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Executives

Jeff Surges – CEO

Justin Dearborn – President

Oreskovich – CFO

Analysts

Ryan Daniels

Deepak Chaulagai

Chad Bennett – Craig-Hallum Capital

Douglas Dieter

Merge Healthcare, Inc. (MRGE) Q3 2012 Earnings Conference Call November 1, 2012 8:30 AM ET

Operator

Good morning and welcome to Merge’s Third Quarter 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 statements.

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

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

Jeff Surges

Well, thank you, operator and thanks to all of you for joining us this morning. I would first like to start and state that we will not be commenting on the previously announced strategic review underway with Allen & Company. This quarter we witnessed acceleration in our move to the cloud, increasing client adoption of our enterprise imaging solutions and so our clients received over $3.1 million in Stage 1 Meaningful Use incentive dollars by using Merge solutions.

As we did last quarter, I will provide an update on the Merge Healthcare side of our business and Justin Dearborn will provide an update on the Merge DNA operating group. Merge Healthcare represents roughly 85% of our business and in Q3 pro forma revenue was 53.4 million. Further, subscription revenue comprised 4.3% of total revenue for this operating group. Adjusted EBITDA for this group was 14.3 million or 26.8% of pro forma revenue.

On our Q1 earnings call, we announced the availability of a subscription-based pricing model to align more closely with our clients’ long-term operating plans. This quarter we saw continued adoption of subscription-based pricing models. I’m very pleased to report that clients contracted with us to move and store over 3.65 million annual studies to the Merge Honeycomb archive, our cloud-based archiving solution. These studies will come from groups of all sizes across a wide range of specialties, including North Texas Hospital, Wood County Hospital and (inaudible) Radiology Group plus earlier this week, as we announced, Resurgens Orthopaedics, the largest orthopedic practice in Georgia, has also selected Merge Honeycomb.

As previously stated and as evidenced by strong adoption in Q3, we expect to see clients continue to embrace our subscription and cloud-based solutions and 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. This quarter we also saw strong uptake in organizations embracing an enterprise imaging strategy with our iConnect enterprise clinical platform, we had over 15 clients select Merge iConnect solutions this quarter ranging from large IDMs to community hospitals, a brand new client for Merge, as I think in hospital who had selected the entire iConnect enterprise clinical platform and merged packs for their enterprise imaging strategies.

In a majority of our iConnect opportunities this quarter clients selected us because of the iConnect enterprise archive or VNA. We’ve seen progress of clients has moved from our iConnect Access and Share to the large anchor solution VNA.

And if you recall, last quarter we announced that Merge was named the number 1 global market leader in providing vendor neutral archive solutions by a leading independent research firm, without question the VNA space is very active right now. And based on our industry-leading products, we are aligning our sales, service and go-to-market teams to ensure that we, – we remain the leader in this space and continue to capture market share.

Just as our VNA strategic so to our partnerships with leading HIT organizations. As we’ve reported in quarters past, we continue to see progress with our partners. This quarter was no exception as we successfully partnered with Cerner and several client opportunities. One example is Rex Healthcare a member of the UNC Healthcare Network which will implement Merge Hemo to automate their cathlab in their Cerner electronic health record.

This quarter, we are pleased to announce that we were also awarded acceptance into the EMC select program and our entire iConnect enterprise clinical platform will be offered by EMC sales reps throughout the country, of which there are over 350 are the sales people, our progress in Q3 was not just in the acute marketplace but also in our ambulatory space. We continue to see clients selecting merge solutions to help them achieve meaningful use goals. Also in Q3, the final rules for Stage 2 meaningful use were announced and as we hoped and expected imaging was included.

The final rule states that 10% plus of all scans and test that resulted in image will need to be accessible through meaningful use certified EHR technology, a perfect fit for our iConnect Access product. We are excited by the opportunity that Stage 2 will represent as we move forward. Even more important, our clients have begun to recede meaningful use incentive dollars from the federal government.

This quarter our clients received $3.1 million from the government as part of the high-tech act. We expect to see this number grow to $10.9 million by the end of the year as clients get their MU checks for all of 2012. This again is solid proof that who our clients are adopting our solutions are effectively using them to improve their efficiency and are successfully attesting to meaningful use.

While we are proud of the Q3 achievements, I also want to remind you that the fourth quarter is generally our strongest quarter, not only for us but for our industry. Many of our clients’ budget cycles correspond to the end of the year, but we also have very exciting opportunity to share our message with prospects and clients at the upcoming RSNA Conference, November 25 through 30, right here in Chicago. We will be hosting a wide variety of events during this meeting of imaging and radiology leaders from around the world and expect to see our industry’s largest tradeshow event help accelerate Q4 deals that are currently in our pipeline.

