UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

☒

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

 

For the quarterly period ended June 30, 2015

 

☐

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 ☒ No ☐

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 ☒ No ☐

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   ☐    No  ☒

The number of shares outstanding of the Registrant’s common stock, par value $0.01 per share, as of July 28, 2015:  98,897,564.

 

---

 

---

INDEX

 

 

---

 

PART I – FINANCIAL INFORMATION

 

Item 1.

Condensed Consolidated Financial Statements

 

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 (in thousands, except for share data)

 

 

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

 

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands)

 

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

(1)	Net of restricted cash of $209 and $392 at December 31, 2014 and 2013, respectively

(2)	Net of restricted cash of $186 and $209 at June 30, 2015 and 2014, respectively

---

 

(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, 2014, of Merge Healthcare Incorporated, a Delaware corporation, and its subsidiaries and affiliates (which may be referred 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 six month periods ended June 30, 2015 and 2014, 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.

 

(2)	Acquisition

 

On February 25, 2015, we acquired 91.5% of the outstanding common shares and voting interest of D.R. Systems, Inc. (“DR Systems”) for cash consideration of $76,514. Cash acquired was $13,455. During the three months ended June 30, 2015, we acquired the remaining outstanding common shares for $7,077, making DR Systems a wholly-owned subsidiary. The results of DR System’s operations have been included in our consolidated financial statements since February 25, 2015. DR Systems is a provider of PACS, RIS and CVIS advanced image processing systems and other medical imaging information system products and services primarily in the United States. We acquired DR Systems to expand our customer base and gain access to its intellectual property and employees.

 

The following table summarizes preliminary estimated fair values of the assets acquired and liabilities assumed at the acquisition date. We are continuing the process of finalizing purchase accounting, including the third-party valuations of certain intangible assets; thus, the provisional measurements below are subject to change.

 

 

---

Acquired intangible assets are subject to a weighted-average useful life as shown in the following table:

As noted above, the fair value of the acquired identifiable intangible assets is provisional pending receipt of the final valuations for these assets.

 

The $55,848 of goodwill was assigned to our Merge Healthcare segment. The goodwill recognized is attributable primarily to expected synergies, the assembled workforce and business activities of DR Systems. None of the goodwill is expected to be deductible for income tax purposes.

 

We recognized $682 of acquisition related costs that were expensed in the six months ended June 30, 2015. These costs are included in the condensed consolidated statements of operations in the line item acquisition-related expenses. From the acquisition date to the period ended June 30, 2015, our condensed consolidated statements of operations include revenues of $12,535 and net income of $899 related to DR Systems. The net income includes $645 of restructuring charges and $1,553 in amortization expense related to the acquired intangible assets.

 

The following represents the pro forma consolidated statements of operations as if DR Systems had been included in our consolidated results for the three and six months ended June 30, 2015 and 2014:

 

Pro forma consolidated statements of operations:

 

These results have been adjusted to reflect the additional amortization that would have been charged assuming the fair value adjustments to intangible assets had been applied on January 1, 2014. The results also include an 8.5% quarterly dividend of $1,063 on the Series A Convertible Preferred Stock (“Preferred Stock”) that we issued to enable us to complete the acquisition as if the issuance had occurred on January 1, 2014. The recognition of a preliminary deferred tax asset valuation reserve release of $18,393, subsequently reduced to $16,555 in the three months ended June 30, 2015, and $4,915 of dividend equivalents related to the Preferred Stock issuance have been shown as January 1, 2014 adjustments to net income (loss) attributable to common shareholders of Merge and have been excluded from the 2015 pro forma results.

 

(3)	Other Current Assets and Other Current Liabilities

 

Other current assets consist primarily of revenue recognized that has not yet been billed to a customer and other receivables, all of which are due within the next twelve months. The balances are comprised of the following as of the dates indicated:

 

 

---

Other current liabilities are comprised of the following as of the dates indicated:

 

(4)	Goodwill and Other Intangible Assets

 

Goodwill

 

Changes in the carrying amount of goodwill for the six months ended June 30, 2015, are as follows:

 

 Other Intangible Assets

 

The following is a summary of intangible assets subject to amortization as of June 30, 2015:

 

Estimated aggregate amortization expense for our intangible assets, which are expected to become fully amortized in 2027, is as follows:

 

In the six months ended June 30, 2015, we increased the gross carrying amount of purchased software and technology, customer relationships, trade names, and non-competes by $27,475, $17,279, $420 and $280, respectively, in conjunction with the acquisition of DR Systems. For the six months ended June 30, 2015, we also added $1,157 in capitalized software.

