Merge Healthcare (NASDAQ:MRGE) fell hard earlier this year when the company announced changes to its business model. In particular, the company moved to offer subscription-based pricing for its healthcare IT software solutions, rather than booking the majority of its revenue in larger blocks as up-front licensing fees. The problem for MRGE shares was that investors saw a major revenue lag about to occur for this health IT vendor as it converted to this new strategy, with an expected drag on financials for the second half of 2012. As a result, the stock plummeted from around $6.50 at the end of March to roughly $2.25 in mid-June. According to company management, MRGE made the change to subscription-based pricing to “align more closely with our clients’ long-term operating plans.” The company also stated that the new model offered flexibility that its clients needed, and would ensure MRGE’s ability to continue to gain share in the healthcare IT software market. In an update provided by the company in August, management said, “Since that time, we have seen acceleration in clients’ eagerness to adopt this type of purchasing model.” The company has begun executing again, posting 2Q revenue growth of 13%, but because shares of MRGE remain substantially undervalued, management announced on September 6^th, that it hired an advisor to explore strategic alternatives for the company. While we believe that the market is mis-pricing the shares and that fundamentals could lift the stock back to levels seen earlier this year, MRGE may now be up for sale and the company has potential to be taken out at an even higher level, perhaps double its current valuation or more. Importantly, recent news reports suggest bids are coming to the table from private equity firms.

Who is Merge Healthcare?

The company develops software to facilitate the sharing and processing of medical images (MRI, X-Ray, etc.) in the healthcare setting. Incorporating medical images into IT applications poses challenges to most medical institutions, such as hospitals and physician clinics, and MRGE’s software improves efficiency of the information exchange. This applies to both small physician groups and broader healthcare systems. The company has a wide variety of products that integrate information in segments like radiology and cardiology, and is beginning to implement cloud computing. A full suite of MRGE’s software is even used in the clinical research setting. Most importantly, the company’s software improves the cost-effectiveness and efficiency of the information exchange within the overall healthcare system. In the U.S., emphasis in recent years has been on digitizing healthcare information to facilitate communication between providers, and the business has become a lucrative market for those who can properly implement such solutions. The government has offered incentives to drive this trend; Providers that utilize electronic medical record technology, like MRGE’s, are eligible for substantial government grants under the 2009 stimulus package.

Here’s why MRGE shares traded off earlier this year

While the company reported year over year revenue growth in 2012’s first quarter, sales had fallen from 4Q 2011, souring analysts and investors. Additionally, management lowered earlier 2012 revenue guidance, confirming that the strategic change would render this year a “transitional” period. Shares dropped by nearly two-thirds of their peak valuation this year on the news.

Notably, the subscription-based model spreads revenue out and disproportionately affects current-year financials until sales catch up to the prior base of would-be, up-front license fee revenues. In fact, longer-term profit usually outweighs the sum of license and maintenance fees that would otherwise be recognized over the same time period. The transition is already creating a growing backlog of subscription revenue; $25M, $30M, and $34M in 4Q 2011, 1Q 2012, and 2Q 2012, respectively. MRGE expects strong revenue growth on a long-term basis because most of its clients currently license just one or two of its product offerings. Under the new business model, the company expects that it can now sell a range of products to its existing clients – more than 1500 hospitals nationwide – while gaining additional share by expanding its customer base.

Eclipsys highlights the potential for MRGE’s business and stock price turnaround

Evidence that MRGE’s change in revenue recognition can be a long-term win was exemplified by Eclipsys, which ultimately was acquired by Allscripts Healthcare Solutions (NASDAQ:MDRX). In 2002, Eclipsys announced that it was shifting from a license fee revenue model to a subscription-based sales approach, similar to what MRGE is currently doing. Eclipsys shares fell from roughly $19 in the spring of 2002 to a low of $4 in October as quarterly reports disappointed investors, hence the aversion to MRGE today. However, the following October, Eclipsys shares had rebounded to more than $19 after investors re-calibrated longer-term sales and growth, and also recognized the benefits of more predictable earnings. When Eclipsys finally merged with MDRX in 2010, the deal valued Eclipsys at $1.3 billion. We believe that MRGE will follow a similar path, with growth improvements in late 2012 and into 2013 driving the stock substantially higher than today’s levels. Shares of MRGE are starting to respond to the news that the company is exploring strategic alternatives as investors may be realizing that the stock is on sale.

MRGE is cheap, with potential to more than double in price

At current levels, MRGE trades at an EV/2012E sales ratio (enterprise value to estimated 2012 sales) of about 2.3x and roughly 2.1x 2013 sales estimates. Most of the healthcare IT world trades in the 2.5 – 3.5x range on 2012 revenue estimates, with market leader Cerner Corp. (NASDAQ:CERN) at nearly 4.5x, and momentum-driven athenahealth (NASDAQ:ATHN) at about 7.2x. MedAssets (NASDAQ:MDAS), an industry rival with a greater debt-load than MRGE, trades at about 3.2x 2012 estimated revenues, while the un-loved MDRX remains the laggard of the sector, at just 1.5x due to slow growth and difficulties competing in certain product lines. Assuming MRGE can trade in the middle of this valuation range (an EV/sales ratio of 3.0x) on 2013 revenue estimates (consensus is $271.34M), the company would be valued at $8.84.

MRGE’s choice of advisor raises confidence in an M&A deal

On September 6^th, MRGE announced that its Board of Directors had retained Allen & Co. to help evaluate strategic alternatives, including the potential sale or merger of the company. MRGE issued no timelines or further details, but it should be noted that Allen & Co, a New York-based investment bank, has proven to be a heavyweight in the business of M&A, with prior advisory work for companies like Google (NASDAQ:GOOG), Coca Cola (NASDAQ:COKE) and LinkedIn (NYSE:LNKD). It is unlikely that a bank with this kind of resume would represent a $350M company unless prospects are looking good. News reports from both Bloomberg and the dealReporter last week suggest that private equity bids are coming to the table.

Recent analyst downgrade helping investors seize an opportunity

After MRGE announced that it hired Allen & Co., the shares enjoyed a modest bounce, but gave back some of those gains on an oddly timed downgrade by Dougherty & Co., whose analyst speculated that a murky earnings outlook today undermines the ability to project a value on the stock. That analyst is essentially a generalist and has a relatively short tenure in the senior analyst role, with only one other pure play health IT stock (HMS Holdings, Inc., or NASDAQ:HMSY) under coverage. As a result, we place little faith in Dougherty & Co’s grasp of either the context of MRGE’s ecosystem, applicable valuation parameters, or investor psychology surrounding healthcare IT.

Regardless of a possible acquisition, MRGE is moving toward unlocking value as its new business model proves itself in terms of market share gains and sustainable revenue growth. Watch for new money coming back into MRGE as the story evolves and the market recognizes that the shares have a long way to rise before reaching fair value.