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

Justin Dearborn

Thanks, Jeff. As I mentioned on our last call, our eClinical group released a new platform during the last week of Q2. Our new platform called Merge eClinical OS is a Software as a Service application offering end-to-end solution for clients to design, deploy and manage clinical trials.

During Q3, this new platform contributed to the great sales results for this group. Q3 saw 25% growth in the number of sites using our solution, 40% growth in the number of studies under contract and well 100% growth in bookings. We saw strong demand across all customer segments with especially strong demand from our CRO channel. We signed over 150 contracts in Q3, far exceeding our best quarter. I would however like to point out that this group does not necessarily follow the seasonal trend that our healthcare group experiences.

With respect to our Health Stations segment, we continue the replacement of disconnected health station units we currently have in retail pharmacy setting with our new connected Merge Health Station. We are currently engaged in pilot with eight large retail chains and continue to evaluate incremental revenue generating partnership opportunities. as we stated in the last call, we don’t expect the variable or recurring revenue component of the business to express itself until 2013.

From a financial perspective, this quarter March DNA generate 7.6 million in pro forma revenue with a 7% adjusted EBITDA margin. Further, subscription revenue comprised over 90% of total revenue for this operating group, while backlog at September 30 grew $7 million to $29 million and is 100% subscription revenue-based. As you may recall, last quarter’s 8.5 million of revenue included about 2.4 million of hardware sales, while this quarter included less than $100,000 of hardware revenue.

We believe the adjusted EBITDA margin in this group will increase in the coming quarters as our subscription revenue recognized accelerates, while our cost structure to deliver this revenue grows at a much slower rate. As you may be aware, on August 28 Merge Healthcare received a warning letter from the FDA related to certain quality process issues and it’s suppliers Tennessee location that was previously owned by Merge for an eight month period.

This location was responsible for manufacturing the legacy kiosks under a separate quality process that represent a few hundred thousand dollars in revenue for the first half of the year. Merge is supporting the new owner of that facility to ensure the process deficiencies are addressed. On October 2 2012 Merge issued a follow up, more detailed response to the FDA and included more than 200 pages documentation regarding actions completed in response to the warning along with plans for any additional outstanding actions they were pending completion.

On October 24, the FDA indicated that responses had been received and stated, the final FDA warning would remain open pending closer of outstanding actions. Now let Steve provide additional comments on the quarter’s financial information.

Steve Oreskovich

Thanks, Justin. We continue to successfully grow revenue, while increasing the amount of revenue generated through subscription and other highly predictable revenue sources, which totaled 61% of total revenue for the quarter subscription revenue accounted for 15% of revenue in Q3. Well maintenance in PDI and EDI was 46%. Company wide pro-forma sales grew by 1% to $61 million compared to $60.6 million in Q3 2011. GAAP sales for the third quarter of 2012 were $60.4 million.

The most relevant indication of the change to subscription is reflected in the continued backlog growth of $6.4 million or 19% in Q3 to $40.4 million as of September 30. In the 9 months since the end of 2011, subscription backlog has grown by over $15 million or 62%. Q3 still had 39% of revenue generated through perpetual license agreements with our customers. Under this type of arrangement the software, hardware and professional services are considered to be sources of non-recurring revenue and related backlog, which grew in Q3 by $3.8 million or 13%, the $31.1 million as of September 30.

Most telling is that our non-recurring backlog has remained constant compared to the end of 2011. Well, we have embarked and significantly grew the subscription revenue model. We have seen the positive impact of providing a hosted solution coupled with subscription-based pricing it’s had on the Merge DNA business since the introduction of eClinical OS and look forward to continue to proliferate this model throughout the applicable Merge Healthcare product solutions. Similar to what has already been done with Honeycomb.

As we’ve discussed in the past, the goal is to increase Merge’s subscription and other predictable revenue sources to over 70% of the total revenue by the end of the next few years. Gross margin, on a pro forma basis, was 59% in Q3, fairly constant with 60% in Q3 2011. Hardware revenue in the quarter was 13% of total revenue, which is consistent with the general quarterly trend over the past couple of years. That said, 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, restructuring and acquisition-related expenses were 26.9 million in Q3 2012 compared to 24.9 million in 2011. The increase is primarily driven by the 2011 build-out of the sales and marketing team, as well as R&D investments, resulting in new product innovations such as the new clinical trials platform, Merge Honeycomb and significant product upgrades like OrthoPACS. Based on the operating expenses, coupled with the change in revenue timing associated with subscription contracting, Merge had an adjusted EBITDA of 12.5 million or 20.5% in Q3 2012 compared to 14.5 million or 24% in 2011. Adjusted net income was $0.01 per share in Q3 2012.

