Merge Healthcare Incorporated (NASDAQ:MRGE) Q2 2013 Earnings Call August 9, 2013 8:30 AM ET
Justin C. Dearborn - Director, Chief Executive Officer of Merge DNA and President of Merge Healthcare
Steven M. Oreskovich - Chief Financial Officer, Chief Accounting Officer and Treasurer
Good morning, and welcome to Merge Second Quarter 2013 Earnings Call.
Today's call is being hosted by Justin Dearborn, Chief Executive Officer; 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 Merge's CEO, Justin Dearborn.
Justin C. Dearborn
Thank you, operator, and thank you to everyone for joining us this morning. First, let me say that the entire board of Merge is extremely disappointed with the company's results. On behalf of the board, and especially its Chairman and our largest shareholder, we apologize for these results. They are unacceptable and we are working day and night to turn this situation around.
Following the acquisition of AMICAS in April of 2010, our plan was to grow our sales and marketing teams and focus on large enterprise sales or system-wide deals with longer sales cycles and lumpier but large upfront revenue. While we have had some success in the past and expect even more in the future, the market did not develop as fast as we had anticipated and no longer justifies the cost structure that we built. We believe that the large, attractive opportunities still exist in the market, but we need to scale our cost to match their timing. We will continue to focus on per-study pricing arrangements that provide for better predictability and we will deliver additional solutions in hosted environments, creating a healthier business model for Merge and our customers.
As you read this morning, after a thorough analysis, the board accepted Jeff's resignation, even though we know that issues facing the company go well beyond any single individual, even the CEO. We also evaluated where the company stands today, and looking past the current situation, I and the board remain bullish on the company, its products and its people. We are in a center of a growing dynamic industry and are well positioned as a leader in health care imaging technology with a great customer base. Our clinical trials business is growing rapidly, as evidenced by the backlog growth of almost $30 million since our new platform launched 1 short year ago. This group is also an example of how a difficult decision a few years ago is paying off with an industry-changing revenue and product delivery model. We have the ability to continue to innovate and develop new products and reach new markets. We have scaled back the size of our sales and marketing team, reducing our cost by several million dollars a year while still addressing our market opportunities. We successfully refinanced the company's high-yield debt, dramatically lowering our annual cash interest cost. I am fortunate to have the support of the management team as well as our board. Nancy Koenig, who is promoted Chief Operating Officer and elected to the Board of Directors, knows the industry, the company and its products and can help drive the company forward on a more streamlined basis. Michael Ferro, Nancy and I worked together for 15 years in 2 different public companies. We successfully resurrected Merge 5 years ago when it had a few million dollars in the bank, rapidly declining revenues and was on the verge of bankruptcy. We, along with the existing management team, can once again grow Merge, albeit, we are starting from a much, much better position. Additionally, Steve Tolle, a 25-year industry veteran, has been promoted as Chief Product Officer. Over the past year, under Steve's leadership, we have taken important steps forward in aligning our entire solution portfolio and bringing several critical innovations to market. Steve will continue to guide our corporate-wide product strategy and will take on additional responsibility for our marketing and overall strategy for our health care offerings.
Now we'd like to address the trends we saw in Q2 that prompted the reevaluation of our organization and cost structures. Q2 was a challenging quarter not only for Merge, but for many other non-electronic medical record vendors and health care IT. First, across-the-board, and especially among larger hospitals and health systems, we saw temporary spending slowdowns. At the end of Q1, Reuters reported that hospital change was reporting a meager first quarter earnings due in part to low patient volume and a weak U.S. economy operating in less than full employment. This had a ripple effect into Q2, as lagging patient volumes hurt hospital earnings, and many of our largest clients and prospects deferred decision-making processes. This trend was also highlighted in the Wall Street Journal last week with respect to pending -- to the pending acquisition of Health Management Associates by Community Health Systems. When hospital spending pauses, it has an immediate impact on us. Second, the March 1 budget sequester introduced uneasiness, as $11 billion in Medicare cuts or 2% of Medicare provider payments were applied across all of health care starting April 1. This, combined with ongoing uncertainty around the future of health care reform, has had a chilling effect in decision-making amongst our largest clients and prospects. Last, we saw many organizations very focused on and, frankly, distracted by the upcoming transition from ICD-9 to ICD-10. As late as this summer, many believe that the deadlines for converting to ICD-10 would be extended once again. However, as to the June 17 announcement that the deadline for conversion will remain October 1, 2014. Health care organizations are scrambling to ensure readiness for this very substantial transition. This has forced clients and prospects to stall decision and projects not directly related to their transition to ICD-10. Given the trends, which we believe are temporary, we have acted. Our comprehensive program is designed to ensure that Merge is lean, operationally optimized to capitalize on our highest growth areas and strategically positioned for long-term success. We expect these actions will result in a reduction of annualized operating expenditures of approximately $6 million. The vast majority of these reductions came from the sales and sales operation areas. Obviously, while our Q2 results necessitate a leaner organization, aligning our business with future growth opportunities is equally important. We are focused on the markets that represent the most attractive business opportunities, and we are confident that our value proposition remains very strong.
