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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 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

Securities registered under Section 12(b) of the Exchange Act:

 

 

Securities registered under Section 12(g) of the Exchange Act: NONE

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

 

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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or 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 aggregate market value for the Registrant’s voting and non-voting common equity held by non-affiliates of the Registrant as of June 30, 2013, based upon the closing sale price of the Common Stock on June 30, 2013, as reported on The NASDAQ Global Select Market, was approximately $239,197,597.  Shares of Common Stock held by each officer and director and by each person who owns ten percent or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates.  This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The number of shares outstanding of the Registrant’s common stock, par value $0.01 per share, as of March 3, 2014:  97,115,148

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain of the information required by Part III is incorporated by reference from the Registrant’s Proxy Statement for its 2014 Annual Meeting of Shareholders.

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INDEX

 

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2

3

o

Honeycomb Archive: A cloud-based, multi-tenant image archive that provides disaster recovery/business continuity services for hospitals, imaging centers, and physician practices.

·

Clinical and Financial Information Systems

o

Digital Imaging Solutions:  Picture Archiving and Communication Systems (PACS), specialty workstations and related applications manage the image workflow of a medical enterprise. PACS can be used by any medical imaging provider at a hospital or outpatient imaging site. We offer PACS solutions for general image review and management, specialty solutions for cardiology, orthopaedics, ophthalmology, mammography and oncology, and add-on modules like referring physician portals and critical test results reporting. We also offer our eFilm Workstation for general radiology reading and CADstream workstations for specialty reading of magnetic resonance imaging (MRI) breast, liver and prostate studies.

o

Clinical information systems. These systems provide a complete electronic record of a medical procedure across a variety of specialties – including Merge OrthoEMR for orthopaedics, and Merge RIS for radiology.

o

Revenue Cycle Management. We offer software and services for the revenue cycle management of physician practices. These solutions can be used across many physician specialties, but our solutions are most commonly used by radiology practices, imaging centers and billing services.

 

·

Software Development Toolkits, Technologies and Platforms.

o

Merge toolkits, technologies and platforms provide software developers with the necessary resources to assist in the timely development of new products and enhance existing products. They can be used by any original equipment manufacturer (OEM), medical device manufacturer, RIS/PACS or general healthcare IT vendors. We offer development toolkits in the basic standards of medical imaging and information interoperability, as well as advanced toolkits and unfinished applications for specialized medical image review and distribution.

·

Hosted Software Solutions for Clinical Trial Data Management.

o

We provide hosted software solutions for the collection, aggregation, analysis, reporting and overall management of clinical trials information. These solutions can be sold to sponsors of clinical trials, including pharmaceutical companies, contract research organizations (CRO) or imaging core labs.  Our solutions include electronic data capture (EDC), interactive voice/web response (IVR/IWR) and electronic patient reported outcomes (ePRO) software and devices.

Competition

The healthcare IT and imaging markets in which we participate are highly competitive, rapidly evolving and subject to rapid technological change. However, we believe that there is no single company that competes against our entire product portfolio. 

Our principal competitors in the healthcare solutions and services market include: General Electric (Healthcare), McKesson Corporation, Fuji, Philips, Carestream, and Agfa, each of which offers software solutions that compete with a portion of our product portfolio. Almost all of these competitors are substantially larger or have more experience and market share than Merge in their respective markets.  We also partner with certain of these companies to resell our products.

Other competitors focus on specific portions of the market that we address or compete against specific products we sell. For example, there are 30 other companies in the North American PACS market, according to Frost & Sullivan.  These companies include original equipment manufacturers, former film companies and healthcare IT companies.  Our eClinical solutions and services are in a highly competitive market led by Oracle and Medidata.  Our OEM technologies most often compete with internal development departments, but also compete with software development companies for our DICOM and HL7 toolkits. 

In addition, major software information systems companies, large information technology consulting service providers and system integrators, start-up companies, managed care companies and others, specializing in the healthcare industry, offer competitive software solutions or services. The pace of change in the healthcare IT market is rapid and there are frequent new software solutions or service introductions, enhancements and evolving industry standards and requirements. We believe that the principal competitive factors in this market include the breadth and quality of solution and service offerings, the stability of the solution provider, the quality, features and performance of the products, the ongoing support for the systems and the potential for enhancements and future compatible software solutions.

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Employees

At December 31, 2013, we had approximately 800 employees worldwide.  Competition for personnel in the industry in which we compete is intense.  We believe that our future success depends in part on our continued ability to hire, assimilate, train and retain qualified personnel.

Software Development

We commit significant resources to developing new health information system solutions. At December 31, 2013, approximately 215 of our employees were engaged in research and development activities. Total expenditures for the development and enhancement of our solutions were approximately $32.4 million, $32.4 million and $27.5 million during 2013, 2012 and 2011, respectively.

Our products, ranging from standards-based development toolkits to fully integrated clinical applications, have been used by healthcare providers worldwide for over 20 years.  Our software solutions follow industry standards such as DICOM, which ensures that images from any DICOM-compliant imaging modality can be displayed, moved and stored within a standard set of guidelines.  In addition, Merge follows the guidelines of the Integrating the Healthcare Enterprise (IHE) standards body, an organization dedicated to developing standard profiles for health information exchange.  Our long-time involvement with the standards committees and continuous development of products like our DICOM and HL7 toolkits have enabled Merge to stay closely tied to industry innovation.  As discussed above, continued investment in research and development remains a core element of our strategy. This will include ongoing enhancement of our core solutions and development of new solutions and services such as Honeycomb, our new cloud-based platform and iConnect Network, our new image and data exchange network.

Patents, Trademarks, Copyrights and Licenses

We hold inbound licenses for certain intellectual property that is used internally, and in some cases, utilized in our products or services. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products and services, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our operations and products and services are not materially dependent on any single license or other agreement with any third party.

Sales, Marketing and Distribution

Sales to large health systems typically require a minimum of nine months development time, while the sales cycle can be shorter when selling to smaller hospitals and imaging centers.  At December 31, 2013, approximately 130 of our employees were engaged in sales and marketing activities. Our executive sales and marketing management is located in Chicago, Illinois, while our sales team is deployed across the U.S. and globally.

We employ quota based sales teams that specialize in particular solutions and services.  In addition, we have sales teams dedicated to establishing and maintaining distributor relationships on a global basis.  We have concentrated inside and telesales staff in one location in order to bring economies of scale in management and process.  Our sales teams are complemented by a staff of lead generation and marketing employees.  These teams use online tools and resources that streamline and track the sales process. 

