Description

Thesis:
The recent uncertainty around Merge Technologies’ stock has created an opportunity to invest in a substantially mis-priced, misunderstood security with a clean balance sheet and solid growth opportunities in an under-penetrated market with 50% - 120% upside from current levels.

Business Description:
Merge Technologies engages in the development and delivery of medical imaging and information management software and services. It provides solutions for both the OEM and end-user healthcare markets. The company provides picture archiving and communications systems (PACS), radiology information system (RIS), and clinical medical imaging software applications. It also develops engineered software applications and development tools for the medical imaging OEM and international markets.

The addressable market for Merge’s products is over $5bn representing approximately 8,000 imaging centers and small hospitals, with less than 20% penetration. The ROI for the imaging center or hospital can be 30%+ for the deployment of a PACS system with the bulk of the savings coming from the discontinuation of using film-based systems. With a RIS/PACS system, the patients x-rays, etc. and the storage associated with that is replaced by a computer and high resolution display units.
Imaging Small Mid-Size
Centers Hospitals Hospitals
Number of Opportunities 3,150 2,750 2,154
Average Sale $400k $700k $1mm
Total Opportunity $1.26b $1.93bn $2.15bn


What Changed?
On February 23, 2006, Merge announced that they would have to delay Q4:05 results, and the filing of their 10-K as a result of a change in revenue recognition in their recently acquired Cedara division, a Canadian-based company Merge purchased several months ago. Merge bought Cedara in a stock deal valued at $393 million, and the purchase expanded Merge’s OEM PACS business. As is the case with all software companies (Healthcare IT especially), revenue recognition is incredibly complex given the nature and timing of each contract. Many of Merge’s healthcare IT peers have gone through some form of a revenue restatement (Camtronics when it was part of Analogics, Emageon, etc.)

Rich Linden, old CEO of Merge, said that revenue they originally expected to book in Q4:05 would have to be deferred and recognized in 2006 given a change in how their accounted for certain contracts. He also said that the dollar amount of sales contracts signed during the fourth quarter exceeded that of the third quarter representing sequential growth and strength in the core business. He also noted that he continued to believe that he felt comfortable with the long-term goals for the company - 25% organic revenue growth, 70% gross margins and 30% EBIT margins, the highest in the industry.

This deferral in revenue and subsequent restatements, delay in their SEC filing, concerns over anonymous complaints and a lack of detailed communication from the Company has all conspired to push the stock down over 60% from February and lower than it was than when they acquired Cedara (which boosted revenues and earnings). MRGE is now valued only slightly above what they purchased Cedara for just a few months prior ($393 million).

Comps EMAG, VTAL, and AMCS have all reported weak Q1 numbers due to mix shifts (Q1 usually stronger in hardware at lower margins), and DRA concerns (Deficit Reduction Act) which could slow hospital spending. The latter of these issues has the potential to impact growth rates in this industry in the short term as hospitals pause to consider a reduction in reimbursements for some procedures relative to the cost savings of moving from print film to digital - which is why for our estimates, we have modeled negative growth in 2006, and handicapped growth by 50% for the base case in 2007. Despite the handicapped growth rates, the company still trades at below 10x 2007E GAAP EPS on a cash and NOL-adjusted basis. Additionally, MRGE has more diversified end-markets given its OEM business, and derives 50%+ of its revenues internationally unlike the aforementioned comps all of which are all domestic - giving more stability to their operating model and protection from US reimbursement concerns.

On 5/16/06, MRGE announced that Rich Linden had resigned and provided no reason for his resignation. The only commentary regarding his departure was that we would be informed of the reasons behind his departure when the company files its form 10-K. Along with this announcement, the company told the street that they would have the 10-K filed within a few weeks. Because of this, we can assume that they have finished the audit, and have moved to the drafting process. This is extremely important for if the audit committee were to have discovered any material impropriety in the accounting, they would have had to have disclosed it already.

What Hasn’t Changed:
The company is still the leading provider of RIS/PACS systems to imaging centers and small hospitals (the most under-penetrated of all groups). Before the company was plagued with these revenue recognition issues, they had guided to 2005 revenue of $95 - $98 million, GAAP EPS of $0.80 to $0.85, and cash EPS of $1.60 to $1.70. The company had also noted that the top-line organic growth opportunity in for their business should be around 25%+. The company has continued to execute on its business model as evidenced by a major win at the Mayo Clinic, and most recently, an OEM agreement with Swissray. The only reason why the guidance was changed was because of this revenue recognition restatement, which should actually help to strengthen the company’s position in 2006 as the deferred revenue will be recognized over the following quarters.