Over the past 2 years, we have talked extensively about the need for interoperability and imaging. We continue to remain confident that this market represents substantial opportunity for Merge and our iConnect solutions. According to industry reports, in 2012, the vendor neutral archive market was estimated to be worth $84 million. This is projected to grow to over $600 million by 2017, with the North American market expected to grow by 33% CAGR between 2011 and 2017. We are confident that the growth potential for imaging and interoperability remain strong, and we believe that Merge is well positioned, thanks to our iConnect product suite, to capitalize on this opportunity. In fact, Frost & Sullivan, a worldwide leader in market research, shows our iConnect enterprise clinical platform as the 2013 recipient of Product Leadership Award for clinical imaging and interoperability. Additionally, IHS, for the second year in a row, named Merge the worldwide leader in vendor-neutral archives. Like last year, more studies have been archived by Merge clients than those of any other solutions provider. In total, Merge clients have stored over 37 million studies, which equates to over 15 billion images. These 2 prestigious awards offer strong validation of our positioning in the imaging and interoperability market. Even in Q2, despite tough market headwinds, our iConnect sales maintained market momentum. We signed 12 contracts for 1 or all 3 components of our iConnect enterprise clinical portfolio. And this was achieved even without some of the much larger opportunities that we alluded to on prior earnings call. Consistent with our strategy around subscription based models, we also saw growth in sales of Merge Honeycomb, our cloud-based archiving solution. This quarter, 10 new clients adopted Merge Honeycomb. To ensure we continue to focus on this market and the opportunities it presents, Kurt Hammond, who has been with Merge and other affiliated companies for over 10 years, has been promoted to President and will be responsible for all go-to-market activities for our imaging and interoperability solutions. Kurt brings 22 years of health care and sales marketing experience. We are also strategically aligning around our strength in the cardiology market. Industry data suggests steady growth in cardiology services in North America through 2017. Consistent with this, we have likewise seen steady growth in both the size and the number of cardiology deals over the past 2 years and believe that this area of our business demanded increased focus and investment. In Q2, we signed 17 contracts for Merge Cardio packs and Merge Hemo products. We believe that we have a substantial opportunity, both with new clients and in our existing client base. In fact, we believe that cardiology represents a $50 million to $75 million worth of opportunity just from our existing customer base over the next few years.
Additionally, as we discussed in the past, our strong relationship with Cerner continues to deliver positive results and great opportunities. For example, in Q2, we closed a 7-figure contract with Cerner in Sydney, Australia. And we expect to see the size, number and value of these joint deals continue to increase. Also recall, like iConnect, we have award-winning products to offer this market. Merge Hemo has been named #1 in KLAS for 2 years running. We have promoted Peter Siavelis, who has been with Merge for 3 years, is a 7-year veteran of Cerner and 16-year veteran of health care IT, to lead our efforts in this market segment. Additionally, working in conjunction with Kurt and Peter, Antonia Wells has taken on the additional responsibility for international go-to-market execution. Antonia has been with Merge for more than 10 years and was instrumental in guiding Merge through a difficult period in 2007 and 2008.
And last, I'd like to discuss our clinical trials group. This group has been operating under the DNA segment. Please recall that around this time last year, we consciously moved this group to almost 100% subscription revenue. This was a big move. The group's string of excellent results have proven that this was the right strategy and structure and gives us hope that similar transformations are possible for many of our other offerings. Our SaaS business model and platform strategy not only created a competitive differentiator, a significant operating leverage, as evidenced by a strong financial performance and momentum, but also facilitated a deeper and more impactful customer relationship. Zaher El-Assi, who has been the General Manager of this group, has been promoted to President of the group in recognition of the group's outstanding performance. Merge eClinical is uniquely positioned at the intersection of life sciences and technology. Our data assets, market leadership and a regulatory environment calling for industry change put us in a position to drive fundamental technology and process change in the industry and, thereby, creating significant value for our customers and for ourselves. In the past years since the launch of our new platform, eClinical OS or ECOS, backlog has grown from $16 million to $45 million and our revenue and margins have expanded as well. We believe we are in the very early stages of what this group can deliver.