Our marketing efforts are mainly electronic, utilizing our website and our extensive email database of customers for our communication campaigns, as well as our website for online communities and certain social media.  Beyond electronic media, we employ consistent media relations efforts for market communications.  In addition, we participate in the major industry trade shows for our respective product lines.  We also have an active user group for our U.S. customers and an industry advisory board. 

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Financial Information about Segments

For financial information regarding our  two operating groups as well as our geographic areas of operation, refer to Item 8, “Note 1 – Basis of Presentation and Significant Accounting Policies” and “Note 14 – Segment Information and Concentrations of Risk” of this Annual Report on Form 10-K.

 

Item 1A.

RISK FACTORS

Discussion of our business and operating results included in this annual report on Form 10-K should be read together with the risk factors set forth below.  They describe various risks and uncertainties to which we are or may become subject.  These risks and uncertainties, together with other factors described elsewhere in this report, have the potential to affect our business, financial condition, results of operations, cash flows, strategies, prospects, or the market price of our common stock in a material and adverse manner.  New risks may emerge at any time, and we cannot predict those risks or estimate the extent to which they may affect financial performance.  We undertake no obligation to update or revise the statements. 

Reductions in Medicare and Medicaid Reimbursement Rates for Imaging Procedures and Professional Services or Delays in the Payment of Reimbursements could Negatively Affect Revenues of our Hospital and Imaging Clinic Customers, which could cause our Customers to Reduce or Delay Purchases of our Software and Services.

The ability of customers to obtain appropriate reimbursement for their services from these programs and payors is critical to the success of our company.  Reductions in the amount of reimbursements or uncertainty or delays in those reimbursements have in the past, and could in the future, cause our customers to cancel or delay making new expenditures on information technology.  Federal budget reductions, such as the recent sequester by the federal government which cut $11.8 billion in Medicare reimbursements to medical providers during 2013, can affect the timing of the sales or our software and services.

In addition, the U.S. Congress has enacted far-reaching health system reform legislation that could have a negative impact on our business.  While the impact of the legislation is difficult to predict, the legislation will increase pressure to control spending in government programs (e.g., Medicare and Medicaid) and by third party payors.  For example, changes in the equipment utilization rate, once fully implemented, have the potential to decrease technical reimbursements for radiology procedures, and could have a particularly negative impact on hospitals and imaging clinics in rural regions of the country where utilization rates are naturally lower.  A second significant potential reimbursement change relates to the Sustainable Growth Rate (SGR) component of the Medicare Physician Fee Schedule.  The SGR is part of the update factor process used to set the annual rate of growth in allowed reimbursable medical expenditures, and is determined by a formula specified by Congress.  Because the annual calculation of the SGR would have led to reimbursement reductions that Congress found unacceptable, Congress has interceded to delay the implementation of this statutory SGR update factor.  While these changes have provided temporary reimbursement relief to healthcare providers and us, because of the significant budgetary impacts, Congress has retained the SGR formula, thereby allowing annual unimplemented payment reductions to accumulate in the Medicare statute.  The Congress and the Obama administration are currently considering legislation to attempt to fix or delay this problem, but the prospects for enactment remain uncertain.  The changes being considered have the potential to negatively impact the professional component of reimbursement.

 Changes related to the equipment utilization assumption and the SGR calculation could result in a reduction in software and service procurement of our customers, and have a material adverse effect on our revenues and operating results.

We are Subject to Government Regulation, Changes to which could Negatively Impact our Business.

We are subject to regulation in the U.S. by the Food and Drug Administration (FDA), including periodic FDA inspections, in Canada under Health Canada’s Medical Devices Regulations, and in other countries by corresponding regulatory authorities.  We may be required to undertake additional actions in the U.S. to comply with the Federal Food, Drug and Cosmetic Act (FDCA”), regulations promulgated under the FDCA, and any other applicable regulatory requirements.  For example, the FDA has increased its focus on regulating computer software intended for use in a healthcare setting.  If our software solutions are deemed to be actively regulated medical devices by the FDA, we could be subject to more extensive requirements governing pre- and post-marketing activities.  Complying with these regulations could be time consuming and expensive, and may include:

·

Requiring us to receive FDA clearance of a pre-market notification submission demonstrating substantial equivalence to a device already legally marketed, or to obtain FDA approval of a pre-market approval application establishing the safety and effectiveness of the software;

·

Requiring us to comply with rigorous regulations governing the pre-clinical and clinical testing, manufacture, distribution, labeling and promotion of medical devices; and

·

Requiring us to comply with the FDCA regarding general controls, including establishment registration, device listing, compliance with good manufacturing practices, reporting of specified malfunctions and adverse device events.

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Similar obligations may exist in other countries in which we do business, including Canada. Any failure by us to comply with other applicable regulatory requirements, both domestic and foreign, could subject us to a number of enforcement actions, including warning letters, fines, product seizures, recalls, injunctions, total or partial suspensions of production, operating restrictions or limitations on marketing, refusals of the government to grant new clearances or approvals, withdrawals of marketing clearances or approvals and civil and criminal penalties.

 

We are subject to periodic FDA inspections and there can be no assurances that we will not be required to undertake additional actions to comply with the FDCA and any other applicable regulatory requirements.  Any failure by us to comply with the FDCA and any other applicable regulatory requirements could have a material adverse effect on our ability to continue to manufacture and distribute our software solutions.  The FDA has many enforcement tools including recalls, seizures, injunctions, civil fines and/or criminal prosecutions.  Any of the foregoing could have a material adverse effect on our business, results of operations or financial condition.

Changes in Federal and State Regulations Relating to Data could Depress the Demand for our Software and Impose Significant Software Redesign Costs.

 Federal regulations under the Health Insurance Portability and Accountability Act (HIPAA) impose national health data standards on healthcare providers that conduct electronic health transactions, healthcare clearinghouses that convert health data between HIPAA compliant and non-compliant formats and health plans.  Collectively, these groups are known as covered entities.  HIPAA regulations prescribe transaction formats and code sets for electronic health transactions, protect individual privacy by limiting the uses and disclosures of individually identifiable health information and require covered entities to implement administrative, physical and technological safeguards to ensure the confidentiality, integrity, availability and security of individually identifiable health information in electronic form.  Although we are not a covered entity, most of our customers are, and they require that our software and services adhere to HIPAA regulations.  Any failure or perceived failure of our software or services to meet HIPAA regulations, or any breach of the HIPAA regulations or any other federal, state or foreign data privacy laws or regulations, could result in remediation costs and fines, and could adversely affect demand for our software and services and potentially require us to expend significant capital, research and development and other resources to modify our software or services to address the privacy and security requirements of our clients.