Cash generated from business operations was 9.2 million in Q3 2012 compared to 8.8 million in 2011. Overall, the cash balance increased by 8.5 million from the second quarter to 42.2 million at the end of Q3. Further, we have increased the cash balance at the end of October to over 44 million which signals the continued strength of our operations and provides us even greater comfort regarding the ability to meet our $14.8 million semi-annual interest payment, which we will make today and not have to repeat again until May of 2013.

Regarding our primary working capital accounts, net accounts receivable increased slightly in the quarter by 1.5 million to 70.3 million at September 30 and the current asset, revenue in excess of billings, decreased by 2.6 million in the quarter to 21.3 million. Deferred revenue only decreased in Q3 by 800,000 to 49.3 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.

Based on the minimal quarterly activity in these accounts, they did not have a significant impact on cash generated from operating activities during the quarter, but the accounts payable activity did. Accounts payable decreased by 4.7 million to 19.5 million at September 30, primarily due to payments to hardware vendors for contracts fulfilled in the second quarter. Please recall that Q2 had a greater than normal percentage of revenue from hardware sales. The AP balance stayed relatively constant quarter to quarter, AP is also down 2.6 million from year-end, cash generated from operating activities would have been over 14 million in Q3 2012.

Turning to 2013, we expect to see continued traction from our subscription-based offerings, resulting in an increase in backlog of at least 25 million by the end of 2013, with pro forma revenue growth to between 265 and 275 million and adjusted EBITDA of 22% to 24%. To provide additional color for those desiring to reconcile adjusted EBIT of pro forma net income and GAAP expected results, please note the following estimates, which I will compare to the actuals for year-to-date 2012.

Sales adjustment for significant acquisitions to reconcile GAAP to pro forma revenue of about a 1.5 million compared to 1.6 million to date in 2012. Amortization and depreciation in cost of goods sold of 7.5 million, of which 4 million relates to the amortization of intangibles from significant acquisitions. This compares to 5.7 million and 3.7 million respectively in 2012. 10.5 million of depreciation and amortization within operating expenses, of which 6 million relates to the amortization of intangibles from significant acquisitions.

These are compared to 8.2 million and 4.5 million for 2012. Net interest expense of 32.5 million, including the amortization of debt issuance and debt discount cost, compared to 24 million for the first nine months of 2012.

Non-cash stock-based compensation expense of 6 million, which compares to 4.2 million to date in 2012. Income tax expense of 2.7 million with about 1 million in cash expense compared to 3.4 million and 700,000 so far today in 2012. And finally fully diluted shares outstanding of between 95 million and 98 million compared to 94.2 million for the third quarter of 2012.

Operator, you may now open the call for questions.

Question-and-Answer Session

Operator

Thank you so much. (Operator Instructions) However, gentlemen, we do have a number of questions in queue at present. First caller, please go ahead. Ryan Daniels, please go ahead with your questions.

Ryan Daniels

Hey guys, sorry about that. Let me ask a quick question on the subscription revenues in the core Healthcare division. I know you talked a little bit about this, but it looks like they were down modestly on a sequential basis, I think it was more like 7% of the sales last quarter and now down to 4.3. Any color you can offer there to explain that?

Steve Oreskovich

Sure. This is Steve. So since the first quarter when we introduced the offering our subscription backlog has increased in both healthcare and DNA compared to year-end. We also note that there is some historical contracting methods included in the definition of subscription, which we include in our earnings release, such as long lease agreements in software licenses that annually renew.

So as a result of those. I’ll call it older subscription methods and the timing of some of those renewals, they may impact the balance at any given quarter within the year, which is why we’re sort of – we focus on the annual results and we’re very pleased on an annual basis of where we’re able to grow it. And we expect as the new products such as Honeycomb continue to grow and the contracting base continues to grow, you’ll see less and less of that quarterly variability related to those old items that are included within the definition.

Ryan Daniels

Okay. That’s very helpful.

Jeff Surges

Ryan, this is Jeff. So a lot of the net new agreements right that we’ve continued to work on a quarter-over-quarter are ratably equivalent over time, 36 months et cetera. What Steve is highlighting is some of the inherent or legacy agreements that we may have executed early on have a cyclical renewal nature and so that may be a little bit on the softer from a seasonality but what’s layering on top of that is a much firmer net new and so as a whole it shows the way you’re thinking about it, but the way we discussed it, it’s growing at a rate we’re excited about.