 

---

Amortization expense is set forth in the following table:

 

 

Our financial instruments are not required to be carried at fair value on a recurring basis. The carrying value of our financial instruments including, 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 their short maturities. Based on borrowing rates currently available to us, with similar terms, the carrying values of our term loan, Series A Convertible Preferred Stock and capital lease obligations approximate their fair values.

 

The carrying value of our long-term debt recognized in the consolidated balance sheets as of June 30, 2015 and December 31, 2014, was approximately $219,362 and $225,426, respectively. See Notes 7 and 8 for further discussions of our term loan and preferred stock.

 

Non-Current Investments

 

At June 30, 2015 and December 31, 2014, we held certain equity securities in private companies, which are classified within other assets in our condensed consolidated balance sheets. The investments in these equity securities are classified as Level 3 investments and are reported at cost or on an equity basis using the equity method of accounting. Any losses due to impairment in value are recorded as realized losses when such losses occur. The carrying value of these Level 3 investments at June 30, 2015 and December 31, 2014, is $453.

 

(6)	Restructuring

 

Subsequent to the acquisition of DR Systems, we completed a restructuring initiative that reduced our workforce by approximately 6% due to the existence of redundant positions. We recorded restructuring charges of $1,178 related to this initiative which consisted solely of employee termination costs. The following table sets forth restructuring activity for the six months ended June 30, 2015:

 

		Employee Termination Costs
Balance at December 31, 2014		$	-
Charged to expense			1,178
Payments			(879	)
Balance at June 30, 2015		$	299

 

See Note 14, Segment Information, for restructuring and other expenses by segment.

 

---

(7)

Debt

 

Term Loan

 

Our Term Loan was established pursuant to a credit agreement (the “Credit Agreement”) on April 29, 2014. The Credit Agreement contains financial covenants consisting of a total leverage and an interest coverage ratio. The total leverage and interest coverage ratios are based on consolidated EBITDA as defined in the Credit Agreement and are not to exceed 6.50:1 or be less than 2.15:1, respectively, as of June 30, 2015. At June 30, 2015, we were in compliance with all applicable operating covenants.

 

Based on an election we made pursuant to the terms of the Credit Agreement with respect to the interest period and optional rate, borrowings under the Credit Agreement bore interest at a rate of 7.00% per annum through June 30, 2015. As of June 30, 2015, borrowings had a weighted average interest rate of 7.00%. Interest is currently payable on the last business day of each month.

 

We are required to make quarterly principal payments totaling $2,938 over the life of the Term Loan. We have made all required quarterly principal payments through June 30, 2015. As of June 30, 2015, the future maturities of principal under the Term Loan for the remainder of 2015 will be $5,875 and for each of the years ending December 31, 2016, 2017, 2018, 2019 are $11,750, respectively, with $170,375 due in 2020.

 

Our prior term loan and revolving credit facility were both terminated on April 29, 2014. During 2014, we made required principal payments of $592 against the prior term loan as well as additional voluntary payments of $8,000.

 

2015 Waiver and First Amendment to Credit Agreement

 

We received a waiver and amended the Credit Agreement (the “First Amendment”) on February 25, 2015, in connection with our acquisition of DR Systems. Our lenders agreed to waive the requirement under the Credit Agreement to make a mandatory prepayment of the term loans to the extent that the excess cash flow for the 2014 excess cash flow period was used for the purchase of DR Systems and for related fees, costs or expenses. The First Amendment allowed for the issuance of the Preferred Stock, including dividends due thereunder and future issuances on similar terms, and the acquisition of DR Systems. We are also permitted to make payment-in-kind dividends on the Preferred Stock or any replacement Preferred Stock. The First Amendment also expanded the definition of events of default such as a default under the Preferred Stock agreement, our inability to redeem Preferred Stock within 90 days of exercise by the preferred holder and certain situations in which replacement Preferred Stock would be issued by us. 

 

In connection with the First Amendment, we paid our lenders a fee of $573, which was capitalized as additional debt discount and will be amortized over the remaining life of the Term Loan in accordance with ASC 470-50 Debt – Modifications and Extinguishments since our debt was considered modified. Third party fees of $145 were expensed and are included in other income expense in our condensed consolidated statement of operations.

