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Merge Healthcare, Inc. (NASDAQ:MRGE)

Q2 2012 Earnings Call

August 1, 2012 08:30 am ET

Executives

Jeff Surges – Chief Executive Officer

Justin Dearborn – President

Steve Oreskovich – Chief Financial Officer

Analysts

Chad Bennett – Craig-Hallum Capital

Deepak Tyagi – Goldman Sachs

Eric Coldwell – Robert W Baird

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Operator

Good morning and welcome to Merge’s Q2 2012 Earnings Call. Today’s call is being hosted by Jeff Surges, Chief Executive Officer; Justin Dearborn, President; and Steve Oreskovich, Merge’s Chief Financial Officer.

Before we get started, please consider that the comments today may contain forward-looking statements under the Private Securities Litigation Reform Act of 1995 and not historical facts. Actual results may differ. Various critical factors that could affect future results are set forth in the company’s recent SEC filings and press releases. The company undertakes no obligation to update or revise any forward-looking statement. In addition, there may be references to non-GAAP financial measures. These measures are supplemental to the GAAP financial measures and should not be viewed as an alternative to them. For greater information regarding these metrics please see the related discussion in the company’s earnings release.

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

Jeff Surges

Well thank you, Operator, and thanks to all of you for joining us. Q2 2012 was a solid one for the company as we saw continued client adoption of our enterprise imaging solutions and subscription pricing model as well as launched several new products.

As you will recall, last quarter we announced the creation of two operating groups – Merge Healthcare and Merge DNA – to provide a greater level of transparency into our operating performance, business strategy and execution. Consistent with this, I will provide an update on the Merge Healthcare side of the business and will ask Justin Dearborn to provide an update on the Merge DNA operating group.

Merge Healthcare represents roughly 85% of our business and in Q2 pro forma revenue was $54.9 million. Further, subscription revenue comprised 7% of total revenue for this operating group. Adjusted EBITDA for the group was $14.5 million or 26.4% of pro forma revenue. Last quarter we made a bold move by announcing our transition to a subscription-based model to align more closely with our clients’ long-term operating plans.

I’m happy to report that we continue to see the client willingness to adopt this type of purchasing model which included subscription-based contracts totaling approximately $2 million. The interest has ranged from some of the large, multi-location imaging groups in the nation to single-doctor practices. Additionally, the uptake has spanned a wide range of our solutions including Merge RIS, Merge PACS, and Merge Eye Care PACS among others.

One such example is Long Island Radiology. With six locations across Long Island the group is rapidly growing. To fuel their projected expansion they wanted a full end-to-end solution but also needed the flexibility of our subscription-based model. Another example is a single-doctor practice and long-time Merge client Horizon Imaging in Alabama. They were looking to upgrade to the latest version of Merge PACS and wanted to be able to accurately manage their cash flow because they are a smaller-sized business. This new model allowed them to do both.

Like these and other practices, we expect to see accelerated adoption in the next two quarters of the year. We remain confident that our transition to the subscription model will increase predictability, position us for continued growth and ultimately prove to be more profitable.

While we saw steady adoption of our new model we also experienced solid traction amongst organizations embracing our enterprise imaging strategy with our iConnect suite. Several client wins speak to this fact. Franciscan Alliance selected Merge to image enable their EMR and provide real-time access to radiology and cardiology images across its network of 14 hospitals throughout Indiana. Children’s Hospital and Research Center in Oakland, California, a Level 1 trauma center, selected us to provide real-time access to images and information among its network of providers and its referring physicians.

Additionally, Our Lady of Lourdes, a member of Ascension Health, completed a successful pilot and will be rolling out iConnect to their entire organization as its enterprise-wide image viewer. And finally St. Vincent’s Hospital, the largest hospital in Green Bay, Wisconsin, and a member of the Hospital Sisters Health System, will be partnering with us to implement Merge’s complete cardiology solution suite to capture, manage, and display cardiac images and hemodynamics data across its enterprise.

On top of this client validation we were also recently acknowledged as the #1 Global Market Leader in providing vendor-neutral archive – or VNA – solutions by InMedica, a division of IMS Research. According to the report, Merge’s iConnect VNA customers accounted for 37% of all studies archived in VNAs worldwide in 2011. In total, Merge clients have stored over 200 million studies which equates to over 13 billion images. InMedica predicts that the market for VNA solutions will grow from 75 million studies in just 2011 to 570 million studies by 2016, a 49.9% compounded annual growth rate.