Ryan Daniels

Sure. That’s very helpful color. And then maybe one for Justin, do you think the DNA division can continue to keep up that kind of momentum? I know you said, it doesn’t have the same seasonality but was there maybe a bolus of demand or an initial excitement after the eClinical OS launch that drove the very strong performance in the division this quarter or did you think that really is something more sustainable as we look forward?

Justin Dearborn

Thanks. There was some demand that we had created it by talking about the solution pre-release related and demoing it consistently in Q2 before the launch. There was some demand pent-up there for that. But overall, I think the ACO maturing as the sales team is in – general manager, it’s about 12 months old in a position he brought in to new sales. Leadership down there and it’s starting to click. So we do expect continued growth. I’m not sure, will be at that pace soft Q3 versus Q2. But we do expect that the growth to continue there.

Ryan Daniels

Okay, perfect. I was just going to say, certainly (inaudible) I was going to ask, just on the broader cross-selling environment, one of the things we’re clearly seeing more of, more of the risk shifting to the hospitals via ACOs or the commercial Shared Savings models. And I’m curious if you look at your customer base, obviously big part of the long-term growth opportunities it’s cross selling into your very strong base. I’m curious if you’re seeing that pick up in those organizations that are risk and your trying to reduce image redundancy in lower cost and improved patient care to just the macro question for you, John.

Jeff Surges

Yeah. So we continue to be excited about what I’ve always called the Post MU Stage 1 EMR dominant discussion at the CIO level. As we’ve stated before, $26 billion was spent in 2011 on redundant or duplicative testing of exams and images. So a lot of these clients are looking at ways and I only store an access but facilitate the sharing because the ACO bundled payment. And as the radiology, cardiology markets talked about reform coming, where they’re going have to participate in the do more with less model that the rest of the healthcare ecosystem.

In that case, we look at that cross-sell, up sell as a great opportunity. Internally will say the average Merge client has 1.4 of our products. Just because the nature of which we’ve acquired some of these solutions and release the innovation. As we think about the sales execution plan, it’s growing that to two, growing that to three modules and that anchors in from the existing client. The other side of that which is opening up is just the pure cost that I think some competitors have been able to enjoy at the high end.

For PACS and moving archives so a net new deal like Huntington, where we’ve replaced a competitive offering and they look to us not only for an upgrade or net new placements, but they’re asking us to then exchange the images and their HIE or get the images up into their EMR, that’s just further prove for us that world is coming. And with MU 2 it’s really asking the question to make it happen sooner. So it’s become a sweetener for us.

Ryan Daniels

Okay, great. Thanks a lot for the color guys.

Justin Dearborn

Yep.

Jeff Surges

Next question, operator.

Operator

Yes, sir. Caller, please go ahead.

Jeff Surges

Operator who is that, can you identify the name?

Operator

Yes, we have Deepak Chaulagai. Your line has been un-muted, please go ahead sir.

Deepak Chaulagai

Good morning, guys. Can you hear me? I’m calling from overseas, so I apologize for any static.

Jeff Surges

Got you Deepak.

Deepak Chaulagai

All right. Jeff, I wanted to follow up on Justin’s – I’m sorry Ryan’s question on subscription-based healthcare revenue and backlog. I understand the differences in definition and what classifies a subscription but just looking it sequentially from Q2 to Q3, subscription-based healthcare revenue, which I consider an important metric, was down sequentially, so was backlog. Any color there would be extremely helpful.

Steve Oreskovich

Sure, yes. Deepak this is Steve, so I can address both. If we have a delay in renewing some of those annual software license agreements, we will not take revenue in that quarter even if the, pardon me, even if the renewal normally would have occurred, so we’ll wait until we fully contracted in order to take revenue. So you’ll have some catch-up opportunity at a later date when the contract gets physically signed. So it could be a quarter to quarter timing there, so they are both part and parcel as far as the decrease in one leads to a decrease in the other, so we would not expect to see that in future quarters.

Jeff Surges

Deepak, adding on that, the good the color I would add is follow the release of our products. So we release Honeycomb, which is 100% subscription, and in the period we contract for over 3.6 million studies from – of which 0 revenue was recognized. So that is a complete 100% subscription. That’s a trend line we’re thrilled about and it’s an appetite that’s growing. Second, we announced that Merge OrthoPACS was a fully subscription model.

As you’ll recall, a few years ago, we acquired from Stryker the ortho business, we wrote that application as a complete subscription model and have been able to launch and had one of our best quarters in that area and the clients are very receptive. So as we look at what we’re motivating our sales force and our clients to embrace, it’s not the wind down of prior legacy lease arrangements or cyclical subscription, it’s the net new – on the net new platform agreements that have the 36 months, a per study ticker or a recurring ratable over time and so that’s seen into.

