen

Okay. And then last one for me. Thinking a little more broadly maybe about the PACS market in general. For 2013, I guess, what did you see the PACS market growing at in 2013? And what do you assume it's going to look like in 2014? What's implied in your guidance there?

Steven Tolle

So this is Steve Tolle, Chief Strategy Officer. I'll answer that question. So the PACS market overall is flat to maybe 5% CAGR over the next 4 years. We're not seeing a lot of net new activity there, primarily driven by hospital focus on Meaningful Use and ICD-10. We do expect to see that market open up at the end of this year as hospitals finish their readiness for ICD-10 and their 10-year-old PACS systems start to show their age and need replacement.


Moving on to our next caller, going now to Ryan.

Ryan Daniels - William Blair & Company L.L.C., Research Division

It's Ryan Daniels from William Blair. Justin, let me start with one for you on the Merge DNA business. It looks like the subscription revenue hit a low point for the year. So can you give us a little color on how that might trend through '14? And then I'd be curious if something rolled off there that drove that down a little bit sequentially?

Justin C. Dearborn

Sure. So I'll take the go-forward. So as we continue to exit a business that did have some subscription revenue tied to it, that's being offset by the growth in eClinical business. Other thing to note there, so I do expect that to grow, but maybe won't be as evident as the top line growth for the clinical trials group because as we move forward with that model, and we've talked a little bit about this in prior calls, ultimately, we want to get to a model where we have a CRO, our sponsors signing a master agreement, and then they basically can configure their own trials and we will bill them monthly for what they've consumed. So at some point, we'll probably move away from signing statements of work and contracts that allow you to identify a booking total upfront. We're not there yet. Some customers are operating that way. So the booking number might, which results from a subscription backlog, might become skewed. And if that trend continues, we'll call that out. But the thing to look for there is the revenue growth and the margin to continue to expand there.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Okay, that's helpful color. And then this is a little bit of a follow up on the PACS question that was just asked. But more broadly, I want to get your take on the CapEx outlook for 2014. Obviously, we saw the impact it had this year, and we could see the numbers from Q4. But as you look forward with a little bit more stability, no sequester, we've got Health Care Reform, we've got some probably positive dynamics on the volume front, are you guys feeling: number one, better about the CapEx outlook for '14; and number two, how does that translate into your decision to reinstitute guidance? Do you feel you have better visibility on the out year than maybe you've had over the past 12 months?

Steven Tolle

So this is Steve Tolle. Say that when we look at 2014 and 2015, we think what's going to be most attractive in the hospital market, the buyers are going to be looking at image exchange, whether it's our Access viewer that has image sharing or it's iConnect Network, because that solves the immediate need they have around things like payment reform and bundled payment and risk sharing. So I think that market clearly is going to be active. The PACS market will be active as well because most PACS systems out there that were purchased in '06 and before are well beyond end-of-life, and so those are going to start to get replaced. And we'll get our share of the replacement market there. So we think the hospital market clearly will be active once they've finished their ICD-10 readiness. The ambulatory market is already active because they're having to replace and do upgrades for ICD-10 and Meaningful Use because most of those ambulatory radiologists are going from Meaningful Use dollars. So we'll continue to see some replacement activity there as well.

Justin C. Dearborn

And maybe I'll add on to that, Ryan. So just with respect to the tail end of your question regarding the guidance. I think that, along with kind of how our products have really matured, and you see that in the cardiology ranking by KLAS and then the overall ranking by KLAS, which we do strongly believe and I think an incredibly objective report. So the fact that we moved up to #8 in health care IT vendors, and we're feeling good about the solutions, the market feels a little better. So that gives us kind of the confidence to give some guidance, which hopefully won't turn out to be a stretch, obviously. It's -- and if you look at our Q4, which Steve mentioned, was our lowest revenue quarter in a while. That's kind of the base plan and move up from there.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Okay, that's helpful. And then last one, I'll hop off. Just on athenahealth, obviously, a nice partnership there, particularly as you're launching the iConnect Network. Can you talk a little bit about how the revenue model is going to work there? Are you going to get paid on a transaction basis, as doctors on athena now kind of share those images? Just any color there would be helpful.