As the industry’s first true standalone vendor neutral archive, iConnect VNA has been successfully integrated with approximately 50 PACS vendors and specialty workstations at over 350 sites across the United States. Again, this is great validation of our approach to enterprise-wide imaging by both clients and industry experts.

Our success in the acute marketplace also includes the progress we’ve made with several strategic partners, in particular with Cerner, one of the largest HIT vendors and our partner for cardiology. This quarter we worked with Cerner on two large opportunities – Citrus Memorial Health System and Tallahassee Memorial Healthcare. Each of these systems decided to add Merge Cardio and Merge Hemodynamics solutions to complement their enterprise Cerner applications.

In the ambulatory space we continue to see clients selecting Merge solutions to help them achieve Meaningful Use. This quarter we added twelve more Meaningful Use deals representing over 125 total physicians. Just as importantly we saw clients who selected Merge last year start to receive their checks from the federal government. Based on data available from HHS via the www.health.data.gov website, over 70 Merge Healthcare clients have already successfully attested for Meaningful Use.

This quarter was also a very busy one for the product front as we continued to enable our new model with the release of Merge Honeycomb Imaging Archiving. We also launched a new version of Merge OrthoPACS, an updated release of Merge PACS and a new version of iConnect Access. Each of these releases represents a tremendous amount of work by our clients, R&D and Solutions Teams; but more importantly they each mean that we have additional opportunities in new and existing markets.

In summary, the Merge Healthcare operating unit had a strong Q2 performance as well as an increase in subscription-based deals that should remain throughout the end of the year. With that I’d like to turn it over to Justin Dearborn to provide an update on the Merge DNA operating group.

Justin Dearborn

Thanks, Jeff. With our first quarter under the new structure completed I’m happy to share an update on the Merge DNA business. The goal of the Merge DNA operating group is to offer innovative consumer, data and analytics solutions outside of our core business. These include clinical trial software, health stations, and data and analytics solutions.

This quarter we delivered on our goals in several areas. First we released Merge eClinical OS at the end of June. eClinical OS is a software-as-a-service application offering end-to-end solutions for clients to design, deploy and manage clinical trials. It delivers a single clinical trial operating platform. Since eClinical OS’ launch at the Drug Information Association Meeting in June, we have seen rapid adoption from existing Merge clients and numerous new clients. This offering enables us to address new segments of the clinical trials marketplace that we could not target with our existing product offerings as well as furthers our transition to a true SaaS revenue model.

Second, we continued the replacement of disconnected health station units we currently have in retail pharmacy and corporate settings with our new connected Merge health station. Here in Chicago we’re seeing strong usage from consumers with a very limited rollout campaign. In fact, many of you on the call who have visited us in our office have seen these new health stations firsthand in CVS locations throughout Chicago.

We will continue to provide updates on our progress as these deployments continue throughout the second half of the year. We don’t expect the variable revenue component of this business to express itself until late Q4 or 2014. From a financial perspective, this quarter Merge DNA generated $8.5 million pro forma revenue and a breakeven adjusted EBITDA margin.

Subscription revenue comprised two-thirds of total revenue for this operating group while backlog at June 30 was 100% subscription-based. It’s important to remember that the DNA side of the business is immature and as such will be less predictable and lumpier for the next few quarters as compared to our Healthcare group. With that said we expect the margins for our DNA group to increase over the next few quarters.

We will continue to closely monitor and balance our investments for each group from a global Merge perspective. Now I’ll let Steve provide additional comments on the quarter’s financial information.

Steve Oreskovich

Thanks, Justin. Company-wide pro forma sales grew by 11% and totaled $63.4 million compared to $57 million in Q2 2011. GAAP sales for Q2 2012 were $62.9 million. This revenue growth took place while we continued to move to a subscription model. As mentioned on our prior earnings call we have some new metrics to share in this call, the earnings release and 10(q) to help gauge the continued progress in the shift from perpetual licensing to subscription-based pricing.