 States and foreign jurisdictions have adopted, or may adopt, privacy standards that are similar to or more stringent than the federal HIPAA privacy regulations.  This may lead to different restrictions for handling individually identifiable health information.  As a result, our customers may demand IT solutions and services that are adaptable to reflect different and changing regulatory requirements, which could increase our development costs. In the future, federal, state or foreign governmental authorities may impose new data security regulations or additional restrictions on the collection, use, transmission and other disclosures of health information.  We cannot predict the potential impact that these future rules may have on our business; however, the demand for our software and services may decrease if we are not able to develop and offer software and services that can address the regulatory challenges and compliance obligations facing our clients.

Our Business could be Harmed by Adverse General Economic and Market Conditions.

Our markets have been and will continue to be affected by general economic and market conditions.  If general economic conditions deteriorate or economic uncertainty continues in the markets in which we do business, our clients might experience deterioration of their businesses, cash flow shortages and difficulty obtaining financing which may impact the decisions of customers to purchase products that improve their processes and delay or reduce their purchases, and in our having higher customer receivables with increased default rates.  General concerns about the fundamental soundness of domestic and foreign economies may also cause customers to reduce their purchases, even if they have cash or if credit is available to them.  This could result in reductions in sales of our products, longer sales cycles, slower adoption of new technologies and increased price competition.  In addition, weakness in the end-user market could negatively affect our OEM and VAR customers who could, in turn, delay paying their obligations, which would increase our credit risk exposure and cause a decrease in operating cash flows.  Also, if OEM and VAR customers experience excessive financial difficulties and/or insolvency, and we are unable to successfully transition end-users to purchase products from other vendors or directly from us, sales could decline.  Any of these events would likely harm our business, results of operations and financial condition. 

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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 $5.0 million 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 $3.2 million 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 $2.5 million 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 $3.0 million 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 $2.5 million within general and administrative expense in our statement of operations with respect to these matters in the year ended December 31, 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 $9.0 million 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 $9.0 million 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 alleged that certain features of products within our Image Interoperability Platform infringed three of HIT’s patents related to internet-based image viewing.  On December 7, 2013, Merge Healthcare and HIT executed a non-exclusive patent license and settlement agreement (Settlement Agreement). The Settlement Agreement settled all claims between the parties and provides Merge Healthcare with access to HIT’s complete portfolio of healthcare information patents.  Merge Healthcare agreed to pay HIT $1.4 million ratably over 11 years beginning in 2013, to collaborate on future products and to make certain contingent payments to HIT if Merge Healthcare incorporates other zero footprint technologies into Merge Healthcare’s products and is not licensing HIT’s zero footprint technology if it is still being offered.  The suit was dismissed with prejudice pursuant to a joint stipulation filed December 17, 2013.

 

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 claims 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.  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 securities fraud class action complaint.  Subsequently, other similar class action and derivative complaints have been filed.  The plaintiffs in these cases have not claimed a specific amount of damages. We expect these complaints to be consolidated into one or two actions.  Merge Healthcare and the other named defendants are actively considering all possible responses to these complaints. While we intend to defend the claims vigorously and carry directors and officers insurance, it is reasonably possible that we may incur a loss in this matter.  At this stage of the proceedings, however, it is not possible for management to reasonably estimate either the likelihood of such a loss or its magnitude. 

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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.

 

Item 4.

MINE SAFETY DISCLOSURES

 

Not applicable.

 

PART II

 

Item 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock trades on The NASDAQ Global Select Market (NASDAQ).  The following table sets forth for the periods indicated, the high and low sale prices of our common stock as reported by the NASDAQ:

 

Common Stock Market Prices

According to the records of American Stock Transfer & Trust Company, our registrar and transfer agent, we had 446 shareholders of record of common stock as of March 3, 2014.

For information regarding securities authorized for issuance under our equity compensation plans, see Note 8 of the notes to consolidated financial statements included in this Annual Report on Form 10-K.

 

Stock Price Performance Graph

 

The graph below compares the cumulative total return on our common stock with the Russell 2000 Index and the NASDAQ Computer Index (U.S. companies) for the period from December 31, 2008 to December 31, 2013.  The comparison assumes that $100 was invested on December 31, 2008 in our common stock and in each of the comparison indices, and assumes reinvestment of dividends, where applicable.  We have selected the Russell 2000 index for comparison purposes as we do not believe we can reasonably identify an appropriate peer group index.  The comparisons shown in the graph below are based upon historical data.  The stock price performance shown in the graph below is not indicative of, nor intended to forecast, the potential future performance of our common stock.

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COMPARISON OF THE 5 YEAR CUMULATIVE TOTAL RETURNS

FOR THE FIVE YEAR PERIOD ENDED DECEMBER 31, 2013

 

Date		Merge Healthcare Incorporated (Nasdaq: MRGE)				Nasdaq Computer Index (^IXCO)				Russell 2000 Index (^RUT)
12/31/2008		$	100			$	100			$	100
12/31/2009		$	263			$	171			$	125
12/31/2010		$	291			$	201			$	157
12/31/2011		$	379			$	202			$	148
12/31/2012		$	193			$	227			$	170
12/31/2013		$	181			$	299			$	233

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Dividend Policy

 

We are prohibited from making certain dividend payments based on the terms of the Credit Agreement for our Term Loan and Revolving Credit Facility and have not declared any cash dividends on our common stock in the past two fiscal years.  We currently do not intend to declare or pay any cash dividends on our common stock in the foreseeable future.

 

Item 6.   SELECTED FINANCIAL DATA

 

 

 

 

Item 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The discussion below contains “forward-looking statements.  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 this Annual Report on Form 10-K.  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 elsewhere in this Annual Report on Form 10-K and Item 1A, “Risk Factors”.

 

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

 

22

Overview

 

We develop enterprise imaging software solutions that facilitate the management 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 believe that certain macro events that occurred in 2013 impacted our operating results (together with those of others in our industry), most notably:

 

•                  The U.S. Federal government’s sequester, which started in April, cut over $11 billion, or 2%, in Medicare reimbursements to providers, and

 

•                  An anticipated delay in converting from ICD-9 to ICD-10 did not occur when it was announced on June 17, 2013 that the deadline for conversion would remain Oct. 1, 2014.  We believe this caused many clients and prospects to delay decisions on any projects not directly related to their transition to ICD-10.

