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Merge Healthcare Incorporated (NASDAQ:MRGE)

Q2 2014 Earnings Call

July 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

Steven F. Tolle - Chief Strategy Officer

Analysts

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

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

Eugene Mark Mannheimer - Topeka Capital Markets Inc., Research Division

Operator

Hello. Thank you for joining today's teleconference. My name is Tegan, and I'll be the operator for this event. [Operator Instructions]

Good morning, and welcome to Merge's Second Quarter 2014 Earnings Call. Today's call is being hosted by Justin Dearborn, Merge's Chief Executive Officer; and Steven Oreskovich, Merge's Chief Financial Officer; Merge's Chief Strategy Officer, Steve Tolle, will also join us to answer questions at the end of the call.

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 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, this presentation may contain 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 will turn the call over to Merge's CEO, Justin Dearborn.

Justin C. Dearborn

Thank you, operator, and thank you, everyone, for joining us this morning. I'm excited to discuss the results for the second quarter. We achieved a record-breaking sales quarter in our Cardiology business, which helped us achieve a return to sequential quarterly revenue growth of 6%. We attribute this accomplishment to our customers' positive feedback for 2013 best-in-class and KLAS category leader recognitions for our cardiology solutions and a great team.

We achieved the following financial results in the quarter. An improved adjusted EBITDA margin of 21%, which represents both an increase compared to Q1, as well as an increase compared to the second quarter of 2013. Subscription backlog rose to $54.6 million, representing a 12% increase from the second quarter of 2013, and we continue to demonstrate strong cash collections.

In addition, we would have realized GAAP net income of $1 million over the noncash charge from refinancing our debt that we announced last quarter, helped us achieving this result.

From an industry perspective, you've probably heard other healthcare IT vendors state that the enterprise imaging market continues to face headwinds. Their buying decisions are stalled due to mergers and acquisitions and other information technology and government mandate priorities. We can confirm that Merge continues to be impacted by provider indecision and our customers remain focused on working through delays in ICD-10 and Meaningful Use Stage 2. We believe that as our client prepared to take on financial risks either in the form of bundled payments, value-based purchasing and to our collaborative care shared savings, they're going to need enterprise imaging and advanced interoperability strategy. This is why we believe that the market will open independently of current and any future ICD-10 or meaningful use delays. We continue to take the necessary steps to help our customers prepare for these fundamental changes that we believe will affect many of the markets in which we do business.

In the acute or hospital market, value-based purchasing and bundled payments will drive the need for more image sharing and collaborative care amongst hospitals and their community physicians. Participation in the collaborative care organizations and the creation of provider-sponsored health plans continues to grow. Last week, Health Data Management reported on a study conducted by the Johns Hopkins University School of Medicine that concluded that health care IT is critical for ACOs to succeed. Specifically, they called on the importance of coordination across care teams, from inpatient to outpatient as a critical success factor. In addition, last year, the Healthcare Advisory Board projected that 15% of employers would participate in private exchange models for 2014. We've recently seen this trend become a reality, as some of our largest IDN clients have already started developing and are acquiring their own provider-sponsored health plans.

As these trends continue to gain traction in the marketplace, we fully expect the need for image interoperability, vendor-neutral archiving and advanced interoperability to increase. Hospitals look to create high-performing neural networks to effectively manage premium dollars and eliminate referral leakage.

In the nonhospital or the ambulatory market, bundled payments, especially amongst the orthopedic customers are starting to include imaging as a requirement. As a result, ambulatory customers, just like their acute counterparts, will need to focus on image sharing and collaborative care in reimbursements to stay relevant.

High-performing neural networks, driven by private health exchanges pose a risk to our ambulatory base, as it may disrupt their existing referral relationships, which they depend on to drive revenue. Therefore, it is critical that our customers in this segment take advantage of new technologies that enable them to build an imaging neural network and automate manual processes that are inefficient and costly today.

MU2 continues to be important to our ambulatory customers, as 80% of their physician clients have registered to participate. And we expect our customers to provide certified technologies to help them demonstrate in a test for MU. As we reported in our last earnings call, Merge recently completed 2014 MU2 certifications for all of our applicable solutions, which helps our customers in both acute and ambulatory markets to test and receive reimbursements. In addition, we launched and have received a positive customer feedback on our unique image sharing solution. It's the only product available in the market today that combines universal viewing and image sharing into a single integrated solution. More specifically, to help our customers prepare for these inevitable market changes, Merge continued to invest in and see success in the adoption of our subscription-based service offerings.