 

Interest Expense and Other

 

In the three and six months ended June 30, 2015 we recorded $4,249 and $8,493, respectively, of interest expense related to our debt, including $36 and $72, respectively, of amortization of debt issuance costs and $198 and $384, respectively, of amortization of debt discount. In the three and six months ended June 30, 2014, we recorded $4,178 and $8,297, respectively, of interest expense related to our debt, including $76 and $392, respectively, of amortization of debt issuance costs and $143 and $319, respectively, of debt discount amortization. In the six months ended June 30, 2015 and 2014, we made interest payments of $8,012 and $7,497, respectively, related to term loans. Our borrowings under the Term Loan had an effective interest rate of 7.57% at June 30, 2015.

 

As of June 30, 2015 and December 31, 2014, the long term debt balance in our condensed consolidated balance sheets include $3,888 and $3,699 of unamortized debt discount, respectively, and the balance of unamortized issuance costs included in other assets is $711 and $783, respectively. The debt discount is being amortized over the life of the Term Loan using the effective interest method.

 

 

On February 25, 2015, we issued 50,000 shares of Preferred Stock, par value $0.01 per share for an aggregate purchase price of $50,000 pursuant to a stock purchase agreement. We used the net proceeds to finance the acquisition of DR Systems and to pay related fees.

 

---

Participation Rights and Dividends

 

 The Preferred Stock ranks senior to our common stock with respect to dividend rights and rights on liquidation, winding-up and dissolution. The Preferred Stock has an initial liquidation value of $1,000 per share, and holders of Preferred Stock are entitled to cumulative, compounding dividends payable quarterly in cash at a rate of 8.5% per annum provided we have profit, surplus or other funds legally available for the payment of dividends. If we do not have legally available funds, we may elect to pay dividends in-kind with additional shares of Preferred Stock. We have paid holders of the Preferred Stock quarterly cash dividends of $413 and $1,063 for a total of $1,476 in the six months ended June 30, 2015.

 

The holders of Preferred Stock are entitled to receive dividends declared or paid on our common stock and are entitled to vote together with the holders of our common stock as a single class, in each case, on an as-converted basis. Holders of Preferred Stock have certain consent rights that require us to get the written consent of a majority of the holders regarding actions that affect them including actions that; (1) liquidate, dissolve or wind-up Merge, (2) amend, modify, or repeal of our Certificate of Incorporation and Bylaws that would adversely affect them, (3) reduce their liquidation preference and (4) include the issuance of pari passu or senior equity securities.

 

Conversion by Us

 

Beginning on the first anniversary of the date of issuance, at our election, all or a portion of the Preferred Stock will be convertible into the relevant number of shares of common stock provided that the average of the volume weighted average prices (the VWAPs) during the 30 consecutive trading day period ending on the trading day prior to the date we deliver a notice of redemption is greater than $8.28, subject to a proportionate adjustment in the event of a stock split, stock dividend, combination or other proportionate recapitalization. If we elect to convert the Series A Preferred Shares the holders of the Series A Preferred Shares may, so long as we are permitted to make such payment in cash under the terms of the Credit Agreement (or any subsequent senior credit facility), elect to have us redeem their shares for an amount in cash equal to 80% of the redemption price. In connection with any such conversion, any unpaid Series A dividends will be paid in cash, if permitted and if not, in Series A Preferred Shares which will be deemed to convert into common stock prior to any then outstanding Series A Preferred Shares.

 

The Preferred Stock is convertible into 12,077,500 shares of our common stock based on the conversion rate in place as of June 30, 2015. The conversion rate is subject to customary anti-dilution and other adjustments, except with respect to certain excluded issuances.

 

Conversion by the Holders

 

The Preferred Stock is convertible at the option of the holders at any time into shares of common stock at a conversion price of $4.14 per share, subject to adjustment. When initially issued, a conversion cap limited the conversion of the Preferred Stock to 19.99% of the common shares outstanding immediately prior to the date of issuance in connection with a conversion. On June 17, 2015, our stockholders approved the removal of the conversion cap.

