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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2013

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                    to                  

 

Commission file number 001–33006

MERGE HEALTHCARE INCORPORATED

(Exact name of Registrant as specified in its charter)

 

350 North Orleans Street, 1^st Floor

Chicago, Illinois  60654

 (Address of principal executive offices, including zip code)

(Registrant’s telephone number, including area code) (312) 565-6868

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b–2 of the Exchange Act.

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b–2 of the Act). Yes   o    No  x

The number of shares outstanding of the Registrant’s common stock, par value $0.01 per share, as of October 31, 2013: 94,088,889 

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INDEX

 

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Item 1.

Condensed Consolidated Financial Statements

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 (in thousands, except for share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except for share and per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

(in thousands, except for share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

(1)	Net of restricted cash of $813 and $707 at December 31, 2012 and 2011, respectively.

(2)	Net of restricted cash of $753 and $745 at September 30, 2013 and 2012, respectively.

See accompanying notes to unaudited condensed consolidated financial statements.

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Merge Healthcare Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited and in thousands, except for share and per share data)

(1)	Basis of Presentation and Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) for reporting on Form 10-Q. Accordingly, certain information and notes required by United States of America generally accepted accounting principles (GAAP) for annual financial statements are not included herein. These interim statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2012 of Merge Healthcare Incorporated, a Delaware corporation (Merge Healthcare), and its subsidiaries and affiliates (which we sometimes refer to collectively as Merge, we, us or our).

Principles of Consolidation

Our unaudited condensed consolidated financial statements reflect all adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position and results of operations.  Such adjustments are of a normal recurring nature, unless otherwise noted.  The results of operations in the three and nine month periods ended September 30, 2013 and 2012 are not necessarily indicative of the results to be expected for any future period.

Our unaudited condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We believe that the estimates, judgments and assumptions are reasonable based on information available at the time they are made. Actual results could differ materially from those estimates.  Certain immaterial prior period amounts have been reclassified within the condensed consolidated statement of operations to conform to the current period presentation.

(2)	Other Current Assets and Other Current Liabilities

Other current assets consist primarily of revenue recognized that has not yet been billed to customers and other non-trade receivables, both of which are due within the next twelve months.  The balances are comprised of the following as of the period end indicated:

During the third quarter, we sold the equity investment that was included in other current assets as of December 31, 2012.  See Note 4, Fair Value Measurements for additional discussion of this sale.

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Other current liabilities consist primarily of customer deposits, the current portion of certain acquisition obligations, accrued taxes, leases payable and other non-trade payables, all of which are due within the next twelve months.  The balances are comprised of the following as of the period end indicated:

(3)	Goodwill and Other Intangible Assets

Goodwill

The change in the carrying amount of goodwill in the nine months ended September 30, 2013, is as follows:

 Other Intangible Assets

Our intangible assets subject to amortization are summarized as of September 30, 2013 as follows:

Estimated aggregate amortization expense for our intangible assets, which become fully amortized in 2022, is as follows:

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Amortization expense in the periods indicated is set forth in the following table:

(4)	Fair Value Measurements

Our financial instruments include cash and cash equivalents, accounts receivable, marketable and non‑marketable securities, accounts payable, debt payable, and certain accrued liabilities.  The carrying amounts of our cash and cash equivalents (which are comprised primarily of deposit and overnight sweep accounts), accounts receivable, accounts payable, and certain accrued liabilities approximate fair value due to the short maturity of these instruments.  The carrying amounts of our marketable equity securities were based on the quoted price of the security in an active market.  The estimated fair values of the non-marketable equity securities have been determined from information obtained from independent valuations and management estimates.  The fair value of our Term Loan, which replaced our Notes during the second quarter, was approximately 98.5% of par value as of September 30, 2013, based on quoted prices.  The fair value of our previous Notes was 107.88% of par value as of December 31, 2012.