For iConnect Network, we signed 7 new customers for a total of 29 customers contracted since we launched the service this year, accounting for more than 10% of our total radiology ambulatory client base. We've also executed 2 reseller agreements to broaden our market reach and sales footprint, and we're working on the next big release of the service, which will introduce electronic referral order delivery later this quarter.

For our cloud archive offering, known as iConnect Cloud Archive, we've seen a vast acceleration in the past 12 months, signing 20 new customers since Q2 of 2013. These numbers are promising when we consider the adoption trend we initially saw with this product. It took us over a year to get to 1 million studies, now it's taking us less than 4 months to get to 2.3 million studies. We expect this change to continue as more contracted customers go live and we bundle up within our Merge solutions selling to new market segments on a go-forward basis.

For the Merge eClinical OS platform, we went live with 71 studies, increasing our clinical size by 25%, our users by more than 27% and active subjects by 30%. These results demonstrate the continuous growth for ECOS. This utilization growth is directly linked to the platform software usage revenue driven pay per use business model. We also continue to make solid advancements from a product standpoint, as we successfully updated our DICOM imaging module and introduced enhanced study management, giving users more options for building expressions, developing a graphic workspace, drugging and dropping, editing and testing trials.

Finally, we successfully launched iConnect Retinal Screening, the first end-to-end automated software-as-a-service solution for early screening and detection of retinal disease, including diabetic retinopathy, glaucoma and macular degeneration. This advanced interoperability service complements a key population health strategy many of our integrated delivery system customers in the collaborative care organizations are pursuing. This service eliminates many of the common barriers in successful screening programs, including IT costs and the ability to capture a meaningful photographs by medical assistance.

As I mentioned above, our cardiology team had a great quarter and delivered an all-time record for quarterly sales bookings. We contracted 7 net new customers from both large public and private IDNs, as well as, smaller regional health systems, each time displacing the larger competitor. In addition, we completed 23 6-figure or higher transactions, which we believe further illustrates the strength of our cardiology portfolio.

Notably, a nonprofit, 4-hospital health system in tri-state Louisiana selected Merge cardio and Merge Hemo, as well as iConnect access to eliminate disparate systems, standardize cardiology and image management and provide anytime, anywhere access to images across all of its facilities. This 7-figure net new deal health system will implement an integrated cardiovascular record, and structured reporting for improved efficiency and workflow, allowing physicians to spend more time on patient care.

On top of the success our cardiology business achieved in Q2, our interoperability team also realized 2 solid net new VNA wins, both over a year in the making. Notably, Comanche County Memorial Hospital purchased Merge's VNA, iConnect Enterprise Archive, as well as iConnect Access to implement an enterprise imaging strategy, so that we can archive and share images across the continuum of care. These 2 solutions working together will open the seamless flow of patient data, so that the hospital can improve its disaster recovery and operational workflow, as well as meet Meaningful Use Stage 2 requirements.

Looking ahead, we have several significant product releases coming that our customers are looking forward to receiving later this year. These include a major architectural revision to Merge PACs, new XDS standards functionality and enhanced do-it-yourself migration tools within iConnect Enterprise Archive and hybrid copy one for iConnect Cloud Archive. These products and services will meet our clients' needs to fulfill many of the industry trends I discussed earlier.

Now before I turn over it to Steve, I'd like to address our debt covenant. We believe that the refinancing our debt has allowed us to address financial concerns that have mainly been raised by our competitors, by eliminating the prior covenant package. Even as late as last month, many of our competitors still prefer to compete by casting financial aspersions rather than on a solution and customer service basis.

With the success we've seen in the second quarter and knowing that Merge has the people, products and strategy to be a long-term winner, which continues to be reinforced by outside evaluators, by class, I remain confident with our 2014 guidance. We've seen increased success with larger transactions, our subscription-based services are gaining positive momentum, and our product innovations continue to open up new revenue streams for us to capitalize on.

With that, I'll now ask Steven Oreskovich to provide additional comments on our financial information.