Today, the majority of revenue is still generated through perpetual license agreements with our customers. Under this type of an arrangement the software, hardware and professional services are considered to be sources of nonrecurring revenue and related backlog. Approximately 40% of revenue in Q2 came from nonrecurring sources and backlog as of June 30 was $28 million versus $31 million on a comparative basis at December 31, 2011.

While Merge has traditionally discussed a recurring revenue metric, for better visibility into our operating results we will talk about this in terms of subscription and maintenance revenue. Subscription-based pricing arrangements in which software, hardware and professional services are recognized ratably over a number of years generated 15% of total revenue in the quarter and include those customers which Jeff mentioned earlier.

For those of you who like to model the business, subscription backlog has grown from $25 million at December 31, 2011, to $30 million as of March 31, to $34 million at the end of Q2. Due to the introduction of subscription-based pricing earlier in 2012 and the length of our customers’ sales cycles we would expect these types of arrangements to become more prevalent in the second half of 2012 and beyond.

We anticipate this trend to have a greater impact on the Merge Healthcare operating group which has only 7% of total revenue from subscription sources today. Also, while Merge DNA recognized two-thirds of its revenue from subscription arrangements in Q2 we would expect this percentage to increase significantly going forward as 100% of the Merge DNA backlog as of June 30 is subscription-based. The remaining 45% of revenue in the quarter came from maintenance and EDI which is also highly predictable.

Gross margin on a pro forma basis was 57% in Q2 2012 which was down 2% to 3% from the past few quarters due to more hardware sold in Q2. Hardware revenue comprised approximately 18% of overall revenue in the quarter which is 4% greater than prior quarters. Gross margin in Q2 2011 was unusually high at 67% as a result of hardware comprising only 6% of total revenue. Consistent with prior quarters, the mix of software and hardware sales both individually and as a percentage of overall sales will continue to fluctuate and impact our gross margin on a quarterly basis.

Operating expenses excluding depreciation, amortization and acquisition-related expenses were $26.6 million in Q2 compared to $23.1 million in Q2 2011. $2.9 million of the $3.5 million increase relates to our investment in sales, marketing, and branding efforts that occurred throughout 2011 resulting in sales and marketing costs that comprised 17% of pro forma sales in Q2 2012.

Based on the gross margin mix and sales and marketing investments, Merge had an adjusted EBITDA of $13.6 million or 21.4% in Q2 2012 compared to $17.1 million or 30% in 2011. Adjusted net income was $0.02 per share in Q2 2012 compared to $0.06 in 2011. Cash generated from business operations was $10.2 million in Q2 2012 compared to $6.6 million in 2011. Overall the cash balance decreased by $6.2 million from Q1 to $33.7 million at the end of Q2, primarily due to the payment of the semiannual interest of $14.8 million. We would expect the cash balance to rise significantly at the end of Q3 as our next interest payment is not due until November.

Regarding our primary working capital accounts, net accounts receivable decreased in the quarter by $1.1 million to $68.8 million at June 30, and the current asset called revenue in excess of billings decreased by $2.9 million in the quarter to $23.9 million at quarter end. Deferred revenue also decreased in Q2 by $5.7 million to $50.1 million at quarter end. The activity on these three accounts will fluctuate on a quarterly basis due to contracted billing terms and the achievement of such terms.

Operator, you may now open the call for questions.

Question-and-Answer Session

Operator

(Operator instructions.) And your first question comes from Chad Bennett.

Chad Bennett – Craig-Hallum Capital

Hey, good morning, guys. Questions: I don’t know that I quite got all the ins and outs of backlog but just on an absolute basis, I think in the release you talked about backlog of around $62 million. Is that an aggregate number, Steve?

Steve Oreskovich

That is, Chad, yes.

Chad Bennett – Craig-Hallum Capital

Okay. What was the aggregate number last quarter?

Steve Oreskovich

I don’t have that number currently available. I did walk forward the subscription-based backlog which has grown sequentially from the end of the year to Q1 to Q2 here, which was $25 million, $30 million and $34 million.

Chad Bennett – Craig-Hallum Capital

Okay, alright. And then considering the backlog growth, which I think it grew pretty nicely sequentially in aggregate, help me understand a little bit. And I understand nonrecurring backlog is kind of the label behind it but deferred revenue down sequentially with backlog going up, were there different payment or billing terms that you know some of the subscription deals did not actually hit deferred? Or can you explain kind of the seasonality behind the deferred revenue being down?