Current Investment

During the third quarter, we sold an equity security investment for $1,785 that was classified as a Level 1 trading security within other current assets in our condensed consolidated balance sheets.  We recorded a realized gain of $135 within the Other, net line in our statement of operations for the three months ended September 30, 2013.  We recorded an unrealized loss of $366 within the Other, net line in our statement of operations for the nine months ended September 30, 2013.  We recorded an unrealized loss of $76 and an unrealized gain of $982 within the Other, net line in our statements of operations for the three and nine months ended September 30, 2012, respectively.  Previously, we estimated the fair value of this investment on a recurring basis based on the quoted market price of the security.  

Non-Current Investments

At September 30, 2013, we held certain securities in private companies, which are classified within other assets in our condensed consolidated balance sheets.  The investments in equity securities of private companies are classified as Level 3 investments and are reported at cost or equity.  Any loss due to impairment in value is recorded as a realized loss when such loss occurs.  We performed the evaluation of our Level 3 investments as of September 30, 2013, and recorded a realized loss of $12 and $100 for the three and nine months ended September 30, 2013, respectively, based on our proportionate share of the losses from the Level 3 investment that we account for under the equity method of accounting.

During the third quarter, we wrote off an investment in a publicly traded company as the company filed bankruptcy and trading of the stock was halted.  The investment in the publicly traded equity security, over which we do not exert significant influence, was classified as available-for-sale and reported at fair value on a recurring basis using Level 1 inputs.  Unrealized gains and losses were reported within the accumulated other comprehensive income component of shareholders’ equity.  As a result of the bankruptcy filing, we recorded an unrealized loss of $10 within other comprehensive income for the three months ended September 30, 2013 and reclassified $454 from accumulated other comprehensive income into the Other, net line in our statements of operations for the three and nine months ended September 30, 2013, respectively.

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The following table sets forth the change in the fair value of our investments for the periods indicated:

 

		Level 1				Level 2				Level 3				Total
Balance at December 31, 2012		$	56			$	2,016			$	553			$	2,625
Unrealized gain (loss)			19				(441	)			-				(422	)
Realized gain (loss)			135				-				(100	)			35
Level inputs transfer			1,575				(1,575	)			-				-
Sale of investment			(1,785	)			-				-				(1,785	)
Balance at September 30, 2013		$	-			$	-			$	453			$	453

 

Unrealized gains or losses on our available-for-sale (publicly traded) security, as well as foreign currency translation adjustments, are components of accumulated other comprehensive income as set forth in the following table:

(5)	Restructuring

In the nine months ended September 30, 2013, we completed certain restructuring initiatives.  These initiatives included the end of life of a specific, non-core product in one of our solution sets, consolidations of operations surrounding three facilities and the reorganization of our leadership team and sales organization.  As a result, we incurred $3,856 of employee termination and contract exit costs that were recorded in restructuring and other expenses in our statement of operations.

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The following table sets forth the activity in the nine months ended September 30, 2013, related to restructuring activities undertaken in prior periods:

See Note 13, Segment Information for restructuring and other expenses by segment.  

(6)

Debt

On April 23, 2013, we issued a new senior secured credit facility consisting of a six-year term loan (the Term Loan) of $255,000 issued at 99% of the Term Loan amount and a five-year revolving credit facility (the Revolving Credit Facility) of up to $20,000.  As of September 30, 2013, nothing was outstanding under the Revolving Credit Facility.  The Term Loan replaces $252,000 of Senior Secured Notes that bore interest at 11.75% (Notes).    

The Term Loan and Revolving Credit Facility were established pursuant to a Credit Agreement (the Credit Agreement) which contains certain financial covenants, the most notable a debt-to-adjusted-EBITDA ratio.  The trailing twelve month debt-to-adjusted EBITDA ratio as of September 30, 2013 was 5.1:1, which is within compliance of the maximum allowable ratio of 5.5:1 for the current period under the Credit Agreement.  It also contains various other negative covenants, including restrictions on incurring indebtedness, creating liens, mergers, dispositions of property, dividends and stock repurchases, acquisitions and other investments, capital expenditures and entering into new lines of business. The Credit Agreement also contains various affirmative covenants, including covenants relating to the delivery of financial statements and other financial information, maintenance of property, maintenance of insurance, maintenance of books and records and compliance with environmental laws. As of September 30, 2013, we were in compliance with all applicable covenants.

