When Medicare plays a major role in a company's business model there always seem to be challenges. Such is the case for Fresenius Medical Care (NYSE:FMS). While the company's strong global share in dialysis equipment and strong share in North American dialysis services ought to be a strong positive in the company's favor, the difficult reimbursement environment has created challenges and uncertainties in the company's model. Though there is a significant global growth in the number of patients with end-stage renal disease, Fresenius Medical Care can't afford to drop the ball when it comes to careful expense management.
Time to get more efficient at the center level
Fresenius Medical Care is the largest operator of hemodialysis clinics in the U.S., with its more than 2,100 clinics translating into around 38% share of the market. DaVita (NYSE:DVA) is a close second, with approximately one-third share. After years of consolidation, there are really no sizable competitors to challenge these two companies and the costs of building a competitive for-profit regional or national network would be considerable.
Fresenius provides both hemodialysis services (for which private insurers and Medicare provide reimbursement) as well as ancillary services like the administration of drugs (including Amgen's Epogen) and vascular access procedures.
The challenge is in the how (and the amount that) Fresenius gets paid. Dialysis isn't like most other conditions; while ESRD patients who need dialysis and have private insurance have their insurance company pay for the first 30 months of dialysis, Medicare ultimately picks up the tab irrespective of age, financial considerations, or insurance status.
The entire Medicare system is under serious strain, and with that the CMS (the agency that oversees Medicare) is constantly pushing back on reimbursement. While about three-quarters of Fresenius's patient volume is covered by Medicare, closer to half of its revenue comes from private insurers (where reimbursement is typically significantly more generous, as dialysis is a small part of their outlay). Medicare started bundled reimbursement in 2011, and it has made life more difficult for both Fresenius and DaVita. Making matters worse, CMS has denied an inflation adjustment for 2014 and 2015, and there are real concerns that reimbursement is not going to keep up with costs.
Given this environment, Fresenius and DaVita have no choice but to get fierce on costs. Fresenius believes that about one-third of service cost base is "addressable." Up to 30% of the company's clinics could be loss-making over the "medium term", and closing loss-making centers is very much an option, though the company has to weigh the expense benefits against the prospect of losing clients and revenue (if a Fresenius center is too far away, a client may switch to DaVita). Fresenius is also looking at options like streamlining its billing centers and improving in-center labor efficiency.
Fresenius is also considering other alternatives. The company's Epogen contract with Amgen ends this year, and the expiration of Amgen's patents should allow Roche to enter the market with Mircera. Later on, biosimilars from companies like Hospira could be an option, but there is a risk that Medicare will claw back any and all benefits from switching to these lower-cost alternatives. There is also the option of expanded home dialysis. Fresenius is a significant customer for Nxstage Medical's System One and greater use of a home hemodialysis option could offset some of the dialysis center cost issues.
Products growing faster, but beware Baxter
Dialysis services generate about three-quarters of Fresenius's revenue, but it is also a significant manufacturer of dialysis products, with roughly 50% global share for dialysis machines and dialyzers. Fresenius benefited from some under-investment at Gambro prior to Baxer's (NYSE:BAX) acquisition of that company, and Fresenius also benefits from selling products into global markets where it has much smaller service businesses.
Fourth quarter revenue growth for products was almost double that of services in the fourth quarter, and I expect this to continue to be a faster-growing business. Fresenius estimates that there was 7% global growth in ESRD patients in 2013, and this number is liable to stay high as issues like hypertension and diabetes increasingly become global problems. While competing internationally in services can be challenging due to reimbursement policies, selling products is more straightforward.
Here too, though, there are challenges. Baxter paid quite a lot for Gambro and is very much interested in making this a value-generating acquisition. Gambro is a credible #2 to Fresenius in hemodialysis equipment and improved product development and manufacturing efforts should make it a tougher rival. It's also worth noting that Baxter has a substantial presence in peritoneal dialysis, an alternative to hemodialysis.
How much can Fresenius grow?
I would not be surprised if Fresenius sought to grow its service business outside the U.S. (particularly in emerging markets) via additional acquisitions. The key to that plan would (or, in my opinion, should) be long-term visibility on reimbursement rates that make providing such services a good use of capital. Fresenius should also continue to see additional growth potential in its products business.
Between ESRD patient growth and product growth, offset by reimbursement challenges in the U.S., Fresenius could grow its revenue at a long-term rate in the mid-single digits, with FCF growth likely lagging slightly due to those ongoing challenges from Medicare. Expansion outside of North America, particularly in emerging markets, would seem to be the largest single potential upside driver.
The bottom line
Given that growth outlook, Fresenius seems more or less fairly priced today. Fresenius has a reputation for having a very dependable "all weather" business model, and it is often touted for its defensive qualities. While the business may not be quite as defensive as investors would like (given those reimbursement challenges), the reality is that it does not often get especially cheap.