Steve Oreskovich

Sure. So that’s from a seasonality perspective more from the aspect of when we’re able to bill under some of our contracts. So as we contract more with hospitals they’ll tend to have billing terms that are upon certain milestones such as installation of the software or a completion and going live as opposed to radiology and other imaging centers where we get paid more upfront.

So it’s less from a seasonality perspective, more from the fact that more of our contracting business is coming from the hospital environment which quite frankly is where we want it to be because it allows us to go ahead and sell several of our products into that environment and quite frankly more of our solution set into that customer base than the imaging center customer base.

So that’s really what’s causing the change and it will fluctuate on a quarterly basis between what’s in accounts receivable, what’s in revenues in excess of billings which just means we haven’t yet reached that milestone in order to bill, and then what’s in deferred revenue which essentially means we reached a milestone to bill but we haven’t recognized all of that revenue at that point in the contract milestone.

Chad Bennett – Craig-Hallum Capital

Okay. And is there a way to break down deferred revenue between maintenance and subscription or is it just too early?

Steve Oreskovich

It’s too early. As it relates to the subscription billings essentially when they’re set out it’s going to for the majority of it occur on a monthly or quarterly basis. So I would not expect to see a significant amount of deferred revenue associated with subscription-based contracts just based on the fact that we should be recognizing most of those revenues in the quarter in which we’re performing the invoicing.

Jeff Surges

Chad, this is Jeff. So you take a 36-month contract and you have to from a revenue standpoint roll all of it into 136, 236, 336 – it flattens that number out and it gives a lot of consistency to it, whereas in maybe some of our other applications like cardiology where we’re installing across three, four, five, six hospitals there’s more of a milestone payment depending on how well we’re penetrating the overall project. So trying to split out both of those is a way to think about subscription in one model and cardiology, which is one of the products we talked about that is still in the perpetual world because of the way it’s sold and deployed.

Chad Bennett – Craig-Hallum Capital

Okay, fair enough. So the subscription business basically, I mean you’re not billing anybody a year upfront where anything would go into deferred. It’s just going to, billings will essentially be revenue pretty much seamlessly, right?

Jeff Surges

That is correct, yes.

Chad Bennett – Craig-Hallum Capital

Alright. And then adjusted EBITDA margin was a little over 21% in the quarter, a bit better than what I was thinking. How sustainable, Jeff, Steve, whoever is that margin looking into the back half of the year and do you hope to potentially improve on that?

Steve Oreskovich

Yeah, so I would start with I believe that that margin is sustainable through the back half of the year. The margin, the adjusted EBITDA margin will fluctuate based upon the gross margin so we would expect if the gross margins were to come back in the back half of the year typical to how they’ve been in the prior quarters that the adjusted EBITDA margin would follow that trend.

Jeff Surges

Again, if you think about it we did have a more intense hardware quarter and some quarters we have that, some quarters we don’t. And the end of June is a great buying cycle for a lot of hospitals – they clean out the remainder of their budgets, they start 7/1 or July 1st with their new and so it’s at that time when they may take advantage of those available funds and refresh some of their hardware. So we were a recipient of that.

So to be able to maintain this adjusted EBITDA with a somewhat heavier hardware load was encouraging number one. Number two, if you think about the prior question you had where there’s not a lot of upfront revenue in subscription-based and the ability to still generate 21% only gives us more confidence that if we anchor that baseline which is again, as you said a little bit higher than you had, then you can start to see as we grow the backlog of subscription to greater numbers over the next few quarters, few years, we should see that number continue to grow.

Finally as we said our investment in sales and marketing is complete and we don’t have a lot of big investments. We have more execution, training and education versus adding droves like we did a year ago, and so if we’re managing it appropriately we’re starting to see the benefit of that being realized in the next two quarters as well.

Chad Bennett – Craig-Hallum Capital

Okay. And then just on how we should think about seasonality in the back half: I think obviously the June quarter is a nice quarter from a budget standpoint. I think typically the September quarter is kind of flattish, maybe a slight improvement and then obviously the December quarter is seasonally nice. Is that, and I know you’re not back to giving guidance but is that directionally, qualitatively, however you want to put it how we should think about the business from here?