 

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 our core markets and right-sized our cost structure, primarily within sales and marketing, in the third quarter of 2013.  Since we believe that market opportunities still exist over the long-term for our products and the solutions we have developed, these actions did not impact our product research and development costs as we have decided to continue to invest meaningfully in our product solutions.  We believe that investment in our development has been validated, most recently by being ranked the 8^th best software vendor overall in KLAS Research’s 2013 Best in KLAS Awards Software and Services Report, by Merge Cardio receiving the “Best in KLAS” honor in the cardiology category, by Merge Hemo maintaining its number one spot as KLAS Category Leader in cardiology hemodynamics for the third year in a row, by receipt of  a Product Leadership Award from Frost & Sullivan for iConnect® Enterprise Clinical Platform and, for the second straight year, by being named the global leader in VNA according to IHS.

 

Business Segments

 

We operate under two reportable operating segments: Merge Healthcare and Merge DNA.  Merge Healthcare represents about 83% of our 2013 total revenues and markets, sells and implements interoperability, imaging and clinical solutions to healthcare providers.  Merge DNA (Data and Analytics) represents 17% of our 2013 total revenues and focuses on data capture software for clinical trials and other solutions.  We evaluate the performance of each operating group based on their respective revenues and operating income.  The performance evaluations exclude certain corporate costs, interest expense, amortization of debt issuance and discount costs and income taxes.

 

Merge Healthcare primarily generates revenue from the sale of software (including upgrades), hardware, professional services, maintenance and electronic data interchange (EDI) services. Today, 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 approximately $24.2 million and $31.2 million as of December 31, 2013 and 2012, respectively.  In January 2014, we revised our previously announced subscription backlog totals for the June 30, 2012 through September 30, 2013 quarters upon learning that a former sales employee in our eClinical business had falsified the existence or amount of certain customer contracts.

 

Subscription-based pricing arrangements include contract elements that are payable by our customers over a number of years.  In 2013, subscription revenue was approximately 16% of total net sales.  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 include, but are not limited to, contracts that are structured with monthly payments (including leases), clinical trials or renewable annual software contracts (with very high renewal rates).  As of December 31, 2013 subscription revenue backlog was $55.8 million, compared to $39.8 million at December 31, 2012.  This significant increase is the result of our strategic plan to continue to move to a subscription based business 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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Revenues and Expenses

 

The following is a brief discussion of our revenues and expenses:

 

Net Sales

 

Net sales consist of:

 

·

Software and other sales, net of estimated returns and allowances, including our internally developed software, third party software and hardware revenue recognized in sales to OEM customers, healthcare facilities and other providers;

 

·

Professional services, including hosting, installation, custom engineering services, training, consulting and project management; and

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·

Maintenance and EDI, including software maintenance and support.

 

Cost of Sales

 

Cost of sales consists of:

 

·

Software and other cost of sales, including purchased components and third-party royalties included in software and hardware sales to our customers;

 

·

Professional services cost of sales, including headcount and related costs incurred in our performance of SaaS offerings, installation, custom engineering services, training, consulting and project management;

 

·

Maintenance and EDI cost of sales, including headcount and related costs and direct third-party costs incurred to fulfill our maintenance and support obligations and to deliver EDI services; and

 

·

Depreciation and amortization, including any impairment, for amounts assessed on capital equipment used to fulfill contract obligations as well as our purchased and developed software and backlog assets.  Depreciation and amortization are recorded over the respective assets’ useful lives.  Each quarter we test our purchased and developed software for impairment by comparing its net realizable value (estimated using undiscounted future cash flows) to the carrying value of the software.  If the carrying value of the software exceeds its net realizable value, we record an impairment charge in the period in which the impairment is incurred equal to the amount of the difference between the carrying value and estimated undiscounted future cash flows.

 

Sales and Marketing Expense

 

Sales and marketing expense includes the costs of our sales and marketing departments, commissions and costs associated with trade shows.

 

Research and Development Expense

 

Research and development expense consists of expenses incurred for the development of our proprietary software and technologies.  The amortization of capitalized software development costs and any related impairments are included in cost of sales. 

 

General and Administrative Expense

 

General and administrative expense includes costs for information systems, accounting, administrative support, management personnel, bad debt expense, legal fees and general corporate costs.

 

Acquisition-Related Expenses

 

Acquisition-related expenses are costs incurred to effect business combinations, including banking, legal, accounting, valuation and other professional or consulting fees.

 

Restructuring and Other Expenses

 

Restructuring and other expenses consist of severance to involuntarily terminated employees and relocation expenses resulting from our restructuring initiatives, loss on disposal of subsidiaries and impairment of non-cancelable building leases associated with restructuring activities.

 

Depreciation, Amortization and Impairment

 

Depreciation and amortization, including any impairment, are assessed on capital equipment, leasehold improvements and our customer relationships, trade names and non-compete agreement intangible assets.  Depreciation and amortization are recorded over the respective assets’ useful lives.  We also record impairment of these long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable based primarily upon whether expected future undiscounted cash flows are sufficient to support recovery of the assets.

 

Loss on Debt Extinguishment

 

Loss on debt extinguishment includes charges for unamortized debt issuance costs, unamortized net debt discount and early retirement costs.

 

Other Income (Expense)

 

Other income (expense) is comprised of interest income earned on cash and cash equivalent balances, interest expense, amortization of costs and discounts incurred from borrowings and issuance costs on borrowings which did not qualify for capitalization.  It also includes foreign exchange gains or losses on foreign currency payables and receivables.  In addition, we also record any other-than-temporary impairment charges recognized on our equity investments in non-public companies in other income (expense).

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Results of Operations

 

The following have significantly impacted the results of operations for the periods discussed herein:

 

·

In the second quarter of 2013, we entered into a new senior secured credit facility (Credit Agreement) 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. While the interest on the borrowings under the credit facility is variable, we made an election pursuant to the Credit Agreement, with respect to the interest period, such that the Term Loan bore interest at a fixed rate of 6.00% during 2013. As part of this transaction, we incurred $4.6 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 funded.  We recorded charges of $5.2 million for unamortized debt issuance costs, $1.7 million for unamortized net debt discount and $16.9 million of early retirement costs associated with the extinguishment for the Notes.

·

In 2013, we completed certain restructuring initiatives.  These initiatives included the end of life of specific, non-core products at low or negative margins, consolidations of operations surrounding three facilities and the reorganization of our leadership team and sales organization.  As a result, we incurred $3.9 million of employee termination and contract exit costs that were recorded in restructuring and other expenses in our statement of operations.

 

·

During the fourth quarter of 2012, we recorded charges of $3.9 million related to third party licenses and technology considered unusable, $1.3 million for the write-off of acquired intangibles and $9.2 million related primarily to uncollectible billings from customer contracts obtained through acquisitions in the past few years.