The Credit Agreement provides that borrowings will bear interest at a variable rate which can be, at our option, either (i) a LIBOR borrowing rate for a specified interest period plus an applicable margin or, (ii) an alternative base rate plus an applicable margin, subject to a LIBOR rate floor of 1.25% or a base rate floor of 2.25%, as applicable. The applicable spread for borrowings under the Credit Agreement is 4.75% per annum for LIBOR loans and 3.75% per annum for base rate loans.  Based on an election we made pursuant to the terms of the Credit Agreement with respect to the interest period, through December 31, 2013, borrowings under the Credit Agreement will bear interest at an interest rate of 6.00% per annum.  If an event of default occurs under the Credit Agreement, the applicable interest rate will increase by 2.00% per annum during the continuance of such event of default.  As required by the terms of the Credit Agreement, we entered into a two-year, interest rate cap at 3.00% for 50% of the total amount of Term Loan principal outstanding on October 21, 2013 at a cost of $65.

During 2013, we capitalized $4,588 of debt issuance costs in other assets in our consolidated balance sheet.  In the three months ended September 30, 2013, we made a required principal payment of $638 against the Term Loan as well as an additional voluntary payment of $6,000.

In the three months ended September 30, 2013 and 2012, we recorded $4,149 and $8,094, respectively, of interest expense related to the Term Loan and Notes, including $124 and $520, respectively, of amortization of debt issuance costs and $70 and $171, respectively, of amortization of net debt discount.  In the nine months ended September 30, 2013 and 2012, we recorded $17,303 and $24,217,  respectively, of interest expense related to the Term Loan and Notes, including $901 and $1,512, respectively, of amortization of debt issuance costs and $342 and $498, respectively, of amortization of net debt discount.  In the nine months ended September 30, 2013 we also recorded a charge for $5,235 of unamortized debt issuance costs, $1,724 of unamortized net debt discount and $16,863 of early retirement costs associated with the extinguishment of the Notes in other expense in our consolidated statement of operations.

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(7)	Shareholders’ Equity

In the nine months ended September 30, 2013 and 2012, we issued 40,225 and 1,410,491 shares, respectively, of our common stock (including zero and 53,574 shares subscribed at December 31, 2012 and 2011, respectively) valued at $124 and $5,561 as consideration for insignificant acquisitions.  The value of the shares issued was based on the closing price of our common stock on the date of issuance.

In the three months ended September 30, 2013, we also released from escrow 297,973 shares of our common stock as consideration for an insignificant acquisition as part of a settlement entered into with the seller.  These shares were issued in 2011 at the time of acquisition and were already included in outstanding shares.  Additionally, we cancelled 122,292 shares that were previously included in subscribed common stock.  As a result of the settlement, we recorded a charge of $1,345 within general and administrative expense. 

In the three months ended September 30, 2013, we also issued 400,000 shares of our common stock valued at $885 as consideration in the settlement of a lawsuit that existed at the time of an insignificant acquisition.  The value of the shares issued was based on the closing price of our common stock on the date of issuance, discounted for a trading restriction, and was recorded within general and administrative expense.

(8)	Share-Based Compensation

The following table summarizes share-based compensation expense recognized during the periods indicated:

The expense recorded within the restructuring line relates to the acceleration of certain stock options held by our former CEO.

Stock option activity in the nine months ended September 30, 2013 is set forth in the following table: 

As of September 30, 2013, there was approximately $6,943 of unrecognized compensation cost related to stock options that may be recognized in future periods.