Jeff Surges

Yeah, I think that’s consistent. In our particular line of business, RS&A is Q4, a heavy number of our imaging center clients and our ambulatory clients are purchasing more in the later half of the year when they see better visibility into what their years look like. We are in the same industry with many others, right – Q3 you have some vacation time, you have people gearing up.

I think what may offset that is going to be the Meaningful Use Stage II announcements. I think that’s going to potentially drive some uptick. I think as you saw in some of these announcements by these large health systems embracing iConnect – I think that’s going to continue and that may offset a typical seasonality mix, but we anticipate some imaging news on Meaningful Use II. And with a lot of people wanting to attest by the end of the year we may see that it may have a unique ability to offset that seasonality drag but we’ll have to play that out.

Steve Oreskovich

The one thing I’ll add to that as well, Chad, though is we anticipate seeing more subscription or a greater number of subscription-based contracts coming through in the back half of the year. So whereas traditionally Q4 may have been and was for us a strong quarter, dependent upon the number of subscription-based agreements that we’re able to sign in Q3 and more notably in Q4 it might not be such an uptick from Q3 to Q4 as you’ve seen traditionally in the past.

Chad Bennett – Craig-Hallum Capital

Okay, fair enough. Last one from me: Jeff, can you give us a sense of where we are in terms of iConnect penetration into your base right now, not to mention potential new customers?

Jeff Surges

Yeah, so we continue to focus on the current client, right? Our treasured asset is 1500 hospitals that use only one or a little bit more than one on average of our products. So as a focal point, when you have a premier client base you want to go back into that base. So it continues to be a high percentage of same-store growth, and the iConnect as we’ve always talked about Access and Share is the lighter-weight modules that go in quickly, that image enable Epic, image enable Cerner, image enable a variety of EMRs. And then the more heavy, productive load is the VNA, right and that’s when we announce VNA deals that’s a bigger, stronger platform for us to really grow in.

Complementing that then comes cardiology, complementing that comes other eye care, orthopedics, etc. So focus has been on the base. I think with the subscription arrangement I think we’ll start to penetrate some net new because that onboarding opportunity will give people who were maybe wed to a vendor because they paid upfront money maybe one or two or three years ago but it isn’t working out – we’re giving them an onboarding opportunity without a big sum cost so they can start their subscription.

And having experience in this business, if you do it right some of what they may be paying in annual maintenance to a competitor could be what they start paying us for the subscription model. So if we work it well and see that backlog growth start to happen that would be a way that you would look at our penetration into not only the existing base but net new.

Chad Bennett – Craig-Hallum Capital

Okay, thanks guys.

Operator

Your next question comes from Deepak Tyagi.

Deepak Tyagi – Goldman Sachs

Good morning, guys, thank you for taking my questions. Just to follow up on that point with iConnect, now that you have gone to the market with your subscription-based model how should we think about the number of contracts and potentially the size of the contracts? Although it may not be upfront revenue with a subscription-based model how should we think about the landscape given that you may be able to penetrate net new accounts now?

Jeff Surges

Thanks, Deepak. One of the things we’ll continue to try to introduce, and I think I was pleased that we were able to introduce some new metrics for everybody as we talked about last time – transparency, predictability, showing the two different operating units and starting to give some of those metrics. One of the metrics we then consider is how to show these new backlog growth numbers because if somebody signed up for 36 months or beyond that’s committed for contract revenue that falls on. And then in the same way, think about customer accounts as existing versus net new, right?

So we’re only one quarter into this where I know our focus has been always on our current customers just because of the premier names in our base, that’s where we should be focusing. What will work on playing out for you and everybody is how that looks from net new where we’re stealing or taking share from the rest of the marketplace and adding it in there. I think for now the way we’re kind of showcasing the backlog and our growth is the right way to do it but we’re open to seeing what other trends come up and a way to portray that for you and others.

Deepak Tyagi – Goldman Sachs

And I know you just had one contract with one unit of Ascension Health. I know that’s a large healthcare system so is that the premier? Like you get into one and then potentially you have an opportunity to expand perhaps more effectively now with your subscription-based model?