 

·

We completed restructuring initiatives in September 2012 to reduce our workforce and in August 2011 concurrent with the acquisition of OIS. These initiatives assisted in providing operational rigor to a combined, larger organization and enabled us to decrease costs as a percentage of revenue (most notably general and administrative costs).

 

·

We issued $200.0 million of Notes in April 2010 as part of the financing for the acquisition of AMICAS.    We issued additional Notes in June 2011 to redeem and retire our Series A Preferred Stock (which had been issued as part of the financing for the acquisition of AMICAS).  We issued these additional $52.0 million of Notes at 103.0% of the principal amount with terms identical to the Notes issued in April 2010.  We used these proceeds to retire all 41,750 outstanding shares of our Series A Preferred Stock at the face value of $41.8 million and paid cumulative dividends of $7.3 million (which were accruing at a 15% annual compounded rate).  The year ended December 31, 2012 includes twelve months of interest expense and amortization of the premium and certain issuance costs, whereas the year ended December 31, 2011 includes only seven months.  Also, in the year ended December 31, 2011 we incurred $3.2 million in costs related to the issuance of the additional Notes, including $1.7 million which was expensed in “other expense, net” of our statement of operations and $1.5 million which was capitalized and amortized into interest expense over the then remaining term of the Notes.

Year Ended December 31, 2013 Compared to the Year Ended December 31, 2012

 

The following table sets forth selected, summarized, consolidated financial data for the periods indicated, as well as comparative data showing increases and decreases between the periods.  All amounts, except percentages, are in thousands.

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Net Sales

 

Software and Other Sales.  Total software and other sales in 2013 were $78.6 million, a decrease of $15.9 million, or 16.8% from $94.5 million in 2012.  Software and other sales decreased $21.6 million in the Healthcare segment, primarily due to the customer buying delays we experienced as a result of the previously discussed change in market conditions in 2013.  Software and other sales increased $5.7 million in the DNA segment, primarily due to the sale of digital kiosks in 2013 for $3.1 million more than the prior year, as we exited this low margin product line, and increased clinical trials bookings which drove the remainder of the increase.  Software and hardware orders sold through perpetual software agreements in the Healthcare segment are typically fulfilled, and revenue recognized, in either the quarter signed or the following few quarters.  Revenue recognized from software and other sales may vary significantly on a quarterly basis.

 

Professional Services Sales.  Total professional services sales in 2013 were $43.8 million, an increase of $2.8 million, or 7.0% from $41.0 million in 2012.  Professional services sales in our Healthcare segment increased $0.7 million as a direct result of the increase in overall perpetual software license agreements.  Professional services sales in our DNA segment increased $2.1 million, primarily due to increased clinical trials sales.  Revenue recognized from professional services sales generally lag software and other sales by one to three quarters due to the timing of when such services are performed compared to when the products are delivered.

 

Maintenance and EDI Sales.  Total maintenance and EDI sales in 2013 were $109.3 million, a decrease of $4.2 million, or 3.7%, from $113.5 million in 2012. The decrease is primarily due to a decrease in software maintenance support sales as we exited unprofitable product lines (see restructuring and other expenses discussion).

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Gross Margin

 

Gross Margin – Software and Other Sales. Gross margin on software and other sales was $36.8 million in 2013, a decrease of $14.4 million, or 28.2%, from $51.2 million in 2012.  Gross margin as a percentage of software and other sales decreased to 46.8% in 2013 from 54.2% in 2012, due to a decrease in software sales which produce a much greater margin than do hardware sales.  Hardware sales were 48.0% of software and other sales in 2013 compared to 40.0% in 2012, primarily due to the aforementioned kiosk sales.  We expect gross margins on software and other sales to fluctuate depending on the software and hardware mix.

 

Gross Margin – Professional Services Sales. Gross margin on professional service sales was $18.7 million in 2013, an increase of $2.4 million, or 14.9%, from $16.3 million in 2012.  Gross margin as a percentage of professional service sales increased to 42.7% in 2013 from 39.7% in 2012, primarily due to the billable utilization of our professional services resources.  As the majority of professional services costs are fixed, we expect gross margins to fluctuate depending on billable utilization of these resources.

 

Gross Margin – Maintenance and EDI Sales. Gross margin on maintenance and EDI sales was $80.3 million in 2013, a decrease of $2.1 million, or 2.5%, from $82.4 million in 2012.  Gross margin as a percentage of maintenance and EDI sales increased to 73.5% in 2013 compared to 72.6% in 2012, as we continue to focus on controlling third party costs.

 

Depreciation, Amortization and Impairment

 

Depreciation, amortization and impairment decreased $2.0 million, or 22.3%, to $7.0 million in 2013 from $9.0 million in 2012, primarily due to a decrease in amortization related to certain acquired intangible assets which were written off in 2012, including the related $0.8 million charge for the write-off of those acquired intangibles in 2012.

 

Sales and Marketing

 

Sales and marketing expense decreased $7.3 million, or 16.7%, to $36.6 million in 2013 from $43.9 million in 2012.  As a percentage of net sales, sales and marketing decreased by 1.8%, to 15.8%, primarily due to the restructuring activity undertaken in the third quarter of 2013.

 

Product Research and Development

 

 

General and Administrative

 

General and administrative expense decreased $7.7 million, or 18.1%, to $34.7 million in 2013 from $42.4 million in 2012. Offsetting factors caused this change and include a reduction in bad debt expense of $7.0 million, a favorable non-cash settlement of $2.5 million in 2013 (for which significant legal costs were incurred in prior periods) and the negative impacts from a $1.3 million non-cash charge relating to the settlement involving an insignificant acquisition and a $0.9 million non-cash charge associated with stock consideration provided for in the settlement of a lawsuit that existed at the time of an insignificant acquisition.

 

Acquisition-Related Expenses

 

Acquisition-related expenses are costs incurred to effect business combinations, including banking, legal, accounting, valuation and other professional or consulting fees.  Acquisition-related expenses decreased $2.5 million in 2013 to $0.9 million, from $3.4 million in 2012 primarily due to reduced activities in the year.

 

Restructuring and other expenses

 

We incurred $3.9 million and $0.8 million of employee termination and contract exit costs that were recorded in restructuring and other expenses in our statement of operations in 2013 and 2012, respectively, as a result of the previously discussed initiatives in each year. 

 

Depreciation, Amortization and Impairment

 

Depreciation, amortization and impairment expense decreased $0.8 million, or 6.8%, to $10.5 million in 2013 from $11.3 million in 2012.

 

Loss on Debt Extinguishment

 

During the second quarter of 2013, we recorded a charge of $23.8 million for the early extinguishment of our Notes. This charge consisted of $5.2 million for unamortized debt issuance costs, $1.7 million for unamortized net debt discount and $16.9 million for early retirement costs.