Justin C. Dearborn

Sure. So the first stage of the partnership is report delivery. So that's really coming out of our installed base, so our customer. So we will actually pay athena a transaction fee, if that makes sense. So it's coming from our customer. Our customer will contract with Merge, and then Merge treats athena like a partner, and we pay them a transaction fee.

Ryan Daniels - William Blair & Company L.L.C., Research Division

But then, do you charge your customer for that? I assume it's not a cost for you. Or is it...

Justin C. Dearborn

Correct. So we have a partnership [ph] with our customers. Okay. So we will charge our customers for report delivery and then we pay athena just like we will pay Surescripts to deliver a report.

Ryan Daniels - William Blair & Company L.L.C., Research Division

I guess maybe the better way to ask it, is there a -- my root question, is there a margin opportunity on that for you? So is there kind of an arbitrage between what you pay athena and what you'll collect? Or is this just a value-added service to expand the network and your value proposition?

Justin C. Dearborn

No. So there is a margin. And because it is a SaaS platform, there's the ability to have a significant margin. And to Joe's earlier question around margin expansion, we are counting on iConnect Network to lift the overall margins of the business. So there is a nice margin in that offering.


Moving on to our next question, going now to Eugene.

Eugene M. Mannheimer - B. Riley Caris, Research Division

Gene Mannheimer here from B. Riley. Just a follow-up on the earlier one on subscription, the subscription business. So are you giving any guidance for subscription backlog this year as you did last year?

Steven M. Oreskovich

Gene, this is Steve. We are not, primarily due to what Justin had mentioned when answering one of Ryan's calls, which is we're seeing in the clinical trials business, customers looking to essentially sign a master agreement and then orders underneath that master agreement that will allow them to simply be billed on a monthly basis, as opposed to signing up for a contractual minimum. We're starting to see a little of that ask, as well as it pertains to iConnect Network. So under that model, there really is no contractual minimum. Thus, on a booking per se, when we enter into the transaction with the customer, rather more of a monthly toll that they will be paying, so it starts to alleviate the concept of subscription backlog. And we're not yet sure the mix of customers trending in that direction, albeit, we believe it could grow quickly. So that's the reason why we're not providing anything in terms of anticipated backlog growth in that area. Albeit, we would expect a pickup overall in the revenue coming from subscription sources, as it pertains to gross dollars during 2014.

Eugene M. Mannheimer - B. Riley Caris, Research Division

Okay. So we should look at the growth in subscription revenue and perhaps, customer additions as an indicator as to how that subscription businesses is tracking?

Steven M. Oreskovich


Justin C. Dearborn

Yes. So Gene, let me just clarify that again. On the iConnect Network, so the contracts we've signed to date, they're committed to pay us when they use the service and really, that's it. So there's no minimums yet. Now of course, we could get into some of those with our own price negotiation. But right now, it's pay-as-you-go, and I think that was a better way to roll this new service out. So you wouldn't see any backlog from those contracts.

Eugene M. Mannheimer - B. Riley Caris, Research Division

Got you. Okay. And with respect to some of the new business you announced in the fourth quarter, I think you indicated there was about $3 million of sales from the 2 customers that you called out. Was the majority of that booked and recognized in the fourth quarter? We can expect some of that to trickle forward this year, particularly Honeycomb, I would imagine.

Justin C. Dearborn

Yes. So the $3 million that was called was for the 2 agreements. So just to maybe add a little bit of color there, I think sometimes, we focus on some of the bigger deals for obvious reasons, but behind that was another 75 deals to 100 deals. But for those 2, there was a better than 50% in-quarter revenue conversion. So there is something left to recognize professional services, first year of supports for both are built into that number. So that will roll out over the next 12 months, but about 50% in-quarter recognition for those [indiscernible] contracts.

Eugene M. Mannheimer - B. Riley Caris, Research Division

Okay. And then lastly from me. With respect to how the guidance is going to play out this year, given seasonality, you talked a little bit about ICD-10 as a headwind, which should let up at the end of the year. Also, I would imagine your image-sharing product should build with MU Stage 2. So do we expect to see, say, a stronger second half than the front half for 2014?