What Makes Us Comfortable:
• Balance Sheet: Merge has nearly $2 in cash per share, no debt and a present value of $1.50 per share in NOLs
• Stand-alone Valuation: At current levels, MRGE is trading at 10.4x our base-case 2007E EPS and ~10% free cash flow yield.
• Relative Valuation: Comps (AMCS, VTAL and EMAG) trade at 34.2x 2007 EPS.
• Even at our base case EPS which assumes half the growth of management’s previous guidance and a multiple that is 40% less than its peers (20x vs. peers at 34x) we achieve a price target of $21 or 68% upside from current levels.


Merge Valuation 2006E 2007E
Stock Price $12.65 $12.65
Net Cash/Share $1.90 $1.90
PV of NOL / Share $1.41 $1.41
Adjusted Stock Price $9.34 $9.34

Base Case GAAP EPS $0.63 $0.89
Bull Case GAAP EPS $0.83 $1.18

Base Effective P/E 14.8x 10.4x
Bull Effective P/E 11.3x 7.9x

Base Target Multiple 25.0x 20.0x
Bull Target Multiple 30.0x 25.0x

Base Implied Value $19.11 $21.19
Bull Implied Value $28.06 $32.81

Base Upside (%) 51% 68%
Bull Upside (%) 122% 159%
2005 Guidance
Revenue $95 - $98mm
Cash EPS $1.60 - $1.70
GAAP EPS $0.80 - $0.85

Comps 2006E 2007E
AMCS 49.3x 35.9x
VTAL 72.0x 46.5x
EMAG 62.3x 20.2x


How do we get Comfortable There is No Fraud?
• Mgmt Commentary on filing timing:
Management’s commentary on 5/16/06 suggests that the company has finished the audit, and is in the process of drafting the document. This would indicate that there was nothing additional found.

• Scott Veech remains the Company’s CFO
If the audit committee had dug up and accounting impropriety, Scott Veech would no longer be the Company’s CFO. The fact that he remains on board give us additional comfort in the fidelity of the accounting and cash flows.

• Recent hiring of Merge President:
Robert White, a 20 year industry veteran and former COO of SourceOne Healthcare (the largest imaging supply company in the country), was recently hired as President of Merge after the delay of earnings announcement – he was given full insights by the audit committee and the board into the accounting struggles of the company and clearly gained comfort with the potential for resolution

• Recent contract win with Mayo Clinic and agreement with Swissray:
Merge recently announced contract wins from respected institutions after the delay was announced – both institutions clearly gained comfort with the ‘going concern’ fear as they entered into strategic relationships to utilize Merge’s products for years to come.

• Conference attendance and User Group Forum:
David Noshay, President of MRGE e-med, and Bill Mortimore, Chairman, attended the annual SCAR convention in Austin, TX last week. This is one of many industry conferences the management has recently attended. In addition management is hosting a User group meeting for over 200 customers next week. The company is still also planning on attending the FBR conference at the end of May.

• Board Authorized Share Buyback:
After the announcement, the Board of Directors increased their share buyback from $10mm to $20mm. They cannot purchase stock until the audit has finished and they are current in their filings.

• Communication:
By law, if the audit committee had dug anything material up in their investigations they would have had to have issued a press release within 4 days of receiving that information.

Hiring a well-respected Industry vet as a President, having a board authorize a doubling of the share buyback program, signing deals from respected institutions, attending industry conferences, and hosting customer forums does not sound like a management team that is in hiding or a company that is going out of business.

Given the strong balance sheet and compelling absolute and relative valuation against an industry backdrop of strong secular growth and the clear misunderstanding of the Company’s accounting review, we believe MRGE is one of the most interesting value opportunities we have seen.

Trading at 9x our conservative forward earnings with the potential for 25%+ earnings growth, no debt and a double digit free cash flow yield we believe MRGE offers 75% - 150% from current levels which should be realized in fairly short order as the Company moves past these recent concerns upon filing of their 10-K and resumes communication with the Street.

Catalyst

Catalysts:
• Resolution of accounting review and Filing of the 10-K
• Potential for further increase in share buyback – up from the current $20m which has been announced, but not executed.
• Short covering – Currently there are 4.6m shares short or 6 days to cover on current average volume
• Management will likely take significant stakes in the company at current levels
• Company road show/ conference attendance
• Continued contract wins
• Potential take-overs – Siemens is in dire need of a new enterprise-wide integrated RIS/PACS solution. Likely candidates include EMAG and MRGE.