PITTSBURGH--The Deficit Reduction Act's 36-month cap on Medicare home oxygen equipment could drastically alter the HME merger and acquisition climate, according to a report released last week by The Braff Group.

In the past, after reimbursement cuts, the most attractive sellers have refocused their efforts on re-engineering their businesses instead of fleeing the market, the 2005 M&A report explained.

"However, this time, we sense that the 36-month oxygen cap may, in fact, drive more non-fringe, i.e. quality providers, to the market, changing the supply and demand dynamics to one that may begin to favor buyers," the report stated. "The big difference this time around is that unlike other past changes in reimbursement, the 36-month O2 cap has no immediate financial impact that a prospective seller has to recover from in order to capture a valuation comparatively consistent with the recent past. Accordingly, while risk has gone up--creating motivation to consider a sale--revenues and earnings remain unchanged ... for now."

Previously, the most important factor to sustain and spike the values of HME companies in an "extremely risky" environment has been the imbalance of supply and demand. "While many of the names have changed over time, the sector has been in a sustained period in which the number of aggressive buyers has exceeded the supply of attractive acquisition candidates," the report said.

Surprisingly, Wall Street's reaction to the DRA's 36-month oxygen rental cap did not have immediate financial impact on the respiratory sector, TBG said.

"The day after the Deficit Reduction Act was signed, the mean decline in the publicly traded HME firms was only 1.4 percent," the report stated. "So while the oxygen cap may have sent shock waves throughout the industry, the reaction from the Street was one of decidedly less concern."

However, the Act "has spiked the sector's risk by providing Congress with yet another mechanism to reduce reimbursement in the future."

The report, which called 2005 a "bellwether year" for HME, said for the first time in five years, transaction volume in the industry declined.

"While 87 deals completed in 2005 was the second highest total recorded over the past five years, it is the first time during the period that transaction volume has declined--a 10.3 percent fall-off from the record 97 deals posted in 2004," the report said. "Given two consecutive years of significant reimbursement pressure, such a slowdown was likely inevitable."

After a "remarkable rebound" in 2004, the HME sector started out strong in the first quarter of 2005 but then fell victim to cuts in oxygen reimbursement tied to Federal Employee Health Benefit Plans, soaring gas prices and cuts in nebulizer dispensing fees.

With three major transactions during the year involving firms that specialize in diabetic supplies, wound care, urologicals, respiratory supplies and other disposables (Warburg Pincus' acquisition of CCS Medical and MP Total Care, and Owens and Minor's acquisition of Access Diabetic Supply), The Braff Group said it expects further activity in this niche.