Now I'll let Steve Oreskovich provide additional comments on the quarter's financial information.
Steven M. Oreskovich
Thanks, Justin. Specific to Q2, total pro forma revenue was $57.6 million compared to $63.4 million in the prior year. Revenue generated through subscription and other highly predictable sources accounted for 65% of total revenue or $37.6 million compared to $37.3 million in Q2 2012. We again experienced strong growth in subscription backlog of $9.1 million in the quarter to $61.9 million overall, which balance has grown by 82% in the last 12 months. Backlog growth was driven by the clinical trials platform, which comprises 75% of the total at June 30. Further, as previously mentioned, the more recent innovations in the health care group such as Honeycomb and iConnect network are also 100% subscription solutions. Revenue generated through perpetual license agreements, also referred to as non-recurring revenue, contributed the remaining 35% of revenue in the quarter. Overall, market conditions and our continued push upstream in contract values in the health care market has resulted in longer sales lead times than we've previously anticipated. In addition, the larger contracts we have recently signed are structured in a manner that generates revenue over a greater period of time than smaller deals. As a result, non-recurring revenue backlog in the health care segment increased by $1.1 million in the quarter to $24.9 million at June 30, but revenue was down $3.7 million from the prior year. Gross margin on a pro forma basis was 56% in the quarter consistent with the prior quarter and the 57% in Q2 2012. Please recall, the mix of software and hardware sales will continue to fluctuate and may impact our gross margin on a quarterly basis.
Costs associated with sales, R&D and G&A increased to $27.4 million in the quarter compared to $26.6 million in Q2 of 2012. As Justin mentioned, the cost alignment actions we have taken are expected to result in annualized savings of approximately $6 million, primarily in the sales and marketing line. Adjusted EBITDA for the quarter was $8.5 million or 15% compared to $13.6 million or 21% in the prior year. Adjusted net income was $0.01 per share in the quarter compared to $0.02 in Q2 2012. As we discussed on the prior quarter's call, we have excluded the $23.8 million of one-time expenses associated with the extinguishment of the old debt, which is recorded in other expense caption of our income statement from both adjusted EBITDA and adjusted EPS. Cash generated from business operations once again improved in the quarter as $10.6 million of cash was added compared to $10.2 million last year. Overall, our cash balance decreased by $27.7 million in Q2, primarily driven by the use of $20.3 million of cash in the refinancing of our debt; further, another $17 million of cash usage related to interest payments due on our extinguished notes for the majority of the semiannual period, which occurred in Q2, as well as the applicable portion of the quarterly interest payment under the new debt, which is due on the last day of each calendar quarter. Going forward, we expect to make regular quarterly interest and minimum principal payments of $4.5 million. To remind everyone, the refinancing that occurred in the quarter will allow Merge to retain over $14 million of cash annually, starting in the third quarter. Now, I will hand it back to Justin to wrap up.
Justin C. Dearborn
In summary, our Q2 results were clearly not consistent with our expectations and cost structure. We continue to have line of sight to large opportunities on the health care side that represent a good mix of subscription or ratable revenue treatment and traditional perpetual or upfront licensing. We continue to believe that the path to a healthy company and passionate customer advocate is to deliver superb solutions in a hosted SaaS model. It's critical that our shareholders and clients understand that we are still investing in research, development and innovation, as evident with the recent industry awards and high product rankings. None of the cost-focused actions taken have impacted the teams that build, support or service our core growth solutions. While I feel confident about the future, I don't want to downplay the challenges ahead. We're in a very competitive industry. Bouncing back will not be easy and may not happen immediately. I do believe, however, that Merge can do just that and come through this period as a stronger company with a great future and financial results that we can be proud of again. Finally, as you may recall, late last year, we published guidance for 2013. Our disappointing second quarter results have created a hole that will make achieving those numbers extremely difficult. Given that today is my first official day back as CEO, I'm not prepared right now to say whether we can or cannot get there by year-end. I can assure you, however, that our board has not backed off on its expectations for the company beyond 2013, and all of us at Merge will be working hard to match them. We will not be taking calls this quarter, but expect to resume taking calls in coming quarters. Thank you for your continued support.
Okay. Thank you, Justin, and thank you to all of our participants for joining us today. This concludes our call, and you may now disconnect.
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