Jeff Surges

Yeah, so just for clarity we announced just the one at Our Lady of Lourdes just as an example of iConnect as part of Ascension. We do business with a number of the Ascension ministries and regions throughout the country. They’re one of our largest clients. We just chose to highlight that one deal but we did several others in the quarter with them.

Deepak Tyagi – Goldman Sachs

That’s helpful. So as we think about back half of 2012 and perhaps beyond, and I’m not asking for guidance; just trend-wise as you go to the market and you see some of your numbers how should we think about Merge Healthcare subscription revenue and backlog trending next six months and perhaps even into 2013?

Steve Oreskovich

Yeah, great question, Deepak. We would expect the backlog to grow at a much more rapid pace than the revenue stream from subscription only because of the fact that when you sign a deal the entire committed amount goes into backlog while you’re taking that revenue and recognizing it ratably over the term of that contract. So especially as it pertains to the Merge Healthcare business unit we would expect to continue to see that grow slightly. But once we reach a peak number of contracts you’ll start to see that growth in the revenue stream from subscription growth at a more accelerated rate. But for at least the next couple of quarters we would expect the backlog to be growing much more rapidly than the revenue.

Deepak Tyagi – Goldman Sachs

So then you still hold the view of about 80% of revenue to be generated really from subscription-based contracts within the next two years or has that accelerated? Or would you might even need longer than two years?

Jeff Surges

Deepak, this is Jeff. I think if we go off of our traditional definitions of sources of recurring revenue prior to subscription we were always in the 55% to 60% range. I think what we’ve intimated is if you cast out over a three-year process and you look at the kind of opportunity to convert, we want to continue to see that growth in the backlog which will then predictably fall to the revenue. That should be an indicator number one.

Number two, I think the demand for margin expansion has to then show up because the subscription model has to then show up as more profitable, higher margin over time. So EBITDA should express itself too in the same way. So it may look as higher backlog with predictable growth in revenue but it should express as a higher gross margin and better EBITDA. But I think I’d be in the 70%’s rather than the 80%’s over the next three years just because 100% of our portfolio will not make subscription.

Some of our critical care products that are at the bedside are not going to be image or cloud enabled through the internet. Our clients are going to want our cardiovascular suites that are in CAT labs and monitoring to be real-time plug and play. They may pay for them through a subscription but there is a little bit of the model that won’t allow the entire portfolio. But I think you’re in the neighborhood.

Deepak Tyagi – Goldman Sachs

That’s helpful, Jeff. So one last view on meaningful use: you gave some good color in your prepared remarks and in your response to Chad I think. I just wanted to dig a little bit deeper. With Meaningful Use Phase II guidelines out do you see that trend going up in terms of your intake contracts? Demand was stable and better than we expected but we what we had expected was with Meaningful Use Phase II guidelines your contracts would ramp up significantly. What catalyst do you think will enable that?

Jeff Surges

Yeah, so I think we have to think of meaningful use in two ways. One, while there clearly was a big pause that we unexpectedly saw in Q1 at hems with a government giving a relax, I think that pause, while it shows up in 2012 – remember, the one thing that they didn’t move was the end of 2014-2015 when you have to have everything enabled, right? They’re not pausing when they can start invoking penalties if you’re not using certified electronic patient records with all the attachments.

So I think this two-quarter pause is going to start to open up again because you’ll have to start to get ready for Phase II, which again I think what you’re seeing in the market is it’s no longer about who’s buying the medical record – it’s more about what data and content fulfills the medical record or the patient record more thoroughly, and that’s where the image becomes an important attachment, right? The image becomes an important content play in that.

So a lot of these iConnect examples we’re giving, when we say image enabling in EMR I think those are the leaders of the industry that have already rolled out Epic, that have already rolled out Cerner and are now saying “Look, I’ve got to get this image one for compliance reasons, but two my referring physicians need to see it.” And three, we know that in $100 billion of imaging that was spent last year, $26 billion of it was redundant. So there’s an accountable care discussion about how do we get waste out of the system – well, in imaging alone there could be upwards of $25 billion on an annual basis.

