Putting the Pieces Together

It’s no secret that many home medical equipment providers hope to sell their businesses soon. With competitive bidding looming large plus new rental caps on oxygen and DME, many would sell today, if only someone would make a good offer.

But according to merger-and-acquisition experts, providers who were dreaming of selling out will have to sleep on those visions a while longer.

The industry’s unpredictable conditions have sent what had been a relatively busy M&A market into a stall, according to Dexter Braff, president of Pittsburgh-based The Braff Group, an M&A firm specializing in the health care markets.

“Demand [for HME companies] is substantially lower today than it has been, and valuations are not as robust as they have been,” says Braff, who has been tracking M&A trends in the HME industry for years now. Over the last 27 months, he says, there has been a marked decline in transactions.

In 2005, Braff counted 95 HME deals. But in 2006, transactions declined by 40 percent to 57. And in the first quarter of 2007, only five HME companies changed hands. “If you annualize the first quarter’s transactions, you would have about 20 deals,” Braff notes. “Overall, there has been a dramatic decline in activity.”

Uncertainty Has Stalled M&A

“The four or five large companies that have been active HME buyers have not bought much of anything for 18 months,” adds Rick Glass, president of Steven Richards & Associates, Tarpon Springs, Fla. “The reason is uncertainty about reimbursements caused by the move toward competitive bidding and the new 36-month cap on oxygen rentals.”

In the world of mergers and acquisitions, buyers value target companies by evaluating future profits, Glass says. If an issue threatens to depress those profits, M&A activity would probably continue; buyers would simply cut their valuations in proportion to the predictable decline in profits.

But uncertainty undoes everything. Today, given the Deficit Reduction Act’s 36-month oxygen cap, what used to be a stable sector has suddenly become unsettled. There are questions about maintenance and repairs, who is responsible and who will pay for what once title of the equipment transfers to beneficiaries as the law requires.

Worse, a report from the Department of Health and Human Services Office of Inspector General recommends slashing the 36-month cap to 13 months, which would dramatically alter the economic model for distributing and servicing oxygen equipment. The proposal to shorten the rental period also made its way into President Bush’s budget for the second year in a row.

“The 36-month cap was a significant change, but not a tipping point. It wouldn’t affect the overwhelming majority of patients,” Braff says. “But a 13-month cap would.”

According to industry estimates, between 20 and 25 percent of oxygen patients require the therapy for more than 36 months, so a provider could lose that portion of oxygen business when the cap kicks in on Jan. 1, 2009 — or much more if the 13-month cap is adopted.

What’s more, providers hoping to win a Medicare contract under competitive bidding may give up profit on individual items and then try to make up the losses with additional volume. But how much additional volume will they need? No one is currently able to estimate. Contracts for the first round of bidding won’t be awarded until December, and observers say it could take longer than that to tell for sure.

This kind of uncertainty, when no one knows how far profits will fall — or rise, for that matter — is not exactly favorable to deal-making. Today, according to Glass, potential buyers have no way of calculating acquisition prices for companies that may lose an undetermined amount of revenue in the coming years.

Not All Buying and Selling Has Stopped

Even so, “there is a lid for every pot,” says Jonathan Sadock, managing director with the Wayne, Pa., offices of Paragon Ventures. “If you have a strong company, there is a buyer out there. And in fact we’re seeing M&A activity with buyers other than the usual suspects. We’re seeing activity from regional and local HME firms and also private equity firms.

“Strategic buyers have gotten out of the market because they don’t know how to value businesses right now, and they don’t want to pay a premium. But regional, local and private equity companies are more entrepreneurial in their approach to acquisitions.”

In short, these companies, while they will make intelligent value assessments, are still willing to take greater risks than the large public HME companies.

Nevertheless, as Braff’s research indicates, regional and private equity buyers offer fewer opportunities than the national providers that have left the playing field.

Valuations Today

Current conditions have also driven valuations down to the point where some sellers are reluctant to sell. Sadock says small providers that are marginally (or less than marginally) profitable have seen their valuations nose-dive.

In such a slow market, many mom-and-pop operators, after tending the business for years, can’t get out of its sale what they were counting on. While there may be portions of the business that are attractive — sleep labs are an active sales sector, for instance — waiting until the market picks up could be a better choice.