Steven M. Oreskovich

Yes, Gene, this is Steve. That is a good way to think about it from an overall annual perspective, if you kind of break it down into the first half of the year versus the second half of the year.


Going to the next caller, going now to Evan.

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

This is Evan Stover with Robert Baird. I had a quick question on the DNA segment. I'm trying to get a better idea. Obviously, there's been exit of certain businesses there. I'm trying to get a better idea of how eClinical grew in the quarter. If I look at the subscription mix there, it was down 9% or 10%, but I'm assuming there's something in the last year's number that's not really letting me know exactly how eClinical is growing. So if you could let me -- if you could give some clarity there, that would be helpful.

Steven M. Oreskovich

Sure, Evan. This is Steve. If you were to break down the $14 million that we talked about as far as nonrecurring items in 2014 and beyond, about $11 million of that in total is in DNA. If you went back through the quarters in 2013, I think you'd see about $7 million or $8 million is nonrecurring. So you would expect, going forward, it's all subscription recurring-type solutions. So the other $3 million to $4 million or so comes out of that subscription base or what was encapsulated in that subscription base. So beyond the kiosks and eClinical, there is a couple of other smaller businesses in the DNA segment, of which is part of what we're not looking at maintaining going forward just due to the profitability on those. So you probably back out about $3 million to $4 million of subscription revenue as a result of the other businesses and, quite frankly, some of the kiosk piece that doesn't translate on a go-forward basis.

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

Okay. I guess I was just trying to get a better feel for -- if eClinical is growing 20% next year, by what we've heard you guys say, is that a similar core growth rate to what we've seen recently? Is it an acceleration or decline from where we've been the past...

Steven M. Oreskovich

Yes, so good question there. Yes, so we -- in an earlier press release in the quarter, we did mention that in 2013 versus 2012, eClinical grew about 30%. I think that specific number is about 27.5%. So that 20% compares to that number, albeit the 27.5% growth, '12 versus '13, did have some perpetual or nonrecurring revenue in it in the first quarter of 2013. So I would say that from a comparability -- a true SaaS-based comparability within eClinical, the growth rate year-over-year would probably be, from 2012 to 2013, in the low 20s. From 2013 to 2014, we're expecting about the same.

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

Okay. And last question on DNA. Is there anything you'd care to call out on the sequential EBITDA step-down? I know you're investing for growth there, but it was a pretty big step-down and it looks like it was not gross margin related. It looks like it was OpEx.

Steven M. Oreskovich

Yes, so good question as well. A portion of that is the -- what you're seeing there is not only the exit from one of the other business lines. It's primarily, though, as you had mentioned, not a change in the COGS, but there will be some fluctuation in the professional services line of the clinical trials business as we're moving all the clinical trials onto the new platform. Recall that there are still some longer-term trials that have a heavy professional services mix to them on the older platforms that were working their way through. We think this is clearly, on the overall DNA segment, the baseline and should grow significantly from here.

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

Okay. And a bigger-picture question, obviously, the market environment remains challenged. You've announced, I think, it was $6 million of cost action. Is it rightsized at this point, given maybe the tail on some challenged markets -- challenge market headwinds continues? Or is there more kind of cost actions that are envisioned in the guidance?

Justin C. Dearborn

Yes. So I'll take this. This is Justin. So we have executed all the streamlining initiatives that we looked at in 2013. We think, again, we have a baseline set for the business, taking into account kind of where the market is right now, where we think it's heading. We wouldn't want to lower the cost structure significantly from here. Now there's constantly process improvement and it will take out incremental dollars as we make the business more efficient. But overall, this is the baseline of business. We have the proper investment still happening in R&D. We have a large-enough sales team and enough quota out there to hit our numbers with a very achievable quota attainment percent. So you should look at the cost structure here as really the baseline go-forward.

Evan A. Stover - Robert W. Baird & Co. Incorporated, Research Division

Okay. Final question for me. As I think about the debt situation, obviously, you're going to have to use most or all of your free cash flow this year, it looks like to kind of stay within covenant ranges where they're stepping down. I mean, is there any debate internally or thought internally about just seeking an amendment, given that's just what we hope is a temporary headwind and maybe it would provide you a little bit more balance between internal investment and debt paydown if there was a little bit more cushion in that leverage covenant?