Steven M. Oreskovich

Thanks, Justin. We're pleased to deliver the results this quarter that our investors have been asking for, so it bears repeating some of what Justin previously stated. We delivered a sequential quarterly increase in revenue of 6%. Adjusted EBITDA increased to 21%, which is 40% greater than Q2 of last year. Adjusted net income grew to $0.05 per share compared to $0.01 in the second quarter of 2013. We continued strong cash generation from business operations of $8.3 million, resulting in a cash balance of almost $24 million at quarter end, which momentum is carried through a balance of $30 million as of this morning. And the refinancing of our credit facility eliminated the previous debt covenants, replacing them with more appropriate measures which will not become operative until Q1 of 2015.

Our first half revenues were almost half of the midpoint of our full year 2014 revenue guidance and our first half adjusted EBITDA is slightly above guidance of 19% to 20% for the year. While we believe our addressable market has stabilized, and we are seeing deals that have been stuck in the pipeline starting to move forward, we remain cautious in our outlook and are maintaining our previously announced guidance for 2014.

Further, in the second quarter, we signed 3 7-figure deals and another 6 contracts between $500,000 and $1 million with health care segment customers. This, combined with normal revenue generating activities, resulted in a nonrecurring backlog from perpetual license deals of $23.2 million at the end of the quarter.

On the subject of large contracts, we are pleased that one of the $1 million plus deals was structured as ratable over 3 years, which along with continued clinical trial study activity, drove the 12% increase in subscription backlog compared to last year. We have also recently introduced another disruptive contracting methodology to our subscription contracts, the use of a no minimum pay per transaction structure. This customer friendly approach will help drive sales expansion, but it will also impact our backlog metric. As a result, we've started to provide additional metrics, such as clinical trial go live and iConnect Archive studies to help gauge the business.

As we have previously stated, our customers often purchase hardware, think medically purposed monitors, servers and storage from us as opposed to buying it directly from other vendors. The mix of software and hardware in any given quarter will affect our overall gross margins in that quarter. In the past few years, hardware has averaged about 15% of total revenue. In the second quarter, our gross margins were 56%, the same as last year. For comparison purposes, our hardware revenue was 15% of Q2 revenue this year, as compared to 13% last year and 10% in Q1 of this year.

Operating expenses, as a percentage of revenue, decreased to 40% in Q2 compared to 48% in the second quarter of last year. While we don't currently foresee the need to significantly increase headcount to meet annual guidance, we expect to see an increase in headcount-related expenses, specifically commissions and bonus in the last half of 2014.

These costs were considered in the 2014 adjusted EBITDA guidance.

As we discussed on our last call, we incurred $4.8 million of noncash charges associated with the refinancing of our debt in the second quarter, which is why we are reporting a GAAP loss of $4 million for the quarter. Without this expense and its impact on taxes, we would've generated over $1 million of net income.

We also continued strong cash collections, resulting in a 27% decrease in day sale outstanding to 88 days when compared to last year's 120 days and 90 days at the end of Q1.

Finally, we will have one executive officer with stock options that will expire in August, 6 years after their grant. Investors should expect to see a filing that will identify the sale of shares by that executive in a sell to cover format, which means only the minimum number of shares required to fund the strike price and related immediate tax requirements will occur in August, similar to the reportable activity that occurred a couple of months ago.

The results for the second quarter and our year-to-date progress are ones that any CFO enjoys reporting, and I applaud the customer satisfaction focused efforts of all our employees in putting the company in this position.

I will now open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Caller.

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. You mentioned in your prepared comments that some of the VNA deals...

Operator

Ryan Daniels, the line has been unmuted.

[Technical Difficulty]

Operator

All right. Let's go to the next question in the queue. Caller.

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

This is Evan Stover with Robert W. Baird.

Operator

[Technical Difficulty]

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

This is Evan Stover with Robert Baird. So I had a few questions. First one is on operating expenses, some pretty impressive control this quarter, and I understand the comment around potentially higher commissions in the back half, but some impressive stepdown in G&A. I thought we were done with some of the restructuring. I was wondering if you could touch on what's really driving that, and if this is a sustainable level going forward?

Steven M. Oreskovich

Great question. This is Steve. As far as looking sequentially Q2 versus Q1, the decrease there is primarily we incur the bulk of our audit and taxes around the year and in the first quarter of any year. Looking year-over-year on a quarterly basis, yes, it's primarily the result of the rightsizing of the business back in the third quarter of 2013. So the Q2 numbers of 2014 are a good baseline to utilize going forward. In addition to the commissions number, you had mentioned, obviously, there's bonus as well in the back half of the year that we expect to hit the P&L, but that will be sort of spattered throughout the categories of the P&L. So it will cause a general increase in -- on a gross dollar amount in any of the individual P&L line items, affecting G&A as well.

