Capital Commentary
by Bradley Smith
June 20, 2016

If you were planning to cross the Atlantic, would you rather cross it in a 20-foot boat or a 200-foot ship?

Obviously, the 200-foot ship will provide a safer, more comfortable trip. In a smaller boat, you will feel everything the ocean rolls your way—and the opportunity for capsizing is much greater.

As the Round 2 Medicare bids are implemented, the bar for gross revenues an HME must book to break even or become cash-flow neutral is being raised even higher. Just as a 200-foot ship can weather Atlantic storms better than a small boat, a company with scale will be able navigate this risk better than a mom-and-pop.

Prior to 2010, a small but well-run company with full-line product mix could profit on $1 million in revenue with an EBITDA of $200,000 or 20 percent plus additional owner benefits. But as Medicare does its best to commoditize HME, this is close to impossible in 2016.

Since 2009, mandatory fixed costs have risen and reimbursements have significantly decreased. As a result, the economies of scale—the cost advantages that companies gain due to the size of their operations—have risen and continue to rise. In simplified terms, your fixed costs (rent, electricity, employees) remain relativity constant regardless of whether you have 10 or 100 patients on service.

In 2015, a well-run mom-and-pop with full-line product mix and $4 million in revenue could achieve an EBITDA of $400,000 or 10 percent plus additional owner benefits. But after July 1, the Medicare competitive bid and rural bid will change again, lowering the reimbursement rates. Where Medicare goes, so go private and managed care providers.

I believe that for most full-line HMEs to survive after July 1st—when the new Medicare rural and Round 2 bids go into effect—they will need at least $5 million in annual revenue to break even—or to gain minimal owner benefits. In 2017, I believe this benchmark will go even higher.

So if you intend to stay in business, your best option is to build your business. Here are three ways to grow quickly and efficiently to get ahead of the commoditization curve.

1. Grow Through Acquisition

This is currently one of the least expensive and most secure ways to grow. HME valuations are at an all-time low, which reflects the current level of market risk and the large amount of inventory currently on the market. That makes it a great time to buy an HME company. Buyers have a ripe opportunity to acquire small, quality companies for one to two times EBITDA (depending on their size), and sometimes even less.

When companies grow organically, they often hire new sales personnel or a sales team. Hiring is always risky, because there is no accurate way to quantify expected performance—aside, of course, from the salesperson selling you on his or her future performance. But when you acquire a company, you also acquire its assets, and that includes salespeople. By acquiring instead of hiring, a buyer has a quantifiable way to determine return on investment (ROI)—past sales performance.

For example, if the company has 100 patients receiving catheters monthly, it’s reasonable to expect that in 12 months time you would retain 100 catheter patients on service. Obviously there will be attrition; however, the referral source you gained from the purchase should make up that difference.

2. Organic Growth

Organic growth is often a slower way to expand, but you can speed things up and gain a more rapid rate of return by looking inward and evaluating underserved patient or product demographics.

For example, I have found it common for PAP suppliers to overlook their resupply business, which is often far more lucrative. Another commonly overlooked area is business development with specific insurance networks. Insurance networks are difficult to penetrate, aside from acquiring a competitor who has an existing contract. Have a referral partner, such as a physician group or health system, campaign on your company's behalf.

3. Parallel Markets

Parallel markets enable an HME to vertically diversify risk and opportunity by leveraging domain knowledge and expertise. If you understand reimbursement dynamics, certain patient populations or employee/contractor requirements, use that knowledge to assess how you could expand your offerings within the existing populations you serve. Then, consider a build versus buy approach to determine your best options. Although some HME owners do consider building their new vertical market, most choose to buy instead. There are several reasons for this.

First, as mentioned previously, growth through acquisition gets an HME into a new market (and positive cash flow) much faster than organic growth does. Second, bootstrapping a new market can quickly deplete current resources and can damage the foundation of the HME operation. Third, while some debt may be required, the financial returns of a well-chosen acquisition usually outweigh the anticipated savings of an organic start-up.

As Medicare’s bid-driven market realities continue to push reimbursements south, small HMEs will have a harder and harder time making ends meet in a manner that benefits owners. As the old saying goes, “get big or die trying.”