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(9)	Commitments and Contingencies

Litigation

On June 1, 2009, Merge Healthcare was sued in the Milwaukee County Circuit Court, State of Wisconsin, by William C. Mortimore and David M. Noshay with respect to the separation of Mortimore’s and Noshay’s employment and our subsequent refusal to indemnify them with respect to litigation related to their services as officers of Merge.  The plaintiffs allege that we breached their employment agreements, unreasonably refused their requests for indemnification and breached other covenants of good faith and fair dealing.  The plaintiffs seek indemnification and unspecified monetary damages.  On April 6, 2011, the Milwaukee County Circuit Court rendered a decision in which it concluded that Merge and Mortimore had entered into an oral employment contract on or about June 15, 2006, but the Court did not make any decision as to damages, which damages would be addressed in a later phase of the litigation.  On May 9, 2011, Merge appealed the Circuit Court’s decision.  On September 18, 2012, the Appellate Court issued its decision reversing the trial court and determined that Mortimore must arbitrate his disputes with Merge.  On June 18, 2013, Merge and Mortimore participated in a hearing before the arbitrator.  On July 17, 2013, the arbitrator rendered a reasoned award in which he concluded that Merge and Mortimore did not enter into an oral contract.  As a result, the merits of Mortimore's claims and Merge's counterclaims will proceed to arbitration.  We believe it is reasonably possible that we may incur a loss with respect to this matter; however, at this stage of the proceedings, it is not possible for management to reasonably estimate the amount of any potential loss. Discovery in this case is on-going.

In January and February 2010, purported stockholder class action complaints were filed in the Superior Court of Suffolk County, Massachusetts in connection with AMICAS Inc.’s (AMICAS) proposed acquisition by a third party.  In March 2010, because AMICAS had terminated the merger agreement with that third party and agreed to be acquired by Merge, the Court dismissed the plaintiffs’ claims as moot.  Subsequently, plaintiffs’ counsel filed an application for approximately $5,000 of attorneys’ fees.  AMICAS opposed the fee petition, tendered the defense to its insurers that provided coverage against such claims and retained litigation counsel to defend the matter.  On December 4, 2010, the Massachusetts court awarded plaintiffs approximately $3,200 in attorneys’ fees and costs.  AMICAS appealed this judgment to the Massachusetts Court of Appeals.  After receipt of the Massachusetts court’s attorneys’ fee award decision, AMICAS’s insurer denied policy coverage for approximately $2,500 of the fee award and filed a declaratory judgment action to that effect against AMICAS and Merge in Federal court for the Northern District of Illinois. We contested the insurer’s denial of coverage, asserted our rights under the applicable insurance policies and filed a counterclaim against the insurer seeking full payment of the Massachusetts court’s fee award, plus additional damages.  On April 30, 2012, the Illinois Federal court ruled in favor of our motion for summary judgment, which decision was appealed by the insurer to the United States Seventh Circuit Court of Appeals.  In late February 2013, the insurer settled the Massachusetts court case by agreeing to pay $2,990 to plaintiffs’ counsel and further agreeing not to pursue AMICAS or Merge for any portion of the amount paid.  As a result of the Massachusetts settlement, we recognized a gain of $2,500 within general and administrative expense in our statement of operations with respect to these matters in the first quarter of 2013 based on the February 27, 2013 Massachusetts appellate court dismissal date.  On July 16, 2013, the Seventh Circuit Court of Appeals affirmed the Federal District court’s decision in all respects and entered Final Judgment.

In August 2010, Merge Healthcare was sued in the Northern District of Texas by the Court-appointed receiver for Stanford International Bank, Ltd.  The receiver alleges that Merge was a recipient of a fraudulent conveyance as a result of a Ponzi scheme orchestrated by Robert Stanford and Stanford International Bank, Ltd. (SIBL).  Merge is not alleged to have participated in the Ponzi scheme.  The receiver’s claims arise from the failed acquisition of Emageon, Inc. (Emageon) by Health Systems Solutions, Inc. (HSS), an affiliate of SIBL, in February 2009, which resulted in the payment of a $9,000 break-up fee by HSS, which payment is alleged to have been financed by SIBL.  Merge subsequently acquired Emageon as part of our AMICAS acquisition.  The complaint seeks to recover the $9,000 payment to Emageon, plus interest, costs, and attorneys’ fees.  We have retained litigation counsel and intend to vigorously defend this action.  We have filed a motion to dismiss the complaint.  That motion has been fully briefed, and we are awaiting a decision from the Court.  We believe it is reasonably possible that we may incur a loss with respect to this matter.  The potential loss may lie in a range from zero to the full amount claimed, plus interest.

