Merge Healthcare Incorporated Management Discusses Q1 2014 Results - Earnings Call Transcript

Apr.30.14 | About: Merge Healthcare (MRGE)

Merge Healthcare Incorporated (NASDAQ:MRGE)

Q1 2014 Earnings Call

April 30, 2014 8:30 am ET

Executives

Justin C. Dearborn - Chief Executive Officer, President, Corporate Secretary, Director, Member of Executive Committee and Chief Executive Officer of Merge DNA

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

Analysts

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

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

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

Operator

Good morning, and welcome to Merge's First Quarter 2014 Earnings Call. Today's teleconference is being hosted by Merge's Chief Executive Officer, Justin Dearborn; and Merge's Chief Financial Officer, Steve Oreskovich. My name is Colin, and I'll be moderating today session. [Operator Instructions]

Before we get started, 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 fact. 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 to them. For greater information regarding these metrics, please see the related discussion in the company's earnings release.

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 to everyone for joining us this morning. Even though the industry continued to be top line challenged, we made progress in many areas of our business operations. We achieved an improved adjusted EBITDA margin of 20%, when compared to the last 3 quarters. We increased our cash flow to $13.5 million compared to $9.2 million in Q1 of 2013. We repaid $8.6 million of debt principal, achieving an incompliance leverage ratio under our credit facility. We reported net income profitability for the first time in more than 3 years. And we completed the refinancing of our credit facility with a new 6-year term loan of $235 million and effective variable interest rate of 7%.

The new facility has no financial covenants for the first year and the covenants, thereafter, provides significant additional operating flexibility, if needed. We continue to experience the same industry trends that drove our results in 2013, as we started 2014. Merge felt the impact to provider indecision, as they focused on big 2014 mandates such as ICD-10, and Meaningful Use Stage 2.

On April 1, President Obama signed legislation that delayed ICD-10 by at least 1 year. Vendors, hospitals and physician practices have been focused on October 1, 2014 for the deadline. This extension impacted both Merge's ambulatory and acute business. In the acute or hospital markets, customers seemed largely ready for ICD-10. The delay may provide hospitals a short window of opportunity to upgrade their legacy systems for imaging, but will also result in another period early in 2015 during which hospitals will again be forced to focus on compliance.

Meaningful Use Stage 2 compliance work is already underway and as unlikely to slow down because of the extension of MU2 announced in December of 2013. This may give Merge an opportunity to sell Interoperability Solutions, including the recently updated iConnect Access and iConnect Network to help prepare hospital customers for the mandate.

In the nonhospital, or ambulatory market, the ICD-10 extension provides release for outpatient customers, who had begun to reserve funds to prepare for reimbursement delays tied to the mandate. The delay may allow them to focus on business fundamentals, including strengthening the referring physician networks and complying with Meaningful Use 2. Despite the ICD-10 delay, we believe, our customers will continue to upgrade to our latest risks and financial solutions releases because important improvements and functionality, including mandatory HCFA claims forms. MU2 is important to ambulatory customers as 80% of their physician clients have registered to participate and expect our customers provide certified technologies that help them demonstrate in a test for MU.

In Q1, Merge completed 2014 MU2 certifications for all of our applicable solutions, which helps our customers attest and receive reimbursements. MU2 had a lesser effect on Merge than EHR vendors, but it does create opportunities with respect to our ambulatory radiology and orthopedic customers, as well as opportunities for our hospital customers to purchase Interoperability Solutions.

To help our customers simplify their interoperability infrastructure, we released iConnect Access 5.0. In version 5.0, we have combined universal viewing and image sharing into a single integrated solution. Referring physicians now have access to both patients' priors and new shared images from browser-based devices. This update gives physician a simple workflow, letting them learn and use only 1 product for all their image viewing and image sharing needs within the EHR.

In addition, Merge saw continued momentum for our subscription base service offerings. We signed 19 new customers to iConnect Network in Q1, including Southern Illinois Healthcare, our first hospital customer for this solution. Additionally, we signed a reseller agreement, enabling a competitor to license the iConnect Network to their installed base. We also released the second version of the solution, which now integrates directly with athenahealth. Athena customers using this solution can receive and view exam results, diagnostic quality images and other critical patient information within their athenaClinicals EHR workflow.

In addition, we introduced new formats to more easily enable Epic integration and solve the provisional patents, covering certain components of the IP of the service offering.

For the Merge eClinical OS platform, over 80 new trials went live in Q1. Our platform now has over 18,000 professionals using the system. The studies are getting larger in duration with more patients in sites being enrolled. As trials become more complex, it is resulting in larger deal sizes.