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

Okay. Shifting to iConnect Network, 7 clients signed up this quarter. I think it was 19 last quarter. I mean, obviously, 10% of your base already signed up for that, so a very good metric. But it did step down sequentially, and I guess I wanted to get your thoughts as it relates to -- I know a key component is having hospitals and your imaging centers on Meaningful Use 2 certified software to really get that offering up and running. Given some of the hardship exemptions and effective delays in Meaningful Use 2, does that kind of change the outlook for when we really get some meaningful revenue flowing through there, and your expectation for client adds in the second half of the year?

Steven F. Tolle

So this is Steve Tolle. I'll answer that. So we've been doing a controlled rollout of iConnect Network, focusing on our risk customer base first and then, of course, our PACs customer base. We've got Southern Illinois, which will be our first hospital client going live soon. We've also got our first non-merge risk ambulatory client going live. So we've been doing some work to make sure that some of our technology is where it needs to be. We've also taken steps to diminish our dependence on the Meaningful Use EMR readiness challenge, because we do expect there to be some additional small delays for Meaningful Use Stage 2, probably in early 2015. So we go direct to Athena, for example, that's not dependent on Meaningful Use Stage 2 technology. We're doing some other direct negotiations with some other EMR vendors again to go direct and to be less dependent on some of the meaningful use in direct technologies. But we are continuing to be aggressive out in the market talking to our current installed base, and as we have more proof points, where they can go talk to Southern Illinois, for example, about their experience with Meditech, that will help drive sales in the second half of the year.

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

Okay. And should we expect to see more direct vendor integration with Athena? Or is that kind of going to see how that goes before you look at doing some more direct connections with vendors?

Steven F. Tolle

No, we're definitely going to be doing more direct vendor connections. Athena was our first. We're negotiating with a number of vendors right now.

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

Okay. I guess my last question, I'll just shift over to D&A, and specifically, eClinical. Given some of the one-time revenue items that are still being discontinued, and maybe confusing year-over-year calculations, can you tell us how much eClinical revenue increased year-over-year?

Justin C. Dearborn

Yes, Evan this is Justin. On the ECOS transaction fee revenue, it's up about 2.5x from Q2 of 2013, so we continue to build nicely, obviously, with ratable recognition, and the way we priced it, it doesn't build as fast as a one-time events are attriting in a different bucket, but we're very happy with the progress that the group has made.

Operator

All right. Let's go to our next question, Ryan Daniels.

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

I want to go back to something you said in your prepared comments, Justin, about the VNA deals that have been over a year in the making. I'm curious what was the final trigger point to move them over the finish line. Is it just that execution on your part? Or better end market? What kind of color can you offer there?

Justin C. Dearborn

Yes, well, I would hope a little of both. You know with some of these deals the struggle with the VNA market is they're typically using a large compelling event. So in this case, these 2, one was, I think, end of the year budget driven. The other was IT resources freeing up. So there's always a unique situation, but in that market, there is not typically a dramatic compelling event like we see in the cardiology side, for instance.

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

Okay, that's helpful. And then, also in your prepared comments, you spent a lot of time talking about hospitals taking on risks and how your solutions will be integral with that value proposition, kind of in spite of other end market challenges. So I'm curious if you look at your sales growth with iConnect Network, for example, is there a common theme among buyers that it is those entering the ACO type models? Number one. And then number two, how are you kind of arming your sales force with the right case studies and ROI materials to target those accounts, if that's where the growth is going to be?

Steven F. Tolle

Yes, this is Steve Tolle. I'll answer that. So we're arming our sales force to focus on mergers and acquisitions and consolidation, which is a key trigger point for VNA and our universal viewers selling, because those are the milestones where hospitals have typically said they've got to get their house in order from an image management perspective or they're starting to take risk, in almost every hospital system with the exception of, I think, one large system is announced that they're considering setting up a provider sponsored health plan. So we see those are the drivers and we're educating our sales force to have that conversation and talk to the C-Suite about how they need to focus on imaging as part of that. The other key driver is the emergence of bundled payments, driven by the Affordable Care Act and by commercial payers, we know that imaging today is a quality indicator, but imaging is going to start getting wrapped into these bundles, and so that will drive image sharing, and VNA and enterprise viewing needs. So we're arming our sales force to have those conversations and we are going to work with our clients to build those ROI and the white paper documents to support the sales effort.