In September 2012, Merge Healthcare was sued in the Middle District of North Carolina by Heart Imaging Technologies, LLC (HIT).  HIT alleges that certain features of products within our Image Interoperability Platform that collectively are expected to represent less than 5% of our net sales during 2013 infringe three of HIT’s patents related to internet-based image viewing.  The complaint seeks equitable relief and damages for patent infringement.  We have retained litigation counsel and are vigorously defending this action.  On July 16, 2013, the court held a hearing on a Motion for a Preliminary Injunction filed by HIT.    On August 14, 2013, the court issued an Order in favor of Merge Healthcare by denying HIT’s Motion for Preliminary Injunction. The case is scheduled for trial in July 2014. Discovery is on-going.  We believe it is reasonably possible that we may incur a loss with respect to this matter; however, at this stage of the proceedings, it is not possible for management to reasonably estimate the amount of any potential loss.

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In addition to the matters discussed above, we are involved in various legal matters that are in the process of litigation or settled in the ordinary course of business.  Although the final results of all such matters and claims cannot be predicted with certainty, we believe that the ultimate resolution of all such matters and claims will not have a material adverse effect on Merge’s financial condition.  Professional legal fees are expensed when incurred. We accrue for contingent losses when such losses are probable and reasonably estimable. In the event that estimates or assumptions prove to differ from actual results, adjustments are made in subsequent periods to reflect more current information. Should we fail to prevail in any legal matter or should several legal matters be resolved against us in the same reporting period, such matters could have a material adverse effect on our operating results and cash flows for that particular period.

(10)	Transactions with Related Party

Merrick Ventures, LLC (Merrick Ventures) and Merrick Venture Management Holdings, LLC (Merrick Holdings), beneficially own, as of September 30, 2013, approximately 28% of our outstanding common stock.  Michael W. Ferro, Jr.and trusts for the benefit of Mr. Ferro’s family members beneficially own a majority of the equity interests in Merrick Holdings. On August 26, 2013, Mr. Ferro resigned as Chairman of the Board and as a director of Merge.  Mr. Ferro’s resignation was not due to any disagreement between Mr. Ferro and Merge on any matter.  Mr. Ferro serves as the chairman and chief executive officer of each of Merrick Holdings and of Merrick Ventures. Accordingly, Mr. Ferro indirectly controls all of the shares of Common Stock owned by Merrick Holdings and Merrick Ventures.

Effective January 1, 2009, we entered into a consulting agreement with Merrick RIS, LLC, an affiliate of Merrick Holdings and Merrick Ventures, which was subsequently amended in 2010. Services provided by Merrick RIS, LLC under the consulting agreement include financial analysis and strategic planning. In 2012 we entered into a second amendment to extend the term of the consulting agreement with Merrick RIS, LLC through December 31, 2013, and modified the fee structure to include a quarterly retainer in the amount of $150 in addition to a per transaction fee of $250 for acquisitions by Merge. Further, the second amendment modifies the success payment in the event of a sale of Merge, by including a payment of two percent (2%) of the total consideration received if the total consideration is greater than $1 billion as well as a one percent (1%) success fee if the total consideration received is less than $1 billion. We paid $177 and $167 to Merrick for such services and recognized $150 and $200 in acquisition related and general and administrative expenses in the three months ended September 30, 2013 and 2012, respectively.  We paid $327 and $876 to Merrick for such services and recognized $477 and $794 in acquisition related and general and administrative expenses in the nine months ended September 30, 2013 and 2012, respectively.  As of September 30, 2013 and 2012, we had $150 and $50, respectively, recorded in accounts payable covering obligations under this agreement.  

In April 2010 and June 2011, Merrick RIS, LLC purchased an aggregate of $10,000 in principal amount of our Notes at the same purchase price as the other investors in the transactions. In April 2013, we commenced a cash tender offer for any and all of the Notes, and Merrick RIS, LLC, or an affiliate thereof, tendered $10,000 of its Notes. We purchased the Notes from Merrick RIS, LLC, or an affiliate thereof, for a total price of $10,670, which is based on the same consideration calculation as provided to other investors that tendered Notes.