The clinical trial industry trends continue to move in our direction. The cost of R&D continues to rise for our clients, as there's renewed focus on innovation and growth through product development. We also see an increase of capital being injected into younger companies in early-stage biotech over the past year. We believe, the combination of these factors will increase demand for our modular, pay-as-you-go solution.

Most importantly, life sciences companies continued to migrate towards cloud-based technology at a higher rate, demanding data rich analytics to meet their needs.

Looking ahead, we'll be introducing a new population health subscription base product that address the significant new white space market opportunity for retinal eye screening. According to a study released by the American Diabetes Association, the total estimated cost diagnosed diabetes rose to $245 billion in 2012, a 41% increase over a 5-year period. Retinal eye screening is an important aspect to both diabetes detection and treatment. Merge's new iConnect retinal screening advanced interoperability service will leverage our large Eye Care installed base, our Eye Care PACS, our cloud infrastructure and iConnect Network to simplify the process of screening patients for diabetes and delivery of vital information back to positions for intergrade delivery systems and accountable care organizations. We believe, the global annual market for rental eye screening program are around $700 million. We are currently engaged in a pilot program launch with Ontario Telemedicine Network that is scheduled for a broader launch by the end of the current quarter.

Future stage that the iConnect rental screen solution will include screen for glaucoma, age-related macular degeneration and other significant neurological diseases. As of noted in our press release yesterday, we refinance our debt with a new 6-year term loan of $235 million with Guggenheim Partners. Guggenheim proactively presented us with an opportunity to refinance our debt to better align, the restrictive covenants in our credit facility with our growth strategy. The new instrument does not contain any financial covenants for 1 year and will provide us with greater flexibility with respect to acquisitions.

While the new credit facility increases our variable interest rate to 7%, it should remove any concerns, customers may have, by our future technical violation of our prior EBITDA covenant. As a result of the debt refinancing, we are updating our prior 2014 guidance to consider the GAAP charges associated with the transaction, as well as the difference in interest rates.

Steve will provide more details on this in a moment.

Q1 is, historically, a soft sales quarter in healthcare IT and was again this year for Merge. I remained confident by our overall outlook for 2014, our subscription-based services continued to gain positive momentum in the market, and we continue to innovate and provide new product offerings.

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

Steven M. Oreskovich

Thanks, Justin. As stated on last quarter's call, that we viewed our financial improvements made is evident that our business is headed in a healthy direction long-term. We carried debt progress in the Q1, as we not only returned to an adjusted EBITDA margin above 20%, but also delivered GAAP net income and beat the cash generated by business operations by approximately 50% over Q1 of last year. We also continued our recent trend of delivering strong customer collections, which enabled us to pay another $8 million of principal under our credit facility ahead of schedule.

As it relates to the comparable quarterly year-over-year results, total pro forma revenue was $51.1 million in Q1 compared to $64 million in the prior year, which was the last quarter prior to the negative change in market conditions that began last year.

Revenue generated through subscription and other highly predictable sources accounted for 2/3 of total revenue in Q1, up from 58% in the prior year. On the backlog front, subscription backlog was $54.1 million at the end of the quarter and grew 23% since the first quarter of last year. Non-recurring revenue backlog at quarter end was $23 million, consistent with the $23.8 million total a year ago.

Gross margin on a pro forma basis increased to 59% in Q1, up from 56% last year. This increase primarily reflects the mix of software and hardware sales in the quarter. Hardware revenue is 10% of overall pro forma revenue in the quarter compared to 16% last year. As a result of operational cost alignments made in late 2013, costs associated with sales, R&D and general and administrative expenses, decreased by $3.1 million, or 12% to $22.9 million in the quarter compared to $26 million a year ago.

Only $600,000 or 1% of total revenue of the decrease reflects our capitalization of certain software development costs in Q1 compared to 0 last year, where all such costs were expensed.

As defined in our press release, adjusted EBITDA for the quarter was $10.2 million, or 20% of revenue compared to $12.5 million, or 20% of revenue in the prior quarter. Adjusted net income was $0.04 per share in the quarter compared to a loss of $0.01 per share in the prior year.

On a GAAP basis, we generated net income of $300,000 compared to a loss of $6.5 million last year. Collection efforts and lower operating expenses in the quarter, drove the $13.5 million of cash generated from business operations. On the balance sheet, this is reflected by the $10.6 million decrease in accounts receivable and an $8.6 million decrease in debt. As a result, our cash balance remained constant in the quarter at $19.8 million and day sales outstanding dropped to 90 for Q1, well below last year's 104 days.