Justin C. Dearborn

Sure. Good question. So we constantly are monitoring it. There is some levers in the credit agreement that we can access that don't require an amendment. But really, we don't look at the cash flow and use -- directing the cash flow to retirement of debt as an obstacle. We're still operating at a 19% to 20% EBITDA. We need to get that number up. So even if we generate another $10 million of cash flow, Steve kind of hinted too from a working capital pickup, there's nowhere else we can put that investment really. We're still spending 13-plus percent on R&D as a percent of revenue. We're going to still spend at the midpoint for sales and marketing costs. So we have to operate in the 19% to 20%, if not above, EBITDA range. So we don't really think we're being hindered by using excess cash to retire the debt. As we've talked in the past, we only get credit in our net debt covenant calculation for $15 million of cash on the balance sheet. So we have strived to kind of keep it at that number. Now we're a little above at the end of Q4 because we have to make the determination a week prior to the end of the quarter. But again, we don't feel like, internally, that we've been jeopardizing or hindering the businesses' growth ability by using excess cash flow to retire the debt.


[Operator Instructions] It looks like we do have another caller, going now to Brooks.

Brooks G. O'Neil - Dougherty & Company LLC, Research Division

Brooks O'Neil at Dougherty. I was just curious, sort of along the lines of Ryan's question, on the athena arrangement, could you just talk a little bit about the arrangement you have with CDI and what potential you see in what, I think, is an expanded relationship with them?

Steven Tolle

Sure. So this is Steve Tolle. CDI agreed to join the iConnect Network. They are building with us integration to their proprietary platform to route radiology reports from their platform to the referring physicians. So they do about 900,000 studies a year, and we expect to route the majority of those studies across the network over time. As the various EMRs update their versions out in the community to the version that accepts the HEN [ph] protocol, which is part of Meaningful Use. So sometime this summer, almost every EMR out there will support our interoperability platform as a standard. And then once that's out there, CDI and all of our other clients will be able to route most of their reports through our network.

Brooks G. O'Neil - Dougherty & Company LLC, Research Division

And how will you get paid for that, Steve? Just...

Steven Tolle

So our clients -- it's a per-transaction cost. So our clients sign up for iConnect Network, it's pay-as-you-go right now. They're not having to agree to minimums yet. They're paying us -- we think the market price is going to land somewhere $0.65 range, probably have some erosion there over time. And they pay that for the first copy. And then if they have a carbon copy, if you want to send a copy of a report to a second physician, they're paying roughly half that for a carbon copy.


And at this time, there are no further questions.

Justin C. Dearborn

All right, thank you for the questions. I mean, one last note on the debt repayment. So in the way we look at it internally is, every dollar of debt repayment has the ability to create some equity value, if you look at a total enterprise value perspective. So that is also an important initiative of the company.

But to summarize the call, we continue to lead the industry and have a solid plan underway for Meaningful Use, having certified all of our appropriate imaging workflow and interoperability solutions for Stage 2. We're making enterprise imaging real as we continue to gain net new customers in the hospital, the acute market, with our portfolio of interoperability, radiology and cardiology solutions. And we're advancing interoperability and we'll continue to take advantage of a significant whitespace sales opportunity with the release and addition of new services and strategic partners for iConnect Network.

With about 80 million studies flowing through our radiology outpatient imaging center clients alone, if we can capture a fraction of these studies in terms of report and order delivery at a combined gross fee of $1.50, the potential for significant recurring revenue and margin accretion is very real. We will continue to streamline our business operations, as mentioned, to tightly manage our cash flows and repay our debt. Customers and shareholders can be confident that we will continue to invest in our core products and identify opportunities in the markets that add value to our client base.

Thank you, and I look forward to seeing many of you next week in Orlando at the HIMSS 2014 Annual Conference.


Okay. Thank you to all of our speakers, and thank you everybody in the audience for joining us today. This concludes the call. You may now disconnect.

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