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Other Expense, net

 

Other expense, net decreased $9.2 million to $22.1 million in 2013 compared to $31.3 million in 2012. The decrease is primarily due to debt refinancing activities that resulted in a lower interest rate and $11.2 million less expense in 2013.   Other expense, net included a $0.6 million realized loss on an equity investment in 2013,  while 2012 included a $0.5 million gain on the same equity security investment as well as a favorable legal settlement of $0.3 million.

 

Income Tax Expense

 

In 2013, we recorded income tax expense of $2.9 million on a pre-tax book loss of $36.1 million, resulting in a negative annual effective tax rate of 8.0% compared to a $4.1 million tax expense in 2012 and a negative effective tax rate of 16.5% The tax expense in each year resulted from profitable Canadian operations (which was greater in 2012), state income taxes, and the deferred effect of tax deductible goodwill amortization.  Only the state income taxes resulted in cash tax payments.  Our expected effective income tax rate is volatile and may move up or down with changes in, among other items, operating income and the results of changes in tax law and regulations of the U. S. and the foreign jurisdictions in which we operate.

Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

 

The following table sets forth selected, summarized, consolidated financial data for the periods indicated, as well as comparative data showing increases and decreases between the periods.  All amounts, except percentages, are in thousands.

 

(1)

Percentages are of total net sales, except for cost of sales and gross margin, which are based upon related net sales.

(2)

Depreciation, amortization and impairment expenses are excluded from these gross margin calculations.

(3)

NM denotes percentage is not meaningful.

Net Sales

 

Software and Other Sales.  Total software and other sales in 2012 were $94.5 million, an increase of $13.5 million, or 16.7%, from $80.9 million in 2011.  Software and other sales increased $11.5 million in the DNA segment, primarily due to $9.1 million in sales and rentals of kiosks as well as an increase in clinical trials software sales of $2.4 million.  Software and other sales also increased $2.0 million in the Healthcare segment, primarily due to an increase in our interoperability solution, which was introduced in January 2011.  Software and hardware orders sold through perpetual software agreements in the Healthcare segment are typically fulfilled, and revenue recognized, in either the quarter signed or the following two quarters.  Revenue recognized from software and other sales may vary significantly on a quarterly basis.

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Professional Services Sales.  Total professional services sales in 2012 were $41.0 million, a decrease of $0.9 million, or 2.2%, from $41.9 million in 2011.  Professional services sales in our Healthcare segment increased $4.1 million, primarily due to a greater number of projects in 2012 compared to 2011.  This increase was offset by a decrease of $5.0 million in our DNA segment, primarily due to an enhancement to the clinical trial platform that resulted in less professional services being required.  Revenue recognized from professional services sales generally lag software and other sales by one or three quarters due to the timing of when such services are performed compared to when the products are delivered.

 

Maintenance and EDI Sales.  Total maintenance and EDI sales in 2012 were $113.5 million, an increase of $3.9 million, or 3.5%, from $109.6 million in 2011 primarily due to maintenance revenue related to new contracts which exceeded the rate of attrition from our existing maintenance customer base.

 

Gross Margin

 

Gross Margin – Software and Other Sales.  Gross margin on software and other sales was $51.2 million in 2012, a decrease of $0.7 million, or 1.3%, from $51.9 million in 2011.  Gross margin as a percentage of software and other sales decreased to 54.2% in 2012 from 64.1% in 2011, due to $2.0 million related to third party licenses and $1.9 million in technology considered unusable and an increase in hardware sales, which are at lower margins than those involving software only.  Hardware sales were 40.0% of software and other sales in 2012 compared to 32.0% in 2011, primarily due to the kiosk sales.  We expect gross margins on software and other sales to fluctuate depending on the software and hardware mix.

 

Gross Margin – Professional Services Sales.  Gross margin on professional service sales was $16.3 million in 2012, a decrease of $4.5 million, or 21.6%, from $20.8 million in 2011.  Gross margin as a percentage of professional service sales decreased to 39.7% in 2012 from 49.6% in 2011, primarily due to the billable utilization of our professional services resources.  As the majority of professional services costs are fixed, we expect gross margins to fluctuate depending on billable utilization of these resources.

 

Gross Margin – Maintenance and EDI Sales.  Gross margin on maintenance and EDI sales was $82.4 million in 2012, an increase of $1.9 million, or 2.3%, from $80.5 million in 2011.  Gross margin as a percentage of maintenance and EDI sales increased to 72.6% in 2012 compared to 73.5% in 2011, primarily due to an increase in third party maintenance costs.

 

Depreciation, Amortization and Impairment

 

Depreciation, amortization and impairment decreased $0.3 million, or 3.8%, to $8.9 million in 2012 from $9.3 million in 2011, primarily due to a decrease in amortization related to certain intangible assets which became fully amortized in 2011 offset by $0.8 million for the write-off of acquired intangibles in 2012.

 

Sales and Marketing

 

Sales and marketing expense increased $5.1 million, or 13.2%, to $43.9 million in 2012 from $38.8 million in 2011.  As a percentage of net sales, sales and marketing increased by 0.9% to 17.6% due to increased branding efforts, customer facing events and personnel investments in these functions.

 

Product Research and Development

 

Product research and development expense increased $4.9 million, or 17.7%, to $32.4 million in 2012 from $27.5 million in 2011, primarily due to an increase of $2.7 million in headcount and related expenses and $2.2 million for professional fees.  As a percentage of net sales, product research and development increased to 13.0% in 2012 compared to 11.8% in 2011.

 

General and Administrative

 

General and administrative expense increased $9.8 million, or 30.0%, to $42.4 million in 2012 from $32.6 million in 2011, due to an increase of $9.1 million related to bad debt expense primarily due to our reserve for revenue in excess of billings and uncollectible billings from customer contracts obtained through acquisitions in the past few years, an increase of $2.4 million related to increased headcount, offset by a decrease in charitable contributions of $1.9 million.

 

Acquisition-Related Expenses

 

Acquisition-related expenses are costs incurred to effect business combinations, including banking, legal, accounting, valuation and other professional or consulting fees.  Acquisition-related expenses increased $1.8 million in 2012 to $3.4 million, from $1.6 million in 2011 primarily due to $1.6 million in contingent consideration paid for an insignificant acquisition.

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Restructuring and other expenses

 

Restructuring and other expenses consist primarily of severance to involuntarily terminated employees and relocation of certain employees resulting from our restructuring initiatives and abandonment of non-cancelable building leases associated with restructuring activities.  In 2012, we incurred $0.8 million of such expenses primarily related to the initiative that commenced in September of 2012.  In 2011, we incurred $1.2 million of such expenses, primarily related to the reorganization of our business concurrent with the acquisition of OIS.