 

Redemption by Us

 

At any time after the first anniversary of issuance, we will have the right to redeem not less than all of the Preferred Stock provided that, at the time of any such redemption, the average of the VWAPs during the 30 consecutive trading day period ending on the trading day prior to the date we deliver a notice of redemption is greater than $8.28. Upon any such redemption, we will pay a price per Series A Preferred Share with respect to which such redemption requests have been made in cash equal to the greater of (i) (A) the liquidation value (as defined in the Credit Agreement), multiplied by 2, (B) plus any Preferred Stock unpaid dividends with respect to the Preferred Stock upon such occurrence and (ii) the sum of (A) the product of (1) the then current fair market value of our common stock and (2) the initial conversion rate and (B) any Preferred Stock unpaid dividends with respect to the Preferred Stock upon such occurrence (the “Redemption Price”); provided, further that if we elect to redeem the Series A Preferred Shares (including any Preferred Stock unpaid dividends), the holders of the Preferred Stock may, within three days following receipt of our notice to redeem, elect to convert such holders’ Series A Preferred Shares into common stock at the then-applicable conversion price (prior to the stockholder approval, subject to the conversion cap), provided that any Preferred Stock unpaid dividends will be paid in cash to the extent permitted under the Credit Agreement (or any subsequent senior credit facility entered into by us) and applicable law. Notwithstanding anything to the contrary in the Certificate of Designations, each holder of Series A Preferred Shares to be redeemed by us may elect to convert all or any portion of the Series A Preferred Shares held by such holder into conversion stock (as defined in the Credit Agreement) at any time prior to the applicable redemption date.

 

---

Redemption by Holder

 

At any time on or after July 29, 2020, any holder of Series A Preferred Shares may request redemption, out of funds legally available therefor, of all or any portion of the Series A Preferred Shares held by such holder, by delivering written notice of such request to us specifying the number of Series A Preferred Shares to be so redeemed and the date of such redemption (which date may not be earlier than 30 days after delivery of such redemption notice). We will be required to redeem on the date so specified in such holder’s written notice delivered to us all or any portion of their Series A Preferred Shares with respect to which such redemption requests have been made at a price per Series A Preferred Share in cash equal to the liquidation value, plus all Preferred Stock unpaid dividends.

 

At any time during a 10 day period following a debt refinancing by us, any holder of Series A Preferred Shares may request redemption, out of funds legally available therefor, of all or any portion of the Series A Preferred Shares held by such holder. We will be required to redeem their Series A Preferred Shares at a price per Series A Preferred Share in cash equal to the greater of (x) the liquidation value, plus any Preferred Stock unpaid dividends with respect to the Preferred Stock upon such occurrence, plus the amount of any prepayment premium (as defined in the Credit Agreement) required pursuant to the terms of the Credit Agreement as if the Credit Agreement was to be repaid on the date specified for redemption in such holder’s written notice to us, and (y) the sum of (A) the product of (1) the then current fair market value of the common stock and (2) the initial conversion rate, and (B) any Preferred Stock unpaid dividends with respect to the Preferred Stock upon such occurrence. If following the refinancing repayment eligibility date, we do not repay all amounts outstanding pursuant to the Credit Agreement or any replacement credit facility entered into by us, we are prohibited from calling the Series A Preferred for redemption at the time.

 

Change in Control

 

Upon certain change of control events involving us, the holders can require us to repurchase the Preferred Stock for an amount in cash equal to the greater of (i) the liquidation value, multiplied by 1.5 or (ii) (A) the liquidation value, multiplied by 1.25, (B) plus any Series A unpaid dividends with respect to the Preferred Stock upon such occurrence; provided, that the Preferred Stock majority holders may waive the right to receive the change of control payment in connection with any change of control.

 

In connection with the issuance of the Preferred Stock, we incurred expenses of approximately $566 which were netted against the proceeds allocated to the fair value of the preferred shares. We also recognized a beneficial conversion feature at the time of issuance in accordance with ASC-470-20 and allocated its intrinsic value of $4,349 to paid-in-capital. We then immediately amortized the intrinsic value in full and recognized it as a dividend to the preferred shareholders since the Preferred Stock was convertible upon issuance. The intrinsic value was measured as the difference between the closing price of our common stock on February 25, 2015, of $4.50 and the conversion price of $4.14 per common share.