Merrick Ventures owns 39% of the outstanding equity interest of an entity called higi llc (higi).  Mr. Ferro is higi’s Chairperson and Founder.  In December 2011, we entered into a master services agreement with higi, pursuant to which we agreed to provide higi with certain professional services, including software engineering design, application and web portal development.  Revenue of $14 and $155 was recognized under this Agreement in the nine months ended September 30, 2013 and 2012, respectively.  In addition, the agreement granted higi certain branding rights related to our health station business and requires higi to pay to us a fixed annual fee of one hundred dollars per station for each station that is branded with higi’s trademark and that includes higi’s user interface.  On March 28, 2012, we entered into an agreement to sell higi health stations and related equipment for $2,750.  Revenue of zero and $2,750 was recognized related to this Agreement in the three and nine months ended September 30, 2012.  

On September 8, 2010, we entered into an assignment agreement with Merrick Ventures under which Merrick Ventures assigned to us its sublease with Aon Corporation for approximately 11,934 square feet located on the 20th floor of 200 East Randolph Street, in Chicago Illinois, at an annual base rental rate of approximately $19.4 per month from August 1, 2011 to July 31, 2012, $19.9 per month from August 1, 2012 to July 31, 2013 and $20.4 per month from August 1, 2013 to December 9, 2013, when the sublease expires. The rent will be paid to the sub–landlord monthly and is the same rate as Merrick Ventures paid under the sublease.

On February 24, 2012, we entered into an agreement with Merrick Ventures under which Merge will sublease from Merrick approximately 4,700 square feet located at 200 E. Randolph Street, 22nd floor, Chicago, IL at an annual rental of $80, terminating on December 13, 2013.  The rent will be paid to Merrick monthly and is exactly the same rate as Merrick currently pays under its lease.  Under the Assignment, Merge paid approximately $74 (which represents the book value) for all fixtures, leasehold improvements and furniture located in the space.

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(11)	Income Taxes

We are subject to tax in multiple jurisdictions and record income tax expense on an interim basis using an estimated annual effective tax rate.  The estimated annual effective tax rate is modified to exclude the effect of losses for those jurisdictions where the tax benefit cannot be recognized and a separate estimated annual tax rate is required.  Items discrete to a specific quarter are reflected in tax expense for that period.  A valuation allowance is established when necessary to reduce deferred tax assets to the amount more likely than not to be realized.  Further limitations may apply to deferred tax assets if certain ownership changes occur.  There was no material change in unrecognized tax benefits in the nine months ended September 30, 2013.  We do not expect a significant change in unrecognized tax benefits within the next twelve months.

(12)	Earnings Per Share Available to Common Shareholders

Basic and diluted net earnings or loss per share are computed by dividing earnings or loss available to common shareholders by the weighted average number of shares of common stock outstanding.  The computation of earnings or loss available to common shareholders is presented in our condensed consolidated statements of operations.  Diluted earnings per share includes the dilution that could occur based on outstanding restricted stock awards and the potential exercise of stock options, except for stock options with an exercise price of more than the average market price of our common stock, as such exercise would be anti-dilutive.

In the three months ended September 30, 2013 and 2012, options to purchase 3,412,352 and 4,992,671 shares of our common stock, respectively, had exercise prices greater than the average market price of our common stock during such respective periods, and, therefore, are not considered in the above calculations of diluted net loss per share.  In the nine months ended September 30, 2013 and 2012, options to purchase 4,902,352 and 4,632,431 shares of our common stock, respectively, had exercise prices greater than the average market price of our common stock during such respective periods, and, therefore, are not considered in the above calculations of diluted net loss per share.  

As a result of the losses in the three months ended September 30, 2013 and 2012, incremental shares from the assumed exercise of employee stock options totaling 6,522,188 and 7,418,750 shares, respectively, have been excluded from the calculation of diluted loss per share as their inclusion would have been anti-dilutive. As a result of the losses in the nine months ended September 30, 2013 and 2012, incremental shares from the assumed exercise of employee stock options totaling 5,032,188 and 7,778,990 shares, respectively, have been excluded from the calculation of diluted loss per share as their inclusion would have been anti-dilutive.    