 

Depreciation, Amortization and Impairment

 

Depreciation, amortization and impairment expense decreased $1.6 million, or 12.1%, to $11.3 million in 2012 from $12.9 million in 2011.  Upon completion of a product rationalization and a product being rebranded in the fourth quarter of 2012, we recorded a $0.5 million charge to trade names.  Upon completion of a product rebranding initiative in the second quarter of 2011, we recorded a $2.9 million charge due to the impairment of our trade names associated with certain products.  This decrease was offset by a $0.7 million increase due to prior year acquisitions.

 

Other expense, net

 

Net other expense increased $0.3 million to $31.3 million in 2012 compared to $31.0 million in 2011.  Interest expense increased $3.5 million primarily due to the $52.0 million of debt issued in June 2011 being outstanding for all of 2012 compared to a portion of 2011. The increase in interest expense is offset by increased interest income of $0.3 million in 2012 over 2011, $1.6 million of debt refinancing costs in 2011 with no corresponding charge in 2012, a $0.5 million gain on equity security investment in 2012 and a favorable legal settlement of $0.3 million in 2012. 

The net change in cash and cash equivalents (including restricted cash) is attributed to the following factors:

 

Operating Cash Flows

 

As set forth in the statement of cash flows included in our audited financial statements, cash provided by operating activities was $21.3 million in 2013, compared to cash used in operating activities of $0.7 million in 2012.  The net loss in 2013 of $39.0 million includes non-cash expenses of $51.3 million. We incurred $24.8 million in interest expense on our $252.0 million of extinguished Notes as well as the applicable portion of the quarterly interest payments under our new Term Loan (which is due on the last day of each calendar quarter).  Additionally, $2.8 million was paid related to restructuring activities during 2013 with $1.3 million remaining to be paid in future periods.

 

Average quarterly DSO in 2013 was 106 days compared to a quarterly average of 103 days in 2012. 

 

Investing Cash Flows

 

Cash used in investing activities was $0.6 million in 2013, compared to cash used in investing activities of $3.4 million in 2012.  In 2013, we purchased $2.8 million in fixed assets and acquired technology, and incurred a $0.4 million decrease in restricted cash.  In 2012, we paid $0.9 million, net of cash acquired, for insignificant acquisitions, purchased $2.2 million in fixed assets, and incurred a $0.1 million increase in restricted cash. 

 

Financing Cash Flows

 

Cash used in financing activities was $36.3 million in 2013, compared to cash provided by financing activities of $0.6 million in 2012. The change of $36.9 million is primarily due to debt refinancing which consisted of a $16.9 million penalty for early extinguishment of debt and debt issuance costs of $4.6 million. Additionally, required minimum Term Loan principal payments of $1.3 million and voluntary principal payments of $15.0 million were made during the year ended December 31, 2013. In the years ended December 31, 2013, 2012 and 2011, we also received $1.5 million, $1.0 million and $1.2 million, respectively in proceeds from the exercise of stock options and shares purchased under the employee stock purchase plan.

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Contractual Obligations

 

Total outstanding commitments as of December 31, 2013 (in thousands), were as follows:

 

The above obligations include lease payments involving facilities that we have either ceased to use or previously abandoned.

 

We do not have any other significant long-term obligations, contractual obligations, lines of credit, standby letters of credit, guarantees, standby repurchase obligations or other commercial commitments except for the contractual obligations shown above and restricted cash of $0.4 million (primarily letters-of-credit related to our leased facilities) at December 31, 2013.

 

As of December 31, 2013, approximately $1.1 million of our cash balance was held by our foreign subsidiaries.  We may need to accrue and pay taxes if we choose to repatriate these funds.

 

General

We believe our current cash and cash equivalent balances will be sufficient to meet our operating, financing and capital requirements through at least the next 12 months, including minimum principal and interest payments due under the Term Loan.  However, any projections of future cash inflows and outflows are subject to uncertainty.  In the event that it is necessary to raise additional capital to meet our short term or long term liquidity needs, such capital may be raised through additional debt, equity offerings or sale of certain assets, however our ability to undertake such transactions may be limited by the Credit Agreement.  If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of our common stock.  Furthermore, the number of shares of any new equity or equity-related securities that may be issued may result in significant dilution to existing shareholders.  In addition, the issuance of debt securities could increase the liquidity risk or perceived liquidity risk that we face.  We cannot, however, be certain that additional financing, or funds from asset sales, will be available on acceptable terms.  If adequate funds are not available or are not available on acceptable terms, we will likely not be able to take advantage of opportunities, develop or enhance services or products or respond to competitive pressures.  In particular, our uses of cash in 2014 and beyond will depend on a variety of factors such as the costs to implement our business strategy, the amount of cash that we are required to devote to defend and address any legal or regulatory proceedings, and potential merger and acquisition activities.  Liquidity on a go forward basis is dependent on our ability to meet covenants in our Credit Agreement, including our financial covenants, in particular a debt-to-adjusted-EBITDA ratio with a maximum allowance of 5.5 : 1 as of December 31, 2013.  As of December 31, 2013, our debt-to-adjusted EBITDA ratio was 5.3 : 1.  For a description of the other covenants included in our Credit Agreement, see Note 6 of the notes to consolidated financial statements included in this Annual Report on Form 10-K.

 

Material Off Balance Sheet Arrangements

 

We have no material off balance sheet arrangements.

 

Critical Accounting Policies

 

Our consolidated financial statements are impacted by the accounting policies used and the estimates, judgments, and assumptions made by management during their preparation.  We base our estimates and judgments on our experience, our current knowledge (including terms of existing contracts), our beliefs of what could occur in the future, our observation of trends in the industry, information provided by our customers and information available from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

 

We have identified the following accounting policies and estimates as those that we believe are most critical to our financial condition and results of operations and that require management’s most subjective and complex judgments in estimating the effect of inherent uncertainties: revenue recognition, allowance for doubtful accounts and sales returns, intangible assets and goodwill, share-based compensation expense, income taxes, guarantees and loss contingencies.

