Hedge fund managers are paid to take calculated risks. A select few have deduced that there are profits to be had in buying shares of scandal-ridden companies.
This philosophy, known as crisis investing, has recently led several fund managers to buy shares of
, a Milwaukee-based medical software company whose shares have been battered since late February by accounting restatements, an ongoing
Securities and Exchange Commission
investigation, the recent resignation of its CEO and a potential delisting from the
Silver Point Capital, a Greenwich-based private equity and hedge fund firm, disclosed earlier this month a 5.28% passive stake in Merge Technologies in a 13G SEC filing. At around the same time, Larry Feinberg, a managing partner at Oracle Partners, a health care hedge fund, disclosed a 5.70% stake in a 13D filing.
Oracle had $800 million under management at the end of last year, but an executive at the firm declined to give an updated number on its assets or comment about Merge. With 1.23 million shares, the position represents less than 2% of the fund's holdings, on the basis of the size of the firm as of December. For Silver Point, a fund with over $5 billion under management, the 1.15 million shares invested in Merge represent less than 1% of the firm's holdings. Executives at Silver Point declined to comment.
In addition, some well-known hedge funds also own the stock. S.A.C. Capital Management, the hedge fund founded by one of the Street's best moneymakers, Steven A. Cohen, reported a 2.2% stake last month, and activist hedge fund manager Jana Partners has a 2.98% ownership.
Merge, which was recently down 1.7% at $11.85, has lost more than half its value since the beginning of the year. These hedge fund managers, among others, are making a huge bet that there's been an overreaction to the scandals, creating an opportunity in a company with a strong business. A short time will tell if they're right.
The Nasdaq threatened last month to delist the company for failing to file its financial reports on time. On March 17, Merge Technologies, which does business under the name of Merge Healthcare, announced that it would delay the filing of its 10-K annual report for 2005.
In a press release, management said that the restatement was due to revenue recognition and tax accounting in the June 2005 merger of Merge Technologies and Cedara Software. This came after the company delayed the release of its fourth-quarter results on Feb. 24. But the Nasdaq postponed the delisting earlier this month, giving management until July 7 to file.
"Hedge funds are betting that the company is going to meet the listing requirements and that the stock will jump," says Heather O'Loughlin, analyst at DE Investment Research, an independent research boutique. She rates the company a trading buy on the basis of upside potential that a filing made within the July 7 deadline could induce. But she declined to predict the potential stock price increase.
Another cause for optimism is that hedge funds do not believe the company was involved in fraud, despite the unexplained departure of its CEO Richard Linden on May 16. That same day, the company announced that Merge had received an informal inquiry from the SEC requesting certain documents related to the restatements.
"If the board had uncovered management malfeasance or fraud, the CFO would have gone also," says a research analyst who covers the stock. To date, Scott Veech remains chief financial officer and treasurer of Merge.
A company spokeswoman did not return calls seeking comment.
David Sackler, a portfolio manager at the $20 million hedge fund Moab Partners, which has a long position in the stock, believes the fear of an accounting fraud is overdone and has left the stock cheap compared with its peers. Sackler would not disclose the size of his position.
"The problems with accounting at Merge are really related to revenue recognition," Sackler says. "The majority of the accounting problems are non-cash-related, and I believe that cash flow will remain intact."
Most of the issues, he notes, have to do with the way the company books its future cash flow when a new contract is signed. If the company signs a 10-year contract, it should recognize its revenue when it delivers the service, but at Merge, revenue may have been booked partially up front. "That is not fraud," Sackler says. "Each dollar they said came in the company actually came in the company."
Fundamentally, the company is "healthy, and its product, software imaging, incredibly strong," he adds.
Indeed, the company, which develops and delivers medical imaging and information management software, is dominant in its market sector. Merge basically transforms X-rays from films to digital format, an incredibly hot field because films are a huge cost for hospitals. Considering that the company dominates this market, its stock is attractively priced, with a multiple of 9.23 based on consensus earnings estimates of $1.30 a share for this year.
In the subsector of small and medium-sized hospitals and imaging centers, which makes for half of Merge's business, the company has between 30% to 40% of the market share in what is estimated to be a $1 billion market, says Ronald Opel, an analyst at investment banking boutique Moors & Cabot Capital Markets.
The rest of Merge's business -- selling special medical application radiology software to large suppliers such as
-- accounts for 40% to 50% of another $1 billion market. In both subsectors, Merge has the leading market share.
"Its price-per-earnings ratio is misleading considering that Merge had operating margins 50% to 100% higher than most of its competitors," says Opel, whose firm does not have a banking relationship with Merge. As a comparison,
, one of Merge's main competitors, has a 22.36 multiple based on a 60-cent earnings estimate.
Recent corporate history has taught investors to be wary of accounting issues. But in the case of Merge, the market's negative sentiment may not be warranted. The July 7 deadline for the company to file its financial reports will likely determine whether that's the case.