(13)	Segment Information

We evaluate the performance of these operating groups based on their respective revenues and operating income, which exclude public company costs, certain corporate costs (amortization expense that is not specific to a segment), net interest expense and income taxes.

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The following tables present operating group financial information for the periods indicated:

 

 

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(14)	Recent Accounting Pronouncements

In February 2013, the FASB issued Accounting Standards Update No. 2013-02 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income” (ASU 2013-02), which is included in ASC Topic 220 (Comprehensive Income). The objective of ASU 2013-02 is to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments are effective prospectively for reporting periods beginning after December 15, 2012. The Company has implemented this amendment and has included the required disclosure in the Notes to Condensed Consolidated Financial Statements.

In July 2013, the FASB issued Accounting Standards Update No. 2013-11 “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (ASU 2013-11), which is included in ASC Topic 740 (Income Taxes). ASU 2013-11 requires an entity to net its liability for unrecognized tax positions against a net operating loss carryforward, a similar tax loss or a tax credit carryforward when settlement in this manner is available under the tax law. The provisions of this new guidance are effective for reporting periods beginning after December 15, 2013. We are currently evaluating the impact of the new guidance on our financial statements.

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Note Regarding Forward-Looking Statements

The discussion below contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act, and Section 21E of the Exchange Act.  We have used words such as “believes,” “intends,” “anticipates,” “expects” and similar expressions to identify forward-looking statements.  These statements are based on information currently available to us and are subject to a number of risks and uncertainties that may cause our actual results of operations, financial condition, cash flows, performance, business prospects and opportunities and the timing of certain events to differ materially from those expressed in, or implied by, these statements.  These risks, uncertainties and other factors include, without limitation, those matters discussed in Item 1A of Part I of our Annual Report on Form 10‑K for the year ended December 31, 2012 and in Item 1A of Part II of our Quarterly Report on Form 10-K for the quarter ended June 30, 2013.  Except as expressly required by the federal securities laws, we undertake no obligation to update such factors or to publicly announce the results of any of the forward-looking statements contained herein to reflect future events, developments, or changed circumstances, or for any other reason.  The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing in our Annual Report on Form 10-K and Item 1A, “Risk Factors” for the year ended December 31, 2012.

Management’s Discussion and Analysis is presented in the following order:

Overview

We develop software solutions that facilitate the sharing of images to create a more effective and efficient electronic healthcare experience for patients and physicians.  Our solutions are designed to help solve some of the most difficult challenges in health information exchange today, such as the incorporation of medical images and diagnostic information into broader healthcare IT applications, the interoperability of proprietary software solutions, the profitability of outpatient imaging practices and the ability to improve the efficiency and cost effectiveness of our customers’ businesses.  Our ability to innovate has driven consistent expansion of solutions and services and entry into new markets.

Our solutions optimize processes for healthcare providers ranging in size from single provider practices to large health systems, to the sponsors of clinical trials and medical device manufacturers.  These solutions are licensed by more than 1,500 hospitals, 6,000 clinics and labs, 250 medical device manufacturers and by top pharmaceutical companies world-wide. We believe that we have an opportunity to grow revenue by expanding our solution footprint with existing customers, as only a small percent currently have more than one of our enterprise solutions.  

We have two operating groups which constitute reportable operating segments.  Merge Healthcare, which represents about 82% of our 2013 total revenues, markets, sells and implements interoperability, imaging and clinical solutions to healthcare providers.  Merge DNA (Data and Analytics), representing 18% of our revenues, focuses on the emergence of consumerism in healthcare, including health stations, clinical trials software and other consumer-focused solutions.  