We won’t solve that overnight but if we image enable and better provide information into that medical record through our diagnostic viewers, through iConnect, we become an important content play to that medical record and that’s where you start to see the size of the client base, the size of the VNA market we have today; the billions of images that now have to get out of the archive, get attached to the record and move around that ecosystem of healthcare. That’s where we get excited about the future and I think RS&A will be a point in time where you’ll see a lot of enthusiasm around how these images start really moving and being enabled for viewing, for facilitating this big attachment that’s important to everybody.

Deepak Tyagi – Goldman Sachs

That’s helpful. One last one on the DNA side: Justin, how is the implementation doing of the newer kiosks and your discussions with potential partners on admin strategy? I know you were keen about it.

Justin Dearborn

Yeah, so as I mentioned we’re doing pilots in Chicago mainly right now with two retailers, and the usage has been very positive. Actually as of this morning 27,000 uses in Chicago across 40 machines. So good usage; we’ll continue to get feedback, tweak the user interface, etc., but that’s what a pilot’s for. So it’s going as planned; always a little slower than you hope just because there is a manual component to this when you have to install the unit. We’re doing that with a partner but we’re on track with our pilot and continue to go from there.

And the partner side is similar I’d say – ongoing discussions, always talking about the size of the network: the bigger the network obviously the more interesting. The scope of the network being national is interesting to the national brands, so ongoing discussions there and we’ll announce those as signed.

Deepak Tyagi – Goldman Sachs

Thank you, good quarter, guys.

Operator

And your next question comes from Eric Coldwell.

Eric Coldwell – Robert W Baird

Thanks, good morning. I have quite a few actually. I’m going to start off with the tax rate was substantially higher than we expected this quarter. Can you, Steve, talk about what happened with the 55% tax rate?

Steve Oreskovich

Sure. So the vast majority of that tax expense, Eric, is non-cash. The difference is generated out of the fact that with the change to the subscription model, in the US it changed whether the full year from a tax basis we projected being in an income or tax loss position. So as a result what we were required to do is catch up the benefit that we recognized in Q1 as well as account for some things that when you’re in a tax income position you would not have otherwise had to account for – all non-cash items.

Additionally we did have a strong quarter from the operations on the Canadian side. We do have NOLs there that don’t have a valuation allowance against those; those are actually recorded up on the balance sheet. We have continued to generate taxable income from our Canadian operations and utilized prior NOLs so about $800,000 of that total expense line was attributed to those tax profitable operations in the quarter.

So that’s the two components – primarily the change from the US projections for the year that caused the catch up there. But all except for $200,000 or so of that expense is non-cash.

Eric Coldwell – Robert W Baird

Okay, got it. And then also in the quarter there were some acquisition-related expenses as well as some add-backs that ran through the cash flow statement and the non-GAAP adjustments. Can you walk through those, the roughly $2.5 million number? What was that?

Steve Oreskovich

Sure. That resulted from an acquisition that we completed in Q1. As part of that acquisition there was a delayed payment stream that was tied to our stock price, so dependent upon the price of our stock ultimately the amount of payments – whether those be in stock or in cash in the future – the accounting rules basically say you have to treat those as contingent, what they call contingent consideration at the outset of the arrangement.

You’re not allowed anymore to take your best estimate and put it up there sort of on the in purchase accounting; you have to flow it through the P&L. So as a result of the change in our stock price in the quarter we had to record an expense for the quarter. We’ll continue to true that amount up until the time of payment or the six month and twelve month payment dates that occur in late Q3 and late Q1 as well. And it was an asset purchased that was related to the DNA operating group if it helps.

Eric Coldwell – Robert W Baird

Got it, okay. And then Justin, did you give the number on actual kiosk sales revenue and/or live deployment of the new Merge health stations? I’m a little confused – only 40 stations but my impression coming out of last quarter was that there could be several million dollars of sales in the quarter.

Justin Dearborn

So we do have revenue with that group right now, Eric, with preexisting contracts. So as you know there’s units out in different retail settings right now. We do derive revenue but those are the older machines with limited functionality so we are receiving revenue for those. But we’re piloting the new unit with some of the retailers in Chicago. When we started we had about 45 units in Chicago right now and piloting those. So the revenue will continue out of those retail contracts, so we don’t expect a large sale of units for this year.

Eric Coldwell – Robert W Baird

Okay. Shifting gears and to follow up on an earlier question: iConnect, you announce the number of deals each quarter but it seems to me the number of contracts is less relevant and what’s more relevant is the number of hospitals or providers you’re touching with those iConnect sales. And I was curious if we could get an update on what the install base is of iConnect in terms of the number of hospitals for example.

Jeff Surges

Yes, so I think one of the things that we need to start to transition with iConnect – and your point is a great one, Eric – is as opposed to announcing it’s now more about how many images are we facilitating or how many end user or locations. So I think we’ve always talked about iConnect in terms of customer acquisition – well over 100 when we go through the whole iConnect portfolio, right? It may even be in the several hundred range when you look at all the modules: Access, Share, archive, second copy, etc. So each of those has a different flavor and a different rollout.

So we can take as a to-do in future quarters to find a way to try to express that, but it gets a little bit hard to try to pin it into a quarter. Last quarter we talked about Advocate, 14 hospitals implementing all of their cardiology suites with our cardiology system and then they also purchased iConnect Share and Access to move millions of cardiology reads and images around their ecosystem but that was just cardiology alone. So it gets hard to determine was that one customer or are they using it for everything when it was that focused business problem they had was around cardiology?

So maybe as we continue to give more statistics and more information we can think about a way to express that, and I think that’ll be important to show further penetration as we get ready for Meaningful Use II, get ready for image enabling not only EMR vendors but image enabling physician users maybe not traditionally in our core but they need to be able to see an image at a general physician or internist level and they need a viewer to be able to see that. A long-winded way of saying we’ll work on it.

Eric Coldwell – Robert W Baird

Okay, that’s fair. Last question for now: in the past we’ve been tripped up a few times in our model with some of these one-time seasonal events, RS&A and Merge Live in the second half of last year, charitable donations that have hit – last year being a big number I think in Q4 if I remember. Any sense on what we should be thinking about this year in terms of the actual tradeshow expense for Merge Live and RS&A as well as what the thought process is on donations? Should we be building a $1 million or $2 million number into Q4 for that?

Jeff Surges

Yeah, so from an operating perspective I think we’ve consistently throughout 2012 talked about the sales force investment as complete. We have what I call our A Team here – they’re in the stable, they’re productive. So any big events in terms of investment are really not going to be any greater in the future than they were last year; in fact, if at all we’re going to start to see scalability and start to see efficiency. So Merge Live’s a great example. We have 3x the amount of sponsorships this year than we did last year – that means our partners are paying to come, paying to see our clients and help offset the costs. That helps, right?

RS&A very similar – we’re not growing our booth size in that but what we’re doing is restructuring that and starting to look at that. So I think as we think about the operating groups of Healthcare and DNA we get a little bit better focus on what we’re messaging and what we’re trying to provide. So I don’t think there’s a lot of heavy back half of the year investments in those areas.

Steve Oreskovich

And if you are looking at it from a quarterly perspective you know, and you’re basing it off of Q2 for the sales and marketing line, Merge Live will occur in Q3 and then RS&A will be in Q4. Traditionally as well the bookings in Q4 are stronger, so between RS&A and commissions you’ll see the Q4 expense probably trend in a similar direction as it has in prior years. But I wouldn’t expect as Jeff mentioned anything big outside of that.

Eric Coldwell – Robert W Baird

Any thoughts on the charitable donations?

Jeff Surges

I don’t think we have a lot there. I think we have an interest payment in November. Cash is king right now; we continue to focus on that. I think you saw the cash collected in the quarter is really strong and I think that’s our operating plan. This model of subscription as you know, Eric, really calls for us to be less lumpy in our spend and to be more prudent about it so that we can start to take out over the long term this model so it views and expresses itself. So I think we’re comfortable with that.

Eric Coldwell – Robert W Baird

Okay, thanks very much.

Jeff Surges

Okay, well what I’d like to do is thank you all for joining the call today. I do want to reiterate on behalf of management and our company that we are very excited to see our clients adopt these subscription-based pricing models across our business. In light of that and in anticipation of the soon to be announced Stage II Meaningful Use rules that all signs today indicate include imaging, we believe that we’re well positioned to meet the demand for solutions that focus on the most important part of the electronic patient record – that being the image. So with that, Operator, thank you and thank you all for joining our call.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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