As HME ascends the face of a politically insecure future, revenues and new market potentials remain strong. In 2003, most companies, large and small, reported peak sales, but as Washington winds up to cut reimbursements more deeply, the positive outlook is not universal. HME businesses will have to retrain themselves, like finely tuned athletes, to beat credibility issues on Capitol Hill and deal with new requirements mandated by the Medicare Modernization Act. But the numbers in HomeCare's Top Companies listings speak for themselves. The market is out there. The climb may be harrowing — but that much more worthwhile — in the years ahead.

By Tom Gray

Sometimes you win. Sometimes you lose. Sometimes, as in the past year, the home medical equipment industry seems to be doing both at once.

Economically, 2003 was a winner for the HME business, and by most accounts 2004 is shaping up to be a repeat performance. Favorable demographics and a recovering economy both kept the industry on a strong growth track.

Politically, it has been a far different story. Since last summer, HME has been hit by a major scandal and has been run over by the bandwagon of Medicare reform. As a result, it faces tougher regulations and much leaner reimbursement than it did a year ago. It may be thriving out in the field, but it's having a hard time on Capitol Hill.

The economic scorecard for 2003 shows double-digit sales growth among industry leaders and robust merger and acquisition (M&A) activity. Among the few publicly traded companies in HME, stock prices were on a tear for most of the year. Even now, after the bad news of the Medicare reform bill is factored into business outlooks, values in both public and private markets have not fallen off a cliff.

Among the majors, respiratory-therapy leader Lincare Holdings had another in a series of strong years, with 2003 revenue up nearly 20 percent over 2002 and earnings per share (EPS) up nearly 28 percent. Apria Healthcare had slower growth from its more diversified mix of respiratory, infusion and DME, but it still achieved a year-over-year sales increase of 10 percent and EPS growth of 15 percent.

Two other publicly traded companies, Rotech Healthcare and American HomePatient, were in recovery from financial troubles. American HomePatient emerged from Chapter 11 bankruptcy protection in mid-year as a profitable firm. Rotech, which had come out of Chapter 11 in a 2002 spin-off from its parent company Integrated Health Services, was profitable by the end of 2003 and repaid $50 million in debt during the third quarter.

The good times seemed to roll from these leaders to most of the little guys. For HME companies across the board, it was a “threshold year,” says Jerry Baker, an M&A consultant based in Overland Park, Kan. 2003 was the year in which the industry finally shook off the last after-effects of the huge revenue hit it took (on the respiratory side) from the Balanced Budget Act of 1997, Baker explains.

After the reimbursement cuts hit in 1998, Baker says, HME firms “just cut their dreams in half. They had to go all the way down to the depth of the valley.” Last year, they were clearly past the bottom and rebuilding. One sign of a return to growth, Baker says, was the re-entry of people into the business after they had either sold out or been laid off earlier.

Some, including Lincare and Apria, already had seen a string of profitable years with revenue growth. Growth stories could be found among small companies, too. Helen Kent, a respiratory therapist who owns the Vista, Calif., HME firm Progressive Medical, says 2003 was “a wonderful year,” with her company (in the $2 million to $3 million sales range) growing 35 percent over 2002. This was a notch above her 30 percent growth in 2002 and 25 percent growth in 2001. Looking ahead, she's optimistic: “I see 2004 being a marvelous year, with lots and lots of opportunities.”

But that sunny outlook is far from a universal view in the industry. In fact, the prevailing mood early in 2004 seemed to be a troubled mix of short-term optimism and longer-term foreboding, with some anger and frustration toward Washington thrown in. For that, one can blame the political twists of 2003, particularly the year's main event, the passage of a Medicare prescription drug benefit with a surprisingly harsh cost-cutting regimen aimed at HME.

In this view, 2004 looks like a continuation of 2003. The Medicare Modernization Act (MMA) did cut reimbursements in 2004 for the inhalation drugs albuterol and ipratropium bromide, but the reductions are not considered too deep for a well-run company to absorb.

2005 may be quite a different matter. Respiratory drug reimbursement is due to be cut much more deeply, to 106 percent of average sale price (ASP), and payment for major categories of DME will be cut to levels prescribed in the Federal Employee Health Benefits Program (FEHBP). By 2007, if the law is not changed, the competitive bidding fought so tenaciously by the HME industry will go live. Even if it's sunny now, there are plenty of storm clouds on the horizon.

That troubled outlook emerged in November 2003, just as negotiations on the Medicare reform bill were winding up. Until then, the HME industry was doing fine not just operationally — in sales and profits — but in the expectations game as well. Prices of HME firms in public markets, reflecting hopes for continued growth and profitability, spent most of the year rising. In the private markets, according to one M&A adviser, prices were firm, and buyers were pouring into the market.

In fact, the first 10-and-a-half months of 2003 saw HME stocks rise more briskly than the general market. From the start of the year to Nov. 14, when prices of the HME leaders peaked, Lincare rose nearly 39 percent and Apria was up 40 percent. During that stretch, the market as measured by the Standard & Poor's 500 rose 19 percent.

But from mid-November on, the market kept rising while HME fell by the wayside. Lincare, which gets most of its revenue from respiratory services, ended the year 31 percent off its peak and was down nearly 5 percent for all of 2003. In contrast, the S&P 500 rose 26 percent for the year. Apria, with a more diversified sales mix, fell less from its high and still managed to outpace the S&P 500, with a 28 percent gain on the year. But from Nov. 14 to Dec. 31, it still fell nearly 9 percent while the market had a 6 percent gain.

What happened? The simplest answer is that investors got a big, unpleasant surprise when the House-Senate conference reached agreement on the prescription drug measure and its details were finally made clear. Dexter Braff, head of the Pittsburgh-based M&A firm The Braff Group, says the fateful day was Nov. 22, the Saturday before Thanksgiving, when the House of Representatives passed the Medicare reform measure. That's when the reality sank in that the legislation would impose sharp cuts, especially on the respiratory side, and that it was virtually certain to become law.

“It was kind of unquestionable that President Bush would sign it,” Braff says, “so people took it literally on the 22nd.” Before that, he added, “there were a lot of people who felt that it wouldn't get out of conference.”

The bad news actually seemed to leak out just before that, since Lincare had tumbled more than 16 percent the day before. A few days later, on Nov. 26, Lincare issued a statement confirming that the reimbursement cuts would have a serious impact on profit margins if they were not revised.

Of the ASP provision in respiratory drugs due to take effect in 2005, Lincare said, “The Company does not believe that the ASP provisions contained in the Medicare bill would adequately compensate home care providers for inhalation drug therapies and, if implemented, could eliminate access to these critical respiratory medications by home care providers to more than 1 million end-stage emphysema patients across the United States.” In other words, the supply of drugs would dry up because no one could make money selling them.

Could HME companies and investors really not have seen this coming? Bill Bonello, an equity research analyst who covers Apria and Lincare for Wachovia Securities, believes that even those companies, presumably watching Washington as closely as anyone, “thought that, at the end of the day, Congress just didn't have the will to pass such a severe cut.”

In the aftermath, Bonello adds, “There are clearly people out there who believe the 2005 cut [in respiratory drugs] will never be implemented.” He says they have a strong case, as outlined in the Lincare statement, that all the major distributors of inhalation drugs will simply exit the business without some price relief, leaving a million patients literally gasping for help. “I take the companies at face value that they will exit drug distribution when the new pricing takes effect in 2005,” he says.