Merge Healthcare primarily generates revenue from the sale of software (including upgrades), hardware, professional services, maintenance and electronic data interchange (EDI) services.  The majority of total revenue continues to be generated through perpetual license agreements with our customers.  Merge DNA derives the vast majority of its revenue from software, professional services and hosting through subscription arrangements. Under perpetual license agreements, the software, hardware and professional services are considered to be sources of non-recurring revenue and related backlog.  The backlog of non-recurring revenue was $22.3 million and $31.1 million as of September 30, 2013 and 2012, respectively.  Subscription-based pricing arrangements include contract elements that are payable by our customers over a number of years.  Generally, these contracts will include a minimum image volume and/or dollar commitment.  As such, revenue from these transactions is recognized ratably over an extended period of time.  Subscription arrangements are contracts structured with monthly payments (including leases), clinical trials or renewable annual software contracts (with very high renewal rates).  As of September 30, 2013 subscription revenue backlog was $69.5 million, compared to $40.3 million at September 30, 2012.  This significant increase is the result of our strategic plan to continue to move to a subscription model.  Due to the variability in timing and length of maintenance renewals, we do not track backlog for maintenance and EDI.

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In the second quarter of 2013, we entered into a new senior secured credit facility consisting of a six-year term loan (the Term Loan) of $255 million issued at 99% of the Term Loan amount and a five-year revolving credit facility (the Revolving Credit Facility) of up to $20 million as contracted in a Credit Agreement.  While the borrowings under the Credit Agreement are variable, we made an election pursuant to the Credit Agreement with respect to the interest period pursuant to which the Term Loan will bear interest at a fixed rate of 6.00% for the remainder of 2013.  As part of this transaction, we incurred $4.7 million of debt issuance related costs, which will be amortized over the life of the Term Loan.  The Term Loan replaces $252 million of Senior Secured Notes that bore interest at 11.75% (Notes), which we retired at the same time the Term Loan was issued.  We recorded charges for $5.2 million of unamortized debt issuance costs, $1.7 million of unamortized net debt discount and $16.9 million of early retirement costs associated with the extinguishment of the Notes.

We believe that certain macro events that occurred earlier in 2013 continue to impact our operating results (together with those of others in our industry), primarily:

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We believe that among larger hospitals and health systems, infrastructure spending was adversely affected by lower patient volume that started to appear in the first quarter and that carried through to the third quarter.  Accordingly, we believe that some of our largest clients and prospects decided to decelerate their infrastructure spending processes by pushing decisions into the future.

·	The March 1, 2013 budget sequester included $11 billion in Medicare cuts, or 2%, that were applied across all of healthcare.

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We believe that many large organizations changed focus to the upcoming transition from ICD-9 to ICD-10 as an industry-wide belief that the deadlines for converting to ICD-10 would be extended was dispelled when it was announced on June 17, 2013 that the deadline for conversion would remain Oct. 1, 2014.  This caused many clients and prospects to temporarily delay decisions on any projects not directly related to their transition to ICD-10.

While we continue to see an increase in the overall average selling price of our primary offerings in 2013, these events have continued to result in delays in the timing of larger deals as well as a change in the construct of the agreements that leads to revenue being recognized over an extended period of time.  To ensure we maintain a continued, disciplined approach of cost alignment to sales expectations, we reorganized our leadership team and sales organization to focus on the imaging & interoperability, cardiology and clinical trials markets in the third quarter.  We incurred a restructuring charge of $1.2 million and anticipate a minimum of $5 million of annualized savings from these actions, primarily in sales & marketing expenses, as we had previously built up the team in anticipation of better market conditions.  Since we believe that strong market opportunities still exist over the long-term for our products and the solutions we have innovated, these actions do not impact our product research and development costs as we have decided to continue to enhance and further our market-leading solutions as validated by sources such as KLAS, and other independent sources.  These most recently include a Product Leadership Award from Frost & Sullivan for iConnect® Enterprise Clinical Platform and, for the second straight year, the global leader in VNA according to IHS.

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Business Segments

The following tables provide operating group information for our two reportable operating segments, Merge Healthcare and Merge DNA, for the periods indicated, based on GAAP reported information (all amounts are in thousands, except percentage

 

 

These results exclude costs such as public company costs, certain corporate costs (amortization expense that is not specific to a segment), net interest expense and income taxes.

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The following tables provide GAAP sales generated by non-recurring, subscription and maintenance and EDI revenue sources by segment for the periods indicated and non-recurring and subscription backlog as of September 30, 2013 and 2012, respectively (all amounts are in thousands, except percentages):