Although, we maintained compliance with our loan covenants, we regularly received inquiries from investors and customers as to whether failure to comply with the financial covenants on our 2013 Credit Agreement would impact our ability to continue to operate our business. We even heard suggestions that our competition raised this issue with our customers.

To combat this competitive risk, we addressed this issue in a proactive and definitive manner. As a result, we are pleased to announce a refinancing of our entire term loan. Our new facility has no financial covenants for the first year and opens up our ability to pursue strategic tuck-in acquisitions.

A few items of note, we are partnered with Guggenheim Partners, a privately held, global financial services firm with over $210 billion in assets under management. Minimum required principal payments are 5% or $12 million annually, which is significantly less than what we repaid during the past 12 months, including $8.6 million alone in Q1. There are no financial covenants for the first year and thereafter, the leverage covenant starts at 6.5x and moves down to 5x by June of 2017.

There is also an interest coverage ratio covenant that is based off of loan defined adjusted EBITDA. This replaces the capital expenditure covenant in the 2013 facility. The increased flexibility provided by the new facility, comes with an increased interest rate of 1% more than the debt it replaces, or currently 7% annually. The refinancing only impacts our previously provided 2014 GAAP income and cash flow guidance. We will incur $5 million of non-cash debt extinguishment costs in the second quarter, associated with the prior loan and about $2 million more cash interest expense for the remainder of 2014.

These items are illustrated in the earnings release issued this morning. All in all, we are very pleased with the new facility, as it alleviate short-term concerns, while providing Merge greater operating flexibility over the long-term. This refinancing, along with our solid results over the past few quarters, should illustrate that we are financially strong and well-positioned to execute on our long-term strategy.

I'll now turn it over to the operator to facilitate Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We have a question going now to Ryan Daniels.

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

Justin, let me start with one on your prepared comments about some of the regulatory delays, we've seen, in particular ICD-10. It sounds like you think that might open up a pocket for some more new sales or to shrink the timing of sales in the pipeline. Have you actually started to see that manifest? Or is it kind of an assumption, you're hearing from the sales force? Just any color on what we might see in regards to the uptick from that?

Justin C. Dearborn

Sure. Thanks, Ryan. So starting to hear about it so discussions are being had. I don't want to over emphasize it, but there are conversations being had and some roadmaps appear to be being altered and pulled in. So it does create a nice window. But again, as I mentioned in the prepared remarks, we're going to face, kind of the delays next year on this time. Maybe a little deeper into the year and next year, as the October 2015 deadline. So you think it will create a little window, a few quarters, but we need to act quickly as to the hospitals gets projects take, 6 months, typically for a large enterprise project kind of start to finish. So we need to move fairly quickly if we're going to build to take advantage of that.

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

Okay, that's fair. And then you talked a little bit about your retinal screening solution. I know, you start a pilot with that and I get how leverage is your iConnect network. But can you talk a little bit about, where you're trying to place that solution? Is that outside of clients in the core base? Is it going to be going to acute care hospitals interested in ACO. Just talk a little bit more about how the sales force will target that?

Steven M. Oreskovich

This is Steve, so I'll answer that question. The primary target is going to be risk bearing hospitals, most ACOs are going to have a diabetes care management program. And the challenge with eye screen is that with every diabetic followed best practices and got screened every year. We have to have a lot more ophthalmologists in this country. And so we're solving the supply-chain problem there by enabling screening to happen anywhere, there's a camera. And then routing that image as opposed to have the patient go somewhere to have that exam done. So the target is really the ACOs and hospitals bearing risk for diabetes.

Justin C. Dearborn

And right now, I'll add to Steve's comments. So we have seen some RFPs inbound and those are typically more from governments and been international to date. I've been to a few customer sites and we have been discussing it every hospital is thinking about how they tie into publish health management or participate in ACO models. So early discussions, sometimes we are kind of triggering some ideas and thoughts and sometimes we are responding to RFP. The more discussions we have the better for us, but right now, we're not leading with this, but it comes up as a kind of value add. We're out there being strategic, trying to help hospitals with their concerns. So definitely not leading with it right now, but it definitely helps with enterprise imaging solution sale.

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

Okay. And then maybe two more and then I'll hop off. Just the DocuSys acquisition. I know, you didn't -- I know, you think you referenced on your prepared comments, but I noticed that yesterday, it seems pretty small. But maybe talk, one, about that specific transaction? And then two, with a new flexibility under the debt covenant, I mean, how much of a priority is M&A and tuck-in acquisitions going forward?

Steven M. Oreskovich

So DocuSys was a number of years ago, Ryan. I'm not sure, I hope, we had didn't get put in any of the releases.