Traditionally strong companies serving a couple thousand oxygen patients and generating revenues of $5 million to $10 million have also declined in value, but not by as large a percentage as smaller HMEs. “The large companies have probably only gone down in value in proportion to lost profitability,” Sadock says.

Suppose, for example, that a business produces $10 million in revenues and $2 million in EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). If that business lost $200,000, EBITDA would decline to $1.8 million. “That would drive the valuation of the business down by $200,000 times the multiple,” Sadock says.

And that multiple depends on the demand for companies, current and projected profitability, the general economic outlook and a variety of other factors. With the help of brokers armed with accurate financial data, buyers and sellers negotiate these numbers, and the deal must work for both parties.

Hang In There

According to Braff, many providers view today’s HME market as one that offers opportunities to make their businesses grow by winning a competitive bid and pushing fringe providers out.

“My advice to providers today is: Hang in there. You’re still making money. If you’re not in a competitive bidding area, you will likely continue to earn profits for several years.”

Braff, Glass and Sadock all say that providers interested in being acquired can work toward that goal by getting back to the business fundamentals that will make them into attractive acquisition targets.

Braff defines a good target as a company that derives a solid portion of its revenues from respiratory and oxygen services and generates revenue both from Medicare and some reasonably priced managed care or private insurance contracts. Sales of more than $5 million also brighten the picture.

Start To Block And Tackle Again

Attractive takeover targets also practice good business fundamentals. “You have to get back to the fundamentals of blocking and tackling,” Glass says. “Most importantly, cut your costs.”

But hasn’t everyone already wrung all the extra costs out of their companies? No, says Glass. There is always some new approach to focus on. For example, he recommends investigating alternative oxygen systems.

“Today we’re seeing portable concentrators,” he says. “These … machines are smaller and lighter. You can plug them into an outlet at home or into the cigarette lighter in the car, or you can run them on batteries for three hours.

“They provide portability for patients. You don’t have to spend $50 or more to deliver oxygen tanks and more to get the empty tanks refilled. Instead you give customers a portable concentrator, and you’re done. That cuts costs.”

Glass counsels a hunt for cost-cutting alternatives in all product and business areas. He recommends, for instance, improving billing practices to make sure all secondary fees are collected.

Sadock advises planning ahead if you think you want to sell, and commissioning a formal valuation by a professional with expertise in HME. Advance planning can help add to the sale price, he points out, but “don’t shoot the messenger.

“Look for a candid, objective valuation. Then you can decide if you are willing to sell for that price or, if you want to sell for more, we would revisit your numbers in six months and see if it reaches your number. Of course, that can be risky. Your numbers might look worse to a market of potential buyers six months from now.”

Sadock also urges providers to track the costs of doing business. Analyze business performance, he says. Track the amount of revenue a ventilator will generate over the course of a year and how much of that revenue will convert to profit. Do the same for all of your product lines.

“Now is the time for HME and respiratory providers to become good businesspeople,” Sadock says. “To survive today, you have to be good at business. You have to understand financial statements and know how to control costs.”

Look for options, advises Braff. Providers that demonstrate innovative operating practices can become attractive to buyers.

More importantly, don’t make a precipitous decision to sell, one of the most common mistakes HME owners make. All three experts say planning an exit strategy — one in which calculators rule instead of emotions — can help in preserving value for the business.

“If you hold off for now and eventually find yourself in a hostile reimbursement situation that actually prevents you from selling,” Braff says, “it is likely that you will have been able to sock away earnings equal to the bargain-basement price you might have to sell at today.”

Sadock takes a historical perspective, noting that today’s market will only trouble providers that sit by while the industry evolves around them.

“Medicare has always adjusted rates every few years,” he says. “And every time that has happened, M&A activity has tightened because no one can figure out how to price companies with uncertain profits. But as soon as the rates were adjusted, M&A activity returned to normal.”

Providers that find a way to adapt to and survive competitive bidding and capped rentals may end up positioned to sell for a better price. And, according to the M&A experts, they might even discover that it makes sense to continue doing business as the baby boom generation retires, begins to order home medical equipment and helps to revive the profitability of the industry.