(MRGE) Merge Healthcare Grows with Subscription Model

Merge Healthcare (MRGE) recounted a significant addition to its client list with the recent transition of its pricing arrangements to a subscription-based model from the traditional perpetual software license arrangement.  Following this announcement, the company’s share price shot up 7.29% to close at $3.09.

Merge primarily generates revenue from the sale of software (including upgrades), hardware, professional services and maintenance and Electronic Data Interchange (EDI) services. By tradition, majority of the company’s revenues were used to be generated through perpetual license agreements under which the software, hardware and professional services were considered to be sources of non-recurring revenue and related backlog.

The company also generated revenue through subscription-based pricing arrangements in which software, hardware and professional services were payable by customers over a period.

However, of late, the company perceived a change in customers’ buying habits with an increased demand for subscription-based arrangements for huge multi-location groups as well as single doctor practices. Additionally, the interest covered a wide range of the company’s solutions which include Merge RIS, Merge PACS and Merge Eye Care PACS.

As a result, in order to align more closely with its clients’ long-term operating plans, Merge, in the first quarter of 2012, announced a shift in its operations to subscription-based plans. According to this plan, revenue from the transactions will be recognized over an extended period of time. Subscription arrangements contain contracts including leases with monthly payments and long-term clinical trials or renewable annual software contracts with a very high renewal rate.

During the second quarter of 2012, subscription revenue was approximately 15% of total net sales with a subscription revenue backlog of $34.1 million as of June 30, 2012. With the increasing willingness of its clients to adopt this model, the company is optimistic about this arrangement to become more prevalent in the second half of 2012 and beyond.

We are encouraged by the fact that Merge revised its stand to focus on the purchasing requirements of its clients in the face of changing purchase patterns. It is also commendable that despite the general slowdown in hospital spending, low demand for imaging equipment and related technology due to global credit crisis and macroeconomic factors, the company reported balanced segmental revenue growth during the second quarter of 2012.

With the subscription model, the company expects to generate lower revenues in initial phase but the situation is expected to improve over the contract term.

However, the presence of big players like General Electric Co. (GE) and McKesson Corporation (MCK) has made the diagnostic imaging market highly competitive. Currently, Merge retains a short-term Zacks #3 (Hold) Rank. Over the long term, we are Neutral on the stock.

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