 

 In accordance with FASB ASC Topic 480-10-S99-3A, SEC Staff Announcement: Classification and Measurement of Redeemable Securities, preferred stock with redemption features that are not solely within the control of the issuer are required to be presented outside of permanent equity on the condensed consolidated balance sheet. Under the stock purchase agreement and as noted above, the holder has the option to redeem the Preferred Stock any time on or after July 29, 2020, or upon a change in control or subsequent to our call for conversion and the holders’ right to redeem for cash. As such, the Preferred Stock is presented in temporary or mezzanine equity on the condensed consolidated balance sheet. The accreted redemption value at June 30, 2015, was $50,000. On each future consolidated balance sheet through July 29, 2020, the next earliest probable date at which the Preferred Stock will become redeemable, we will use an appropriate accretion method based upon the facts and circumstances at the time, to adjust the carrying value of the preferred stock to its redemption value.

 

---

 

Stock Options

 

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

 

Stock option activity in the six months ended June 30, 2015, is set forth in the following table: 

 

 

Restricted Stock

 

Restricted stock activity in the six months ended June 30, 2015, is set forth in the following table: 

 

As of June 30, 2015, there was approximately $6,368 of unrecognized compensation cost related to stock options and restricted stock that may be recognized in future periods. 

 

Share-Based Compensation Plans

 

On June 17, 2015, our shareholders approved the 2015 Equity Incentive Plan (“EIP”) with a share limit of 2,000,000 shares plus the 2,924,189 shares remaining available for issuance under our 2005 EIP. Any shares of common stock that are subject to an outstanding award under the 2005 EIP that is canceled, forfeited or expires prior to exercise or realization will also again become available for issuance under the EIP. The EIP provides for awards of non-statutory stock options, restricted stock, restricted stock units, performance compensation awards or cash awards to employees. Directors and consultants may receive non-statutory stock options, restricted stock, restricted stock units or performance compensation awards. Awards are limited to 3.0 million shares during any three year period. No further awards will be granted under the 2005 EIP.

 

---

Employee Stock Purchase Plan

 

We maintain an ESPP that allows eligible employees to purchase shares of our common stock through payroll deductions of up to 10% of eligible compensation on an after-tax basis. Effective with the quarter ending June 30, 2015, eligible employees participating in the ESPP receive a 15% discount from the market price at the beginning or end of the calendar quarter whichever is lower. The previous discount was 5%. Eligible employees can purchase up to $12.5 of stock during each calendar year. We recorded stock-based compensation expense of $36 during the three and six months ended June 30, 2015, related to the ESPP.

 

 

Litigation

 

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 Healthcare 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 Healthcare 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 Healthcare 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 filed a motion to dismiss the complaint, which motion was denied. Trial has been scheduled for November 2015. Discovery in this matter is ongoing. 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.

 

On January 16, 2014, a purported shareholder class action complaint was filed in the United States District Court for the Northern District of Illinois by Fernando Rossy, who claimed to be a Merge Healthcare stockholder, against Merge Healthcare and certain current and former directors and officers claiming violations of federal securities laws and asserting that a class of our stockholders suffered damages due to the alleged dissemination or approval of false and misleading statements by Merge Healthcare from August 1, 2012 through January 7, 2014, related to falsified subscription backlog figures and a reluctance amongst large health systems to make enterprise purchases, as well as a lack of effective controls. Several other putative shareholder class action complaints alleging materially the same causes of action were subsequently filed. A hearing was held on March 26, 2014, before the Court of the Northern District Illinois, at which time the Court granted the motion of the Arkansas Teacher Retirement System (“ATRS”) to consolidate the purported class action cases and to appoint ATRS as lead plaintiff. ATRS filed an amended complaint on May 28, 2014. We subsequently filed a motion to dismiss the purported class action lawsuit and, on March 12, 2015, the Court issued a Memorandum Opinion and Order granting our motion and dismissing the lawsuit. We believe that the plaintiff’s time to file a notice of appeal of the dismissal of the case has expired and, accordingly, there is no further action pending in the putative shareholder class action. On February 14, 2014, William B. Federman, who claims to be a Merge Healthcare stockholder, filed a derivative complaint in the Circuit Court of Cook County, Illinois against certain of our current and former directors and officers, asserting breaches of fiduciary duty arising out of materially the same conduct alleged in the purported securities class action complaints. Subsequently, two other derivative complaints were filed in the United States District Court of the Northern District of Illinois. On June 6, 2014, the judge assigned to the purported class action case granted our motion to reassign the two Federal derivative actions to her on the basis of relatedness and stayed the Federal derivative cases pending her ruling on our motion to dismiss the class action case. We are in discussions with the plaintiff in the State derivative case regarding disposition of the matter in light of the Court’s ruling to dismiss the putative class action. The Federal derivative cases remain dormant. At this time we believe the possibility of a loss in these matters to be remote.