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

No, I saw a pop-up, I don't why, but I saw a pop-up on first call, so maybe I missed that, I apologize.

Justin C. Dearborn

Okay. 4 years ago, but to answer your other question. Not a priority, but we've always looked at build by decisions, as we try to enter new markets. So if there was something interesting from a really tuck-in perspective, they would help accelerate our iConnect Network launch, we would look at that. But now we have the flexibility to do that and the prior agreement really didn't allow for that.

Operator

We do have another question going now to Evan Stover.

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

Evan Stover with Robert Baird. I just had a few questions here. Can you guys provide any color on what the financial model revenue recognition. How you will charge for the new retinal screening solution?

Steven M. Oreskovich

So Evan, this is Steve. It will be a transaction-based fee. So much like the past 3 innovations that we've come through, with we're looking more and more to put out a model that is a subscription or transactional-based, so that we can build that recurring revenue stream going forward.

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

All right. On eClinical, some real encouraging metrics on the number of studies on the platform today. But when I look at the backlog, it did drop q-over-q. And I remember, some differences in how we are now looking at master service agreements and the backlog might not be indicative. Is there any data points, you can share on maybe another metric to kind of think about how the backlog is growing there? And has anything changed incrementally better or worse kind of on the 20% core outlook there, this year?

Steven M. Oreskovich

Yes, so Evan, you are correct. So we are starting to see great adoption by that customer base. We've also looked to go less and less from a contracting model that includes a bunch of paper transfer, and I'll call it elongated potentially legal process in which a customer signs up for a contract minimum. Now on the ecosystem, and if you haven't had a chance to go on it, it's a great system to go on and just play around with it. Customers can build the quotes themselves. They're not required any longer to sign up for a contractual minimum period of time. They will put down a small down payment. But it's truly now transaction-based monthly billing. We sort of made the complete evolution there. So backlog is probably no longer going to be the best metric to understand how that business is growing, which is why we came out this quarter with the number of users and the number of studies that we went on live. In the past quarter, that it will be a better indicator of the adoption rate. I can also tell you that in that overall D&A segment, revenue and backlog number, just please recall that part of that is made up by motion, which we did consciously exit in 2013. So what you're seeing there is a drop-off of backlog and revenue from the motion side that is being picked up for a lack of a better term by growth in the clinical trials business. And particularly, on the software line of the clinical trials business year-over-year, revenue grew by over $1 million. So hopefully between that revenue growth and the new metrics, we're providing on a number of users and go lives in the quarter that will help give an indication of the adoption rate.

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

Are we close to getting all that nonrecurring or exited business backlog out of there, so we can just get a clear view?

Steven M. Oreskovich

Yes, it's pretty much into the vast majority, which made up there now to date is clinical trials based. You'll see in Q, particularly in the third quarter of 2013, when we comes to doing the comparatives there, you look a little wonky because there was also some assets, nonrecurring revenue in that quarter due to some sales on the motion side. But as far as the backlog, as it sits today, the vast majority of that is the clinical trials backlog.

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

Okay. And last question for me, it relates to the new debt structure. And then I guess, the comment about the acquisition tuck-in capabilities. Do you have flexibility to prepay above that $12 million because you have been paying kind of above that rate, that pace recently. And then the second part is, what exactly are the areas that you're particularly interested in, in the tuck-in M&A strategy?

Steven M. Oreskovich

Sure, this is Steve, I'll take the first part and then I'll change to Justin for the second. So the new debt has a 5% annual payment requirements from a principal perspective. As you noted, we paid probably twice that amount in prepayments during the past year under the old agreement. It also has the typical basket that catches excess cash flows. And that excess cash flow basket allows us or requires us as how we're going to look at it, allows us to prepay with no interest or penalty. So prepay at par annually and it does also have a floor to it that won't allow that basket to catch more cash than leaving us with anything less than $20 million on the balance sheet at any given time. So long-winded way of saying, while not directly allowing us to prepay at our discretion, there's a basket catches, we're successful here throughout 2014 and beyond to catch that and pay it back at par.

Justin C. Dearborn

And, this is Justin, I'll take the second part of your question. So really looking at, if we were to be acquisitive, it will be around solution footprint expansion. So couple of areas, clinical trials. We think, we developed a pretty unique a platform there and there are some product gaps there, if you look to fully address the entire EDC market, it's probably defined by maybe Medidata, the $10 billion opportunity. So there are areas that we're not playing in right now that we could plug into the platform and the way, it's been designed, it will allow for that. So it's always a build by decision and how quickly, do we need to bring something to market. On the iConnect Network side, there are some additional functionality areas that we will look at acquiring or building. And then lastly, kind of throughout the business, as we've done in the past, we looked at areas, where we can -- we get some margin expansions. So that means looking at some of our partners and some of the products that we bundle and resell, looking to maybe -- be more strategic there, acquiring partners, where we think, we could get some margin expansion. But I don't want to highlight that too much. It's available now, but on our path, we think, we have some good solutions that are market-leading and we have innovated under the old agreement without much issues, so really focus on operating business as is, but we did want to point out, it is now an option, but not a priority.