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

Okay, perfect. And maybe one final follow-up, just on the eClinical Works. Obviously, very good growth in sites and active users from the end of the first quarter. I want to get a better feel or how that should start flowing through to revenue. I know the sales on a recurring basis were up about 4% sequentially despite the 25%, 30% plus in all the metrics. So how should we think about those 2 things correlating on a go-forward basis?

Steven M. Oreskovich

That's a great question, Ryan. This is Steve. It's fairly close to the number that Justin had provided as far as the ECOS transaction fee related dollars that are flowing through. So if you look sequentially, Q1 versus Q2, those fees translated into about a 25% increase in that line. Yes, it's right in line with between 25% and 30% for all the other figures.

Operator

Let's go to our next question. Gene Mannheimer.

Eugene Mark Mannheimer - Topeka Capital Markets Inc., Research Division

My question relates to something that was brought up earlier, just on the VNA product, iConnect Archive. Is the traction there you're seeing all budgetary driven on the part of your customers? Or are there any macro trends that are helping to drive adoption here?

Justin C. Dearborn

Well, I think some of the trends that Steve Tolle mentioned are going to drive more adoption in the future. With 2 enterprise VNA deals kind of in the quarter, it's hard to call it a trend, I'll say, but we do think and we have thought for a while and we've been ahead of the curve on that thinking, but we do think that there will be a robust market for that, but with 2 enterprise deals, I wouldn't call it being here yet, so the 2 in the quarter, budgets did play into it, but that's more of when it falls in and of certain hospitals, maybe a budget flush into their fiscal year. But overall, we do think the trend is going to be in our favor going forward, but we really haven't seen that yet. Speaking to some of the items that Steve mentioned that we think all hospitals and all networks needs to start thinking about.

Eugene Mark Mannheimer - Topeka Capital Markets Inc., Research Division

Okay, okay. Along those lines, when you did cite 3, 7-figure deals in the quarter, another I think half dozen or so north of 500k. Is this -- how does your pipeline look then? I mean, does it continue to consist as some large multimillion dollar contracts that you have some line of sight to in the back half?

Justin C. Dearborn

It does. So we do see about 2x number of deals above $500,000 million in the next 12 months versus the prior. So we do see the pipeline increasing and size of the deals increasing. And hopefully, we try to make a subtle point to this, but we were still facing some, what I'll call financial concern meetings and questions, typically teed up by our competitors, but we've, Steve Oreskovich and I did do a number of calls in the quarter, so hopefully with this Q2 results, I know we're past that, and that's key to moving -- continuing to move upstream on the deal size.

Eugene Mark Mannheimer - Topeka Capital Markets Inc., Research Division

Terrific. And if I could just turn to iConnect Network, you may have mentioned this, but I don't sense there was any revenue from that during the quarter? And do you expect any meaningful revenue in the back half of 2014?

Steven M. Oreskovich

Gene, this is Steve. So there wasn't any meaningful revenue in the quarter. Meaningful, I'm talking above $1 million. And as far as from an adoption perspective, given that it is a transaction-based revenue stream, and how we're going to account for it, you're probably not going to see meaningful revenues in the back half of the year. Rather, it will start to grow in 2015 and beyond.

Operator

At the moment, I'm not showing any further questions in the queue. [Operator Instructions]

Justin C. Dearborn

Well, thank you for your questions. And to summarize, it's the third quarter in the row Merge realized consistent forward momentum in our financial operations, and most notably, we resumed revenue growth and strengthened our adjusted EBITDA. Our cardiology business achieved its highest sales quarter ever. Our eClinical OS platform continued to see adoption at a very high level. And as mentioned, we completed 2 large net new VNA deals. From a solutions standpoint, we realized significant growth in the adoption of both iConnect Networks and iConnect Cloud Archive and we launched our fourth subscription base service with iConnect Retinal Screening. These factors provide confidence and optimism about the remainder of 2014, and we are continuing to invest in our solutions and are focused on building recurring revenue streams. Thank you, everyone.

Operator

Thank you to our speakers, and thank you to everyone in the audience for joining us today. The call is concluded. And you may now disconnect.

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