While two quarters into it, it will appear in your eyes and others to be a little lumpy, I can only tell you the net new that we’re layering on and factoring here is very receptive to our clients, hence some of the announcements we’ve tried to illustrate.

Deepak Chaulagai

Thank you for that additional color Jeff. Switching to the DNA backlog, Justin, how much of that is eClinical and how much of that is Health Stations? And if you can also segment out the revenue, DNA revenue between those two product lines that would be helpful.

Justin Dearborn

Yeah. So almost 100% of the increase in the subscription backlog comes from the eClinical group. As you know we don’t segment out the revenue but the strong performance in the subscription backlog came out of the eClinical group

Deepak Chaulagai

Okay. And one last one.

Jeff Surges

Deepak. Hey Deepak.

Deepak Chaulagai

Sure.

Jeff Surges

This is Jeff. What I want to add and you guys know my enthusiasm for this. In the clinical trials business, we were able to make a decision to push that business to 100% subscription and not bifurcate it with some perpetual and some subscription and migrate over time because that business generates, on any given quarter, less than 15% of the total revenue of the company.

We made a hard-line decision with that sales organization under that leadership to no longer do perpetual license and go 100% subscription and our confidence in making that decision was seen in what they did last quarter that only fuels us as we move over to the healthcare sector where you know we have longer sales cycles and you get into a nine, 12-month range where we have to still finish some perpetual deals, but that experience is giving us the confidence as we said on Honeycomb and ortho to say look 100% subscription and take those over the way we get them and not be enticed by the perpetual upfront deal.

Steve Oreskovich

Yeah. And so let me add to that. The negative side to that early in the game is you see the margin constraints we’re having there. So we have the cost structure set up for a different revenue model that will grow into that, but we couldn’t afford to do that across all our products in Merge one-time either.

So we made a decision to deal with eClinical group early on and you see the results in the bookings growth, subscription backlog growth and again, will grow into a margin there, but just as Medidata talked about yesterday on their call, their operating expenses lift because their commissions were so high. We have a similar anomaly to happen with that group in Q3 to have a much smaller scale. But we saw the commissions come forth scale because of that bookings were so strong but the revenues going to flow for next few years. So again, look like a much better picture to afford but we couldn’t take that full process to company. Just bit margin constraints there.

Deepak Chaulagai

Sure. One last to both of you, your fiscal ‘13 guidance suggest on the top right about 7% to 10% growth from where we are modeling 2012. And on adjusted EBITDA I think about 16% to 30% growth depending on the top line and bottom line of your range. What gives you confidence that you will be able to achieve that and if you could just talk in terms of the segments of growth that you anticipate from healthcare DNA specific products, where should we expect growth to come from

Jeff Surges

So Deepak this is Jeff. Great question. As we’ve stated in Q1 when we gave guidance it was our goal and intent to be able to return to what we’ve done over the last few years, is give guidance on our Q3 earnings call as we released our products and made them, generally available, as we’ve seen our sales pipelines and our sales activity grow and the acceptance of our Honeycomb, our enterprise imaging strategy and the growth of the vendor neutral archive. We continue to have great visibility there, number one.

Number two to talk about MU 2 it’s a sweet mere, many of our hospital clients are still capital constrained and they’re asking for the operating model that gives us not only encouragement. But it gives us strength that we get follow suite with what eClinical did and stay very strong and focused on the subscription model. And I also think as we look at our partners, whether that’s Cerner EMC and Merge solutions are in over 70 epic hospitals, we continue to see an appetite for our solutions. Within the larger enterprise. But having to be priced in a subscription arrangement that’s flexible for the buyer because of the large investment they’ve made at their more enterprise. Well – core clinical systems.

So again, I think it’s our goal having run successful ASP or SaaS businesses in the past to follow suit here with the clinical and what we’ve seen in Honeycomb and OrthoPACS and finish the other releases to get us to that point. So I was excited by our process the data and the receptivity of our clients and partners to be able to have a confident view and in return to providing that information.

Deepak Chaulagai

That’s helpful, I guess one quick follow-up in terms of sequential growth, you will expect in fiscal ‘13. Do you expect sequential growth or is it back-end loaded or how should we forecast that?

Jeff Surges

Yeah, again I still know we’re in a healthcare IT environment, which as you know Q4 – Q2 and Q4 is your stronger quarters based on our buyers’ fiscal years. Q1 and Q3 are quarters where you’re executing and you have a more narrow range. So I think we will continue to see growth quarter-over-quarter and as we look to subscription it becomes less hockey stick and more predictable over time.

