A Rose Among Thorns

During the five years since the Balanced Budget Act of 1997 took effect, the risk profile for home medical equipment and respiratory companies — a critical factor in merger and acquisition strategy and valuation — has remained constant. Market dynamics have been stable, and reimbursement threats from competitive bidding, inherent reasonableness and average wholesale pricing for nebulizer medications never gained enough traction to become more than a steady, annoying drone.

However, the threats increased in 2002. If not for the lack of a Medicare-reform package to attach it to in the Senate, some form of national competitive bidding legislation very well could have become law last year. Still, even if the industry manages to hold the line on NCB, the Centers for Medicare and Medicaid Services' authority to reduce reimbursement via inherent reasonableness is likely to be reinstated soon. Though the impact of this legislation is in no way imminent, the threat has been enough to create an uptick in the industry's risk profile, thereby impacting M&A activity.

From an M&A strategy perspective, we expect that HME buyers will begin to target rural providers in 2003, to avoid the threat of competitive bidding — much like what we saw in the mid-1990s, when buyers targeted rural markets to avoid managed care. If, and when, NCB legislation is passed, the odds are that bidding initiatives will be rolled out in urban markets first, to generate the most immediate significant savings. Consequently, rural providers represent an attractive hedge against NCB and reduced operating margins.

Interestingly enough, from a M&A standpoint, the industry may be best served with a well-thought-out, methodical — that is, long term — roll-out of NCB. If efforts to pass NCB stall, IR likely will be used to cut reimbursement directly — and immediately — with oxygen as one of the primary targets.

Although this would be damaging to M&A activity, buyers would continue to target oxygen and respiratory products and services, because these markets still would offer the best financial returns. That said, even if valuation multiples hold up, as we expect they will, declining profitability will hurt pricing.