recent result sets the tone for the future, page-9

Judging from some commentary I heard yesterday it occurs to me that many people are quite confused about what this latest round of competitive bidding means for RMD's future financial performance.

And more importantly, how this compares to prevailing expectations immediately prior to the announcement.


Let's recap what's happened in simple terms:

As a result of DMEs bidding for business from the Centers for Medicare and Medicaid Services (aka "Medicare"), a 47% cut will be applied across a range of products from 1 July 2012.

These cuts cover 40% of the US population (don't ask...it’s a funny system based on metropolitan demographics).

Note that Medicare patients account for around 20% of RMD’s US-sourced revenue. The balance comes from patients covered by private health cover, or who self-insure.

So, assuming - and we'll expand on this assumption in a minute, that RMD and its competitors bear equally the full brunt of this 47% cut.

That means that RMD's US revenues will fall by 47% of 20% of RMD’s patient base in 40% of the entire US, i.e., 47% of 20% of 40%, which equals 3.8%.

But remember that RMD’s business extend well beyond the shores of the USA. About 55% of its revenues are US-derived.

So for the RMD group’s TOTAL REVENUES, the fall will be 55% of 3.8%, i.e., 2%.


Now let’s revisit that assumption of the manufacturers (RMD, and its competitors, Respironics and Fisher & Paykel Health, who collectively account for some 90% of the manufacturing end of market) bearing the full brunt of a 47% cut.

My contention is that, at the very worst, this cut will be shared equally between the distributors (DMEs) and the manufacturers.

The reason I say “at the very worst” is because of the industry structure: you have a big gorilla end customer (Medicare, which is flexing (rightly so) its muscle) on the one end of the supply chain, and on the other end of the supply chain you have three (well two, really, since RMD and Respironics together represent 80% of the industry’s manufacturing base).

And in the middle you have 4,500 distributors all clamouring for a slither of action (hence the competitive bidding process that results in a 47% cut to prices).

Economic theory, supported in practice by precedent, suggests that what happens is that the weakest link in this case is the centre, and the result will be the removal of capacity at this point in the supply chain.

In other words, DME’s will either go out of business, or this sector will aggressively consolidate.
History shows that a bit of both happens.

Point is, in this industry there is significant duplicated fixed cost overheads baked into the supply chain at the distributor level, and it is this cost structure that will need to flex. That is the path of least resistance.

So looking at the relationship between distributor and manufacturer (DMEs on the one hand, and RMD, Respironics and FPH on the other) the pricing power unequivocally rests with the manufacturers.

Clearly it then becomes a volume game and in that I see DME’s competing aggressively for a share of manufacturing volume in order to achieve scale benefits.

So I think the 47% cut will be shared more like 15% hitting manufacturers and 32% absorbed by DMEs.

In that case, we are talking about a mere 0.66% hit to RMD’s TOTAL group revenues.
(That’s hardly significant in the context for normal forecasting accuracy limits.

Of course, this maths relates to the 47% price cut revealed yesterday.

When you consider that the market was already “expecting” a 30% cut (analysts have been writing along those lines for months already), the “new market information” was an incremental adverse effect of just 17%.

So the “new information” impact on RMD’s TOTAL GROUP REVENUES was effectively 17% of 15% of 20% of 40% of 55%, which is around 0.11%, or about 0.5% at the EBIT line (!).

I think this put yesterday’s price movement into some sort of context.


Cam

PS. Oh, and I haven’t even touched on the fact that the OSA flow generators and masks represent just 20% of DME revenues, the other 80% is derived from distributing fare more commoditised products such as wheelchairs, stretchers, physiotherapy devices, walking aids and other belts and braces, which would be more vulnerable to downward pricing pressure than the comparatively technically-sophisticated, IP-rich, flow generators and masks.

PPS. In the interests of providing objective and balanced assessments, it is not lost on me that the private health insurers (who pay some 80% of reimbursement for OSA products, compared to Medicare’s 20%), will be looking at this with interest. However, remember that private health insurers already reimburse at significantly discounted levels to Medicare already, so I think all this competitive bidding process does is it effectively brings Medicare somewhat more in line with the reimbursement levels of private health insurers. So I think it will be business as usual with private health insurers: aggressive pricing argy-bargy will be nothing new with these guys...it’s constant. Really, nothing has changed.