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Revenue Recognition

 

Revenues are derived primarily from the licensing of software, sales of hardware and related ancillary products, SaaS offerings, installation and engineering services, training, consulting, and software maintenance and EDI.  Inherent to software revenue recognition are significant management estimates and judgments in the interpretation and practical application of the complex rules to individual contracts.  These interpretations generally would not influence the amount of revenue recognized, but could influence the timing of such revenues.  In addition, revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from period to period.  Significant areas of judgment include:

 

·

The determination of deliverables specified in a multiple-element arrangement and treatment as separate units of accounting;

 

·

Whether separate arrangements with the same customer executed within a short time frame of each other are a single arrangement;

 

·

The assessment of the probability of collection and the current credit worthiness of each customer since we generally do not request collateral from customers;

 

·

The determination of whether the fees are fixed and determinable;

 

·

Whether or not installation, engineering or consulting services are significant to the software licensed; and

 

·

The amount of total estimated labor hours, based on management’s best estimate, to complete a project we account for under the input method of percentage of completion accounting.  We review our contract estimates periodically to assess revisions in contract values and estimated labor hours, and reflect changes in estimates in the period that such estimates are revised under the cumulative catch-up method.

 

Typically, our contracts contain multiple elements, and while the majority of our contracts contain standard terms and conditions, there are instances where our contracts contain non-standard terms and conditions.  As a result, contract interpretation is sometimes required to determine the appropriate accounting.  We analyze our multiple element arrangements to determine the estimated selling price of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized. As a result, if facts and circumstances change that affect our current judgments, our revenue could be materially different in the future.

 

Allowance for Doubtful Accounts and Sales Returns

 

Based upon past experience and judgment, we establish allowances for doubtful accounts related to our accounts receivable and customer credits with respect to our sales returns.  We determine collection risk and record allowances for bad debts based on the aging of accounts and past transaction history with customers.  In addition, our policy is to allow sales returns when we have preauthorized the return.  We have determined an allowance for estimated returns and credits based on our historical experience of returns and customer credits.  We monitor our collections, write-offs, returns and credit experience to assess whether adjustments to our allowance estimates are necessary.  Changes in trends in any of the factors that we believe impact the realizability of our receivables or modifications to our credit standards, collection, return and credit, authorization practices or other related policies may impact our estimates. 

 

Intangible Assets and Goodwill

 

Intangible assets include purchased software, capitalized software, customer relationships, backlog, trade names, and non-compete agreements.  Finite-lived intangible assets are amortized to reflect the pattern in which the economic benefits are consumed, which is primarily the straight-line method. 

 

Purchased software and capitalized software are tested for impairment quarterly by comparing the net realizable value (estimated using undiscounted future cash flows) to the carrying value of the software.  If the carrying value of the software exceeds its net realizable value, we record an impairment charge in the period in which the impairment is incurred equal to the amount of the difference between the carrying value and estimated undiscounted future cash flows. 

 

Customer relationships, backlog, trade names and non-compete agreements are evaluated for potential impairment whenever events or circumstances indicate that the carrying amount may not be recoverable, based primarily upon whether expected future undiscounted cash flows are sufficient to support the asset’s recovery.  If the actual useful life of the asset is shorter than the useful life estimated by us, the asset may be deemed to be impaired, and, accordingly, a write-down of the value of the asset determined by a discounted cash flow analysis, or a shorter amortization period, may be required.  We have reviewed these long-lived assets with estimable useful lives and determined that their carrying values as of December 31, 2013 are recoverable in future periods.

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We review goodwill for impairment annually or more frequently if impairment indicators arise. Our policy provides that goodwill will be reviewed for impairment as of October 1st of each year.  In calculating potential impairment losses, we evaluate the fair value of our reporting units using either quoted market prices or, if not available, by estimating the expected present value of their future cash flows.   We use a two-step impairment test.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary.  If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.  The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.

 

Identification of, and assignment of assets and liabilities to, a reporting unit require our judgment and estimates.  In addition, future cash flows are based upon our assumptions about future sales activity and market acceptance of our products.  If these assumptions change, we may be required to write down the gross value of our remaining goodwill to a revised amount.  We performed our goodwill testing and determined that there is no impairment as of December 31, 2013, since the fair value of our reporting units substantially exceeded the carrying value.

 

Share-based Compensation Expense

 

We calculate share-based compensation expense for option awards based on the estimated grant-date fair value using the Black-Scholes option pricing model, and recognize the expense on a straight-line basis over the vesting period, net of estimated forfeitures.  The fair value of stock-based awards is based on certain assumptions, including:

 

·

Expected volatility, which we base on the historical volatility of our stock and other factors; and

 

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Estimated option life, which represents the period of time the options granted are expected to be outstanding and is based, in part, on historical data.

 

We also estimate employee terminations (option forfeiture rate), which is based, in part, on historical data, employee class and the type of award.  We evaluate the assumptions used to value stock options and restricted stock awards on a quarterly basis.  The estimation of share-based awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised.  Although we believe our assumptions used to calculate share-based compensation expense are reasonable, these assumptions can involve complex judgments about future events, which are open to interpretation and inherent uncertainty.  In addition, significant changes to our assumptions could significantly impact the amount of expense recorded in a given period.

 

Income Taxes

 

As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate.  Our provision for income taxes is determined using the asset and liability approach to account for income taxes.  A current liability is recorded for the estimated taxes payable for the current year.  Deferred tax assets and liabilities are recorded for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using the enacted tax rates in effect for the year in which the timing differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of changes in tax rates or tax laws are recognized in the provision for income taxes in the period that includes the enactment date.

 

Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount more-likely-than-not to be realized.  Changes in valuation allowances will flow through the statement of operations unless related to deferred tax assets that expire unutilized or are modified through translation, in which case both the deferred tax asset and related valuation allowance are similarly adjusted.  Where a valuation allowance was established through purchase accounting for acquired deferred tax assets, any future change will be credited or charged to income tax expense.

 

The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws.  We are subject to income taxes in the U.S. and numerous foreign jurisdictions.  Significant judgment is required in determining our worldwide provision for income taxes and recording the related tax assets and liabilities.  In the ordinary course of our business, there are transactions and calculations for which the ultimate tax determination is uncertain.  In spite of our belief that we have appropriate support for all the positions taken on our tax returns, we acknowledge that certain positions may be successfully challenged by the taxing authorities.  We determine the tax benefits more likely than not to be recognized with respect to uncertain tax positions.  Unrecognized tax benefits are evaluated quarterly and adjusted based upon new information, resolution with taxing authorities and expiration of the statute of limitations.  The provision for income taxes includes the impact of changes in the liability for our uncertain tax positions.  Although we believe our recorded tax assets and liabilities are reasonable, tax laws and regulations are subject to interpretation and inherent uncertainty; therefore, our assessments can involve both a series of complex judgments about future events and rely on estimates and assumptions.  Although we believe these estimates and assumptions are reasonable, the final determination could be materially different than that which is reflected in our provision for income taxes and recorded tax assets and liabilities.

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