MRGE Still In Transition; Fundamentals Or Acquisition Point To Higher Valuation

Merge Healthcare (NASDAQ:MRGE) reported adjusted 3Q 2012 revenues and EPS of $61.0 million and $0.01, compared to Wall St. Consensus expectations of $62.9 million and $0.02, respectively. EBITDA for the period came in at $12.5 million vs. the $12.8 million average estimate. The quarterly miss is a modest negative, however investors are likely to look through the softer-than-expected earnings results as the company continues to a work through its transition to a new revenue booking model. Importantly, 2013 guidance was in-line with expectations, and according to one analyst who rates the stock at Neutral, the 3Q results were seen as “uneventful”. Management noted on its earnings call that new 100% subscription-based products are launching very well, but have yet to contribute to quarterly revenues due to an anticipated delay in the ability to book those revenues. Examples of this include the Merge Honeycomb and OrthPacs product lines, which are gaining strong traction in the market. The company has already seen a strong start in 4Q, with management stating that it had a “great October”, and upcoming radiology conferences offer MRGE the chance to accelerate new contract signings in the near term.

Valuation remains attractive. Meanwhile, MRGE’s low valuation relative to other companies in the sector should also minimize any impact on the stock post earnings. Management would not comment on its ongoing engagement with Allen & Co. to explore strategic alternatives, however, this process could result in an offer for MRGE at a significantly higher valuation. At current levels, MRGE trades at an EV/2012E sales ratio (enterprise value to estimated 2012 sales) of about 2.1x and roughly 1.9x 2013 sales estimates, while most of the healthcare IT world trades in the 2.5-3.5x range on 2012 revenue estimates. Assuming MRGE can trade in the middle of healthcare IT valuation range (an EV/sales ratio of 3.0x) on 2013 revenue estimates (consensus is ~$270M), this would value the company at $8.80. In other words, as the business stabilizes on the new strategy, MRGE shares could naturally trade higher unless an acquirer steps in first to take advantage of the current valuation discount.

2013 guidance In-line with expectations. Recall that the key reason MRGE fell from its highs earlier this year was because 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 (see PropThink's prior report). This accounting change led to a transition period in which there is a lag in financials while the new revenue booking strategy catches up. 3Q 2012 represents the 3rd quarter in the cycle, and by early 2013, the company should be past the transition and growing on a more consistent basis. In fact, in its earnings release, the company issued 2013 revenue guidance in the range of $265 million to $275 million with an adjusted EBITDA margin ranging between 22%-24%. The revenue guidance is essentially in-line with the Consensus forecast for 2013 of $271.6 million, and implies top-line growth of approximately 10% off of the current sales run-rate. If one takes the midpoint of the revenue guidance and applies the midpoint of the anticipated EBITDA margin for next year, the company’s guidance is also in-line with Consensus EBITDA expectations of approximately $62.4 million for 2013.

2013 EBITDA growth looks strong, an incentive for acquirers to step up now. Note that MRGE delivered an EBITDA margin of about 20.6% in 3Q, and the expected improvement in operating leverage next year (EBITDA margin guidance above) implies approximately 22% EBITDA growth next year. Management noted strong cash flow in 3Q, and the company continues to pay down debt. The ability to re-finance remaining debt next year at lower rates is also expected to improve equity value. Despite EBITDA guidance that is simply “in-line” with expectations, we think that the company is executing well, and these impressive metrics could be attractive to private equity buyers that want to take advantage of MRGE’s growing cash flow stream. Should MRGE weaken today on the earnings shortfall, we see this as a buying opportunity.