 

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. 

 

---

(11)	Transactions with Related Party

 

As of June 30, 2015, Merrick Ventures, LLC (“Merrick Ventures”) and Merrick Venture Management Holdings, LLC (“Merrick Holdings”), beneficially owned approximately 24.0% of our outstanding common stock. Michael W. Ferro, Jr., the chairman of the board of directors of Merge Healthcare, and trusts for the benefit of Mr. Ferro’s family members beneficially own a majority of the equity interests in Merrick Ventures and Merrick Holdings. 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 in Merge Healthcare owned by Merrick Holdings and Merrick Ventures.

 

On May 29, 2015, we entered into a letter agreement (“Agreement”) with Merrick Ventures providing for the reinstatement and amendment of a consulting agreement between us and Merrick RIS, LLC, an affiliate of Merge Healthcare and Merrick Ventures, which had expired on December 31, 2013. Pursuant to the terms of the Agreement, Merrick Ventures will, for a term of 12 months (the “Term”), provide services to us that include, but are not limited to: product development, strategic planning, industry marketing, investor relations, turn around management and various business relationship introductions.

 

In consideration for these services, we will pay Merrick Ventures a one-time cash fee of $15,000 should we, during the Term (or, if the Agreement is terminated by us other than for cause as determined in good faith by our board of directors, then within 12 months of such termination) consummate, or enter into a definitive agreement to consummate and subsequently consummate, a merger, consolidation, business combination, sale or other disposition of all or substantially all of our equity interests or assets in one transaction or a series of transactions (a “Transaction”) that is at least $1,000,000. The Transaction value is calculated as the total proceeds and other consideration paid or received, directly or indirectly, in connection with the Transaction by us or our stockholders or creditors or any of our affiliates, including the aggregate principal amount of any outstanding debt, pension liabilities, guarantees and any of our other liabilities or obligations, reduced by our cash and cash equivalents. In addition, we will reimburse Merrick Ventures for actual and reasonable expenses incurred in connection with the performance of the services.

 

(12)	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.

We evaluate our deferred income taxes quarterly to determine if valuation allowances are required or should be adjusted. GAAP requires that companies assess whether valuation allowances should be established against their deferred tax assets based on consideration of all available evidence, both positive and negative, using a “more likely than not” standard. This assessment considers, among other matters, the nature, frequency and amount of recent losses, the duration of statutory carryforward periods, and tax planning strategies. In making such judgments, significant weight is given to evidence that can be objectively verified.

In the six months ended June 30, 2015, we reversed a portion of the tax valuation allowance against our net deferred tax assets related to U.S. consolidated federal and state jurisdictions. The release of this valuation allowance is a result of our acquisition of DR Systems. The acquisition included additional sources of taxable income such as the reversal of temporary differences that are available to offset deferred tax assets of the acquiring company in future periods. The net income impact of the tax valuation allowance release was a tax benefit of approximately $16,555.

 

---

 

We apply the two-class method of calculating basic net income per share. Under the two-class method, net income is reduced by Preferred Stock dividends and dividend equivalents related to Preferred Stock accretion and residual earnings are allocated between common stock and participating securities based upon their participation rights. Our Preferred Stock is a participating security and shares in common stock dividends if declared. The Preferred Stock was not outstanding in the comparable prior year periods.

 

Basic net income per share is computed by dividing net income attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period adjusted for the effects of potentially dilutive common stock equivalents which are comprised of; stock options, except for stock options with an exercise price of more than the average market price of our common stock during the period as such exercise would be anti-dilutive, restricted stock awards assuming the potential lapse of restrictions using the treasury stock method and convertible Preferred Stock using the if-converted method or the treasury stock method, whichever produces the greater dilution. The following table sets forth the computation of basic and diluted net income per share.

 

The following table sets forth the number of anti-dilutive shares excluded from the calculation of diluted net income per share attributable to common shareholders for the periods indicated.