Operator

Okay, moving onto the next question going now to Eugene.

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

A couple of questions. With respect to the subscription revenue in the healthcare business $1.3 million, the lowest, we've seen in quite a while. Can you talk about some of the trends there on the -- in the subscription side? And any help reconcile that for me?

Steven M. Oreskovich

Yes, so Gene. This is Steve. You're probably seeing about the low water mark there is all of when we initially started capturing this metric. And if you look in the definition on our press release, it does include 5-year deals that were previously leased under one of the companies that we had acquired. So that revenue is included in there and what you're seeing is that revenue or that those 5-year contracts expired, the revenue turns into maintenance revenues, so falling out of the subscription bucket, moving into maintenance as they continue to renew. So what you seen in the base now is truly subscription revenue from our offerings, like Honeycomb or some of our other longer-term annual renewal contracts that we have on the OEM front.

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

Okay. That's very helpful. And then earlier in the month, your press release that you signed about 19 iConnect agreements. And today, you have said Q1, seasonally the slowest quarter for bookings. So should we expect that 19 to improve throughout the year, as we move closer to the deadline for MU2?

Justin C. Dearborn

So, Gene, this is Justin. So the numbers should go up. We won't stay on that pace just because we we're run out of large customers. But really we look at kind of volume that they represent and that's in the direct based. And also, importantly, today, we announced, we signed basically a competitor out for the solutions, although, private label and resell our solution. And that's also a strategy to address the entire market because we obviously, have a large market presence in the ambulatory side. But clearly, a lot of market, we're not getting too from a direct customer perspective. So we will continue to add customers and volume, but not at the pace of what we did in Q1. I mean, there was -- you typically target your customers that are a little bit bleeding edge, who are willing to be on the innovator side and launch with them. So we had some nice success there, but we're still bringing them live. So obviously, we keep adding customers on the radiology side, and then move to other areas were business like ortho and ophthalmology as we talked about in the past.

Steven M. Oreskovich

This is Steve. I would expect to see late Q2 and Q3 as meaningfully upgrades in the EHR physician community are hitting their stride, that our network will be fully lit up. And I think most of our customers of signed up. So there's a bit of chicken and the egg, where they are waiting for the SureScripts Network to be fully lit up and that's tied to the Meaningful Use upgrades that are happening right now. And so a link Q2 and Q3 will be, I think, the sweet spot for the iConnect Network enrollment.

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

Okay, and last one for me, if you look at overall revenue of $51 million, that number was bit of down 20% year-on-year. How would that look apples-to-apples, if we just adjust for the discontinued operations and businesses that you had wound down after from the year-ago period?

Steven M. Oreskovich

Gene, this is Steve. It's probably a tough one to answer. I can say that, we said overall in 2013, there was about $14 million worth of revenue, of product lines, that we consciously exited, that would not roll into 2014. I think about 3, maybe 4 of that was in Q1. But then recall that it was a different market condition at that point in time as well. We didn't have the second quarter of 2013 activities for lack of a better term, that sort of hit and negatively impacted us. So if you just look on a strip up the comparable piece, it's about 4, but I don't know that's a very good comparison to do thereafter because you are talking about 2 different marketplace or overall macro conditions in the HIT space.

Operator

Okay, and there are no further questions at this time.

Justin C. Dearborn

Thank you for your questions. And to summarize, Merge continues to make headwind in our business operations. In Q1, we reported strong cash flow, profitability and EBITDA growth. Product updates for all of our eligible solutions are now ready for customer upgrades for ICD-10 and Meaningful Use 2. Our iConnect network service offering is gaining momentum amongst our ambulatory customers and starting to gain traction in the hospital setting. Our iConnect Access solution now provides a unique industry-leading, universal dealing and image sharing platform to image enable the EHR and deliver a more complete patient record. As discussed, we'll be defining a new market space with our iConnect retinal screening service, when we launch it later this quarter. And we refinanced our indebtedness to provide solid long-term basis for operations and a planned growth. I remain confident on our 2014 outlook and customers and shareholders should be as well, as we continue to invest in our solutions, streamline our business operations, and capitalize our new market opportunities. Thank you.

Operator

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

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