Deepak Chaulagai

Great. Thank you.

Jeff Surges

Next question, operator.

Operator

Thank you for that gentleman. Chad Bennett, please go ahead with your question.

Chad Bennett – Craig-Hallum Capital

Hey, guys. Good morning.

Jeff Surges

(Inaudible).

Chad Bennett – Craig-Hallum Capital

I guess kind of tackling this whole subscription revenue stuff on the Merge Healthcare business, is there any way to quantify the deals you did in the quarter, maybe on a dollar basis, what – how many – what percentage were subscription versus what were kind of perpetual license or is there anywhere to – any way to maybe look at this metric differently?

Steve Oreskovich

Chad, this is Steve. I would still say that as we’re rolling out of nine to 12-month sales cycle that were in place when we made the announcement back in Q1, we’re still seeing the vast majority of contracts from a dollar perspective being generated under the perpetual license model. That said the dollar – the total gross dollar value associated with subscription in the healthcare business is and continues to grow, but obviously that growth will not reflect itself into revenue until over a much longer period of time than traditionally what you’ve seen being reflected into revenue on the perpetual license model.

Jeff Surges

yeah, Chad, this is Jeff. So when we talk about Honeycomb, one of the ways you would think about that is, that is only offered on the subscription basis and it – and our denominator there is per study. So when you think about 3.65 million studies are contracted for, in the period orthopaedics, which is a smaller file size, but our imaging DICOM file is much larger, we hit a range of between $0.50 to $0.75 per study that will continue to go up because of the mix as we release Honeycomb into our core ambulatory segments. So you take that over 36 months, you’ll start to see that expression.

We recognized 0 revenue from those agreements and now that we’ve got our early adopters and beta clients out of the way, we’ll continue to see an expression. So that’s one way to think about it. As we released OrthoPACS, again another subscription model, and as we go in the RSNA, our largest trade show in our largest segment, remember Merge is the dominant provider in the ambulatory imaging, largest market share, we will be going more aggressive now that we have the product released into the subscription-based environment and allow our clients capital strain to afford them a subscription model. So I think as we go into 2013 looking to breakout and demonstrate that progress, I get the optic that you’re asking about, but again the receptivity of the net clients that we’ve announced in press release to me and our team and our clients and partners remain positive in terms of the direction we’ve gone.

Chad Bennett – Craig-Hallum Capital

Okay. So I know you are not going to answer or you said you weren’t going to answer anything in strategic alternatives. I think I have two questions somewhat related to that, hopefully you can answer. First, did – considering you’ve announced publicly strategic alternatives that you’re looking at that, did that impact your business at anyway or on the negative side, I’d say in the quarter? And then secondly, I don’t think this is anything that – I think that should be something you can answer, how long do you expect to let the process go on?

Jeff Surges

Yes, so having been in this industry a long time, Chad, anytime you make an announcement that your competitors could grab a whole log and extrapolate into their advantage, they most certainly will, so by making a prudent decision internally to announce we did add a few more phone calls and a few more visits to our clients and to our prospects. As I said internally, I couldn’t be more proud of our quarter in the fact that we did make the announcement, the right thing to do, but we did fuel our competitors and others to ask a few extra questions that we normally wouldn’t have had to answer. So the fact that we were able execute and deliver in what is usually tough Q3 for everybody, to me is a real sign of strength of the commitment we have from the client. So that’s what I would talk about on the first one.

Steve Oreskovich

And what I would add to that Chad is that those that may have rolled over or delayed a bit, we’ve had a great October, in fact probably the best single month of contract bookings perspective in the healthcare side of the business. So I think we’ve seen strong ability of our sales force and strong commitment from our customers to understand what we’re considering and it’s leading to trust and continued confidence from those customers.

Jeff Surges

On your second question, I think the best answer I can give is we’re not commenting on it, it’s the decision of our team here. Since we have something to talk about definitively, we most certainly like.

Chad Bennett – Craig-Hallum Capital

Another one for me Steve, probably for Steve typically fourth quarter is the cash usage quarter I think because of, it’s a large revenue generating quarter and typically back and loaded like everybody else, considering that the interest payment in the quarter and what I think would probably cash usage. What would be a good target for year-end cash.

Steve Oreskovich

I won’t specify in exact number for you Chad, but I’ll just give you some information directionally. One, I think – I spoke on the prepared comments about the change in the accounts payable balance. If you compare that against year-end of last years, it’s down even $2.5 million from that. So I think as you look to Q3, we were timely with our vendors. We want to remain timely with our vendors.