 

As a result of the loss incurred in the three and six months ended June 30, 2014, the dilutive effect of incremental shares from the assumed exercise of employee stock options, and the potential lapse of restrictions on outstanding restricted stock awards totaling 694,936 and 568,698, and 871,127 and 417,157 shares, respectively, have been excluded in the calculation of diluted net loss per share as their inclusion would have been anti-dilutive.

 

Potentially dilutive common stock equivalent securities, including securities that may be considered in the calculation of diluted earnings per share outstanding as of June 30, 2015 and 2014, were 20,082,851 and 8,836,370, respectively.

 

(14)	Segment Information

 

We have two operating groups which constitute reportable operating segments: Merge Healthcare and Merge DNA. Merge Healthcare includes the assets and results of DR Systems from the date of acquisition. 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.

 

---

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

 

(1)

Net corporate/other expenses include public company costs, corporate administration expenses, amortization expense which is not attributable to business segments, acquisition-related expenses and net interest expense.

 

(15)	Recent Accounting Pronouncements

 

We describe below recent pronouncements that have had or may have a significant effect on our financial statements or on our disclosures. We do not discuss recent pronouncements that are not anticipated to have an impact on or are unrelated to our financial condition, results of operations, or related disclosures.

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 also adds Subtopic 340-40 Other Assets and Deferred Costs‒Contracts with Customers. The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for generally accepted accounting principles and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. ASU 2014-09 requires retrospective application either, a) to each prior period presented, or, b) retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application as an adjustment to opening retained earnings. The provisions of this new guidance are effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. Earlier application is not permitted. We are currently evaluating the impact of the new guidance on our financial statements.

 

---

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,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,” “may,” “will,” “would,” “intends,” “estimates” and similar expressions, whether in the negative or affirmative, 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, 2014. 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, 2014.

 

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

 

·

Liquidity and Capital Resources

·

Material Off Balance Sheet Arrangements

Overview

 

We develop enterprise imaging 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, and the ability to improve the efficiency and cost effectiveness of our customers’ businesses. We believe that 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.

 

We operate under two reportable segments: Merge Healthcare and Merge DNA. We evaluate the performance of each operating segment based on its respective revenues and operating income.

 

Our Merge Healthcare segment represents approximately 90% of our total revenues and markets, sells and implements interoperability, imaging and clinical solutions to healthcare providers. It generates revenue from the licensing of software (including upgrades), the sale of hardware, professional services, maintenance and electronic data interchange (“EDI”) services. This segment includes D.R. Systems, Inc. (“DR Systems”), which was acquired during the six months ended June 30, 2015. Segment results for the six months ended June 30, 2015, include four months of operations for DR Systems, which contributed $12.5 million of net sales and $0.9 million of net income to the overall segment results.

 

 

---

On February 25, 2015, we acquired 91.5% of the common stock of DR Systems and on April 17, 2015, we acquired the remaining shares of common stock. We used $49.4 million of net proceeds received from the private placement of 50,000 newly-issued shares of Series A Convertible Preferred Stock (“Preferred Stock”) and $20.4 million of cash on hand, to fund the acquisition of DR Systems for $70.1 million, net of cash acquired. The Preferred Stock accrues dividends at a rate of 8.5% per annum, payable in cash on a quarterly basis. As a result of the timing of the completion of the acquisition, the comparability of the results of operations in the three and six months ended June 30, 2015, differs from the same periods in 2014. At the end of March 2015, we completed a restructuring initiative focused on the elimination of redundant positions. This initiative enabled us to decrease general and administrative costs as well as product research and development costs as a percentage of revenue through a reduction of 6% of headcount across the organization.  We expect to fully recognize the cost savings benefit of this initiative in the statements of operations by September 30, 2015. In the three months ended June 30, 2015, we realized expense reductions of $0.8 million.

 

Business Segments

 

The following tables provide operating group information for the periods indicated, based on GAAP reported information (all amounts are in thousands, except percentages):

 

 

The majority of total net sales continue to be generated through perpetual license agreements with our customers. Under perpetual license agreements, the software, hardware and professional services are considered to be sources of non-recurring revenue. Subscription-based pricing arrangements involve fees that are payable by our customers and revenue recognized by us over a number of years, including leases, clinical trials software-as-a-service, certain interoperability solutions, and renewable annual software contracts (with very high renewal rates).

 

---

The following tables provide GAAP net sales generated by non-recurring, subscription and maintenance and EDI revenue sources by segment for the periods indicated: