Earlier this month, PACS vendor Merge Healthcare reported financial results for what most analysts saw as a largely disappointing first quarter. The company posted a $1.8 million loss, and it said it was dividing its PACS and its clinic kiosk businesses into separate operating groups. After the financials were released, its stocks tumbled almost 40 percent.

But coupled with the fiscal news, the Chicago-based company also revealed a new strategy: it plans to shift much of its PACS sales away from a traditional licensing model -- where a hospital, in effect, buys the rights to software indefinitely -- and instead move towards a subscription model, where hospitals would make no upfront purchases and instead pay on a per-exam basis.

Capital budgets drying up

The reason for the change lies mostly with hospitals' shrinking capital budgets, Steven Tolle, vice president of solutions management with Merge, explained to DOTmed News during a recent interview.

"It's really a reaction to hospitals' economic realities," Tolle said. "They just don't have the capital budgets left."

The capital budget squeeze is well known. A study by the GPO Premier found one-third of member hospitals who answered an online survey said they had less to spend this year than last.

Also, it's not just that budgets are lower, but that the priorities are different. Many hospitals are investing a big chunk of their capital budgets to implement electronic medical records in advance of federal meaningful use incentives and penalties which take effect over the next few years, Tolle said.

These EMRs are expensive. For a hospital or health system, an enterprise-wide EMR could cost between $50 million and $200 million. But Tolle said most hospitals wouldn't see a return on investment either from efficiency gains or reimbursements from the government for at least a few years.

As a result, many of these hospitals can't afford the hefty upfront costs of a PACS as the "reset cycle" closes, the time when they have to buy a replacement system, which usually comes about once every 5 years when they upgrade their hardware, or earlier if there has been an acquisition or merger, Tolle said.

Win-win?

Here's where a subscription model comes in. In this "pay-as-you-go" scheme, a hospital would pay a certain amount per study with a commitment to a minimum amount of studies per year.

Under most contracts, Tolle said, the hospital would pay a fee on the studies it has done at the end of every quarter. If at year-end the hospital exceeds its minimum commitment -- which can be anywhere from 50,000 exams a year to 1 million, depending on the institution's size -- it has to pay the difference.

With this, hospitals can finance the PACS out of their operating budgets, not their capital budgets, and they're saved the lump sum upfront fees. PACS can cost anywhere from $300,000 for a simple radiology PACS to several million dollars for an enterprise-wide vendor neutral archive, Tolle said.

Also, the pay-as-you-go model gives them a predictable cost curve for health systems deciding on buying an imaging center or another hospital: they can easily gauge what the additional studies are going to cost them over the next year, Tolle said.

As for Merge, Tolle said with the subscription model "in-quarter revenue hurts, but it lowers the bar for clients" to sign up for a PACS. Also, in the licensing model, although the vendor is getting a fat wad of cash when the contract's signed, they also typically have to discount the product, as the buyer is shopping around with other vendors. In fact, the total cost of ownership, after 5 or 10 years, will be higher for a subscription-basis schedule, he said.

Gradual transition

In Merge's first quarter filing, the company reported that about $2 million in PACS revenue had come from subscriptions that would previously have come from licensing fees. However, subscription-based sales represented a small fraction of total revenues, which were around $61 million for the quarter.

"But we didn't make the change because of Q1," Tolle said. "We see the pipeline growing Q2, Q3, Q4."

Merge plans a gradual roll-out of the subscription model to much, but not all, of the product line. A new OrthoPACS, for orthopedic surgeons, a refresh of a system Merge acquired from Stryker, is coming out this summer, and Tolle said it was a "natural" fit for this market, as are its ophthalmology products. But he said Merge Cardio, an information management system, and Merge Hemo, cath lab software, for instance, would probably not be sold on the subscription model.

Moving to the cloud

In broader terms, the move to the subscription is part of Merge's movement towards a "software as a service," or SaaS, model for its PACS products. This means not only is software not sold on a licensing model, but generally it's provided over the Internet, or the "cloud." After the company bought Amicas, a PACS business, in 2010, Tolle said a key factor when deciding on "go-forward" products was ones made with Web technologies.

Over the next 18 months, he said he envisions a complete roll-out of a cloud-based PACS. The company has already released some imaging SaaS products under its Honeycomb brand. In November, Merge launched Honeycomb Image Sharing, a Web-accessible image-sharing tool, and at the beginning of this month it released an image archiving tool, Honeycomb Archive.

As the products advance, Tolle said one goal was to create an architecture that could be shared across clients.

"The perfect example of cloud software is Salesforce.com [a company that makes SaaS programs for customer service] or online banking," Tolle said. "Unless you're Warren Buffet, you don't have your own version of Chase.com. We want to get to a mode where things that can be shared across clients, mainly administrative functions, things like managing user privileges, make them truly multi-tenant."