But that being said, we probably have a little flexibility there to manage that number towards the end of the year. Secondly, any given – in any given first month after a quarter-end is when lot of vendor payments tend to come up and true up for lack of a better term. So we are no different than any other company, tend to have that cash balance decrease in that first month and then significantly increase in month 2 and 3. Just as a basis of collections versus payments.

We talked about the fact that our cash balance is actually increased in month one compared to prior quarters where typically, it would be down to the $4 million on average. So I won’t specify a number. I think that should be enough information give you directionally where we think it will come out at year-end.

Chad Bennett – Craig-Hallum Capital

And then last one for me, probably for Justin, looking at your guidance for next year. Should we expect the DNA business from an EBITA standpoint to be positive and I know, I think you said it was at a 7% EBITA margin this quarter, is that due to we grow from there going into next year or any color there would be helpful.

Justin Dearborn

As we will so indicated. Yeah, we expect EBIT margin to appreciate it, we have the cost structure in place the downs that our subscription revenue that first quarter or two. Right, so we had a huge bookings number paid out a lot of commissions recorded expenses. And lot of commissions and the revenue will flow like to see in next few years. So we do expect it to build but obviously deposit subscription revenue is, we’re starting Q4 that are really, really solid base of growth in America.

Steve Oreskovich

Chad, this is Steve. I also coupled with the new offering it is been designed to be much more user friendly from a configuration of the clinical trial perspective. So we would anticipate having to use much less professional services going forward, as Justin did mention one of the other companies in this space. A lot of those companies still have to utilize all of big professional services team to get the trial up and running.

We will not have to so we think that the number of professional services providers or heads that we have today should not have to significantly grow in order for us to meet those increased revenue and booking expectations that we have for 2013. There’s definitely leverage on that will express itself and an increased adjusted EBIT on that as well.

Chad Bennett – Craig-Hallum Capital

So EBITDA margins go up from seven is what you’re saying?

Steve Oreskovich

Correct.

Jeff Surges

Yes.

Chad Bennett – Craig-Hallum Capital

Okay. So it is, if that’s the case, and I think your EBITDA margin range is 22 to 24, which is on a percentage basis maybe on the high end, it’s a little bit better, but relatively in line to where you are at today is Merge Healthcare EBITDA margin coming down next year.

Steve Oreskovich

Yeah, I think what I’d say is wherever to whatever point that DNA is able to grow. Remember, the revenue is not– is expressing itself over a multiple number of years. So as a percentage wise it’s still going to only be in that 15, maybe slightly higher percent as a total of overall revenue in 2013 as well, if I may – Maybe I’ll go on a couple of points. But that you’re not really seeing a significant increase there that’s why you don’t see a significant uptick in the adjusted EBITDA

Chad Bennett – Craig-Hallum Capital

It’s not going to go to 20% to 25% of revenue next year, is what are saying?

Steve Oreskovich

Correct.

Chad Bennett – Craig-Hallum Capital

Yeah, I heard you. Okay, got it. Thanks guys.

Jeff Surges

Thank you. Operator, next call.

Operator

Thank you. Douglas Dieter, go ahead with your question.

Douglas Dieter

Hi, thanks, Jeff. I first questions for you. This quarter you reported 15 iConnect contracts. That’s up from five from the second quarter. First of all, do you think that that trend is likely to continue with signings and can just discuss the license versus subscription based on the 5 in the second quarter versus the 15 in the third quarter?

Jeff Surges

Yeah. Thanks, Doug. So, as we cycle through what is usually a strong Q4 for most companies and we think about the imaging – enterprise imaging strategy, our current clients are starting to accept. Recall that in the year ago we thought about mostly iConnect Access and Share. Those were the lead products in the strategy, right, that gave the viewer that gave the EMR the ability to see an image and that gave the CIO to make images available across its enterprise. That was a little bit of a lighter weight product and then the anchor that is the vendor neutral archive where they’re going to now get rid of all these disparate tax systems from other vendors and consolidating to one.

So the 15 expresses itself now in a more mature away as some that are starting with the lighter Access and Share and then those that are now past Meaningful Use Stage 1 and saying look I got to upgrade my archive, great data out there in terms of the PACS replacement and refresh and that’s expressing itself in the archive.

So I think what we’re seeing is all of the modules within the enterprise imaging strategy are now starting to participate in when we close a deal versus when first introduced iConnect over 2 years ago, it was hey, start with iConnect Access, start with Share and I think Honeycomb allows for that, I think DNA and cloud allows for that, so you’re getting a better cross-sampling and we continue to see that growing overall because of the sheer client base we have and the requirement to get imaging up and at the patient bedside and into the hands of the physician and the referring physicians.

Douglas Dieter

My second question here is for Steve. Regardless of what happens with the Allen & Company process, we are about seven months away from the call, from the bonds being callable. it seems like leverage is likely performer to be around three times. Is it just fair to assume that those bonds will be called and refinanced for much cheaper financing which we should create an equity value?

Jeff Surges

So in my final ramp up, which I’ll say now just because you asked it. I think it’s real important that the cash we have on hand is a real strength for us here Doug and everybody. As Steve mentioned, we’re making a debt payment today and we will still close with close to $30 million of cash on hand. We take into account, we don’t make another payment until May that gives us at least two more quarters of cash collections and putting cash on our books, extrapolate what we did in Q3 and trend that out, you see that as we keep our cash collection updates.

We will be in a very strong position in May when we will have the first opportunity to refinance this debt instrument if we so choose. So very proud of our accounting team, our clients. Again, as you know in healthcare IT of clients pay, they’re usually pretty happy and you’re trending in the right direction. So I think our cash up two years ago was the question and our ability to start as our debt now that we’re starting to see May of 2013, and our balances increased, it’s becoming more of an opportunity for us that we look forward to discussing and evaluating

Douglas Dieter

And the final question, and Deepak touched on it and I just wanted to readdress the question you gave good bottom, below the numbers, below the line numbers in terms of your data behind your estimates for ‘13 from the topline perspective, is there any specific assumptions or data points you can give us, that will allow us to trend or follow whether that 265 to 275 is meetable or beatable.

Jeff Surges

Yeah. So I think this is, there’s two strengths here that I would point out, number one as you recall, a hundred percent of our portfolio will not be subscription or cloud hosted. Our cardiology products which are number one in class, the best products is rated by Class. Our mission critical patient-centered applications that we just won’t put into the cloud, they need to be one of when a patient is on, on the cath lab table in a procedure. You have to have real-time readiness.

So because of that we will always have a flavor of perpetual license, which will always help our in-quarter revenue conversions and because of that market and our partnerships with Cerner’s, every time we talked about a partner like Cerner that’s the cardiology placement and our growth over the last few quarters, as we announced advocating Carolinas all in Cerner’s shops, continue to grow. So in one way that product in that portfolio supports our in-quarter revenue projections and some of our largest clients like Ascension Health continue expand through the consolidation.

There’s winners and losers in that market, as there is consolidation. Based on our client base. We feel we’re within a line with the winners who are buying these out. Secondly, we want to remain consistent and deliver more subscription value in revenue, in the lines that we can’t. So following on Justin’s team and their success. We want to be strong in our ability to adhere to a more disciplined subscription model.

And as you know in any given quarter that presents itself as an opportunity that lab (inaudible) when our whole industry knows the last week of the quarter is the best time to buy, so by providing this guidance and range we’re doing it based on our plans today. We understand that as we did – as we saw in the past, the government may make a ruling that could change, but these assumptions are based on what we see in the pipeline today, the products we offer and the client receptivity and that’s what gives us the strength to discuss it.

Douglas Dieter

Sorry, one last question. You did mention fourth quarter is your strongest quarter, do you expect to beat fourth quarter of ‘11 numbers in this next quarter, year-over-year?

Jeff Surges

Yes. So yes, while we don’t give guidance, we pulled that in Q1, we have always intimated that our covering analysts and I think you’re included in that, you look at the range they trajected for the full year 2012, we continue to say that’s a good proxy and our covering analysts know the company well in that regard, so we continue to kind of use that as the guidepost as to what we’re striving for here. And then again, and as I say, the fourth quarter is seasonally strong, it’s for the industry as long as I’d been in it and I think if you trend out Merge over the last two 2 years that also presents itself with that data.

Douglas Dieter

Thank you.

Jeff Surges

Okay. With that what I’d like to do is wrap things up and thank you all for joining us. I’d like to leave you with four takeaways that I think are very important to note. First, it’s important note we had a solid Q3 in a marketplace where Q3 is often difficult. Second, we saw progress in our adoption of subscription-based pricing models and cloud offerings across the company.

Third, our 2013 guidance reflects our pipeline, the markets we’re in, and our operational readiness for subscription-based models. And last, as we discussed, the cash we have on hand is a real strength for us, as we look forward to the future opportunity, many months from now before that make our next payment and evaluate what our debt instrument options are at that time. So many things to the proud of here and a good path forward as we look towards the future. Thanks for joining us this morning and operator, that will end our call.

Operator

Thank you so much gentlemen. Ladies and gentlemen, that concludes the call, you may disconnect at your convenience. Thank you.

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