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By David Moskowitz

The CPAP (Continuous Positive Airway Pressure) equipment market is about to enter a pivotal time. The Centers for Medicare and Medicaid (CMS) instituted a round of "competitive bidding," which effectively cuts reimbursement for CPAP treatment (products and services), late last year. It's the second round of Medicare cuts, the first of which lowered average Medicare reimbursement rates on CPAP equipment by 34%, and the latest round will lower reimbursement rates by another 47%. The changes have clear implications for the providers of products and services for CPAP therapy, and the trend is likely to cause Durable Medical Equipment suppliers (DMEs) to pressure manufacturers of CPAP equipment for concessions. The new reimbursement level goes effective in July, but in advance of this change, DMEs have been seeking alternatives to branded CPAP equipment from leading manufacturers like ResMed (NYSE:RMD) in order to reduce costs to provide CPAP carePaykel and to preserve their profits. One such "off-brand" company is 3B Medical, which is indicating that the trend has significantly increased their CPAP equipment supply business.

ResMed is the leading manufacturer of airflow generator equipment based on CPAP therapy, which is designed to deliver pressurized air through a nasal mask to prevent collapse of the upper airway during sleep; it's a treatment for patients with sleep apnea. ResMed has been a long-time focus for PropThink, as we believe the stock is significantly overvalued and due for a major correction as the true impact of these rate cuts are felt. You can read more about ResMed and why we consider it a short in our previous report.

PropThink manager David Moskowitz sat down with Susan Craig, Sales Manager at 3B Medical, a private CPAP manufacturer that recently began marketing their CPAP line in the U.S. Moskowitz asked Craig about the broader CPAP market and why she believes that 3B can differentiate itself in the space as a provider of unbranded, less expensive CPAP equipment vs. the three major competitors in the US: Resmed, Fisher Paykel, and Philips Respironics. With reimbursement pressure from Medicare, Craig believes that Durable Medical Equipment (DME) and Home Medical Equipment (HME) suppliers are looking for less expensive alternatives to the branded products that currently dominate the market. 3B's equipment is 30-40% less expensive, and Craig believes that the products compare equally in quality. The incentives for DME's and HME's to sell lower-cost items is there, and now it's a matter of time to see who steps in to satisfy the changing market dynamic.

(For clarification, Durable Medical Equipment suppliers receive prescriptions for CPAP or other medical equipment from physicians and fill the order with products like 3B's or ResMed's. A Home Medical Equipment supplier serves the same purpose.)

David: Welcome to PropThink's conference call series. Today, we're going to focus on the CPAP equipment market. We're very privileged to have a member of 3B Medical with us. 3B Medical is a supplier to the CPAP equipment market, and we have Susan Craig with us, sales manager for 3B.

Susan, welcome to the call.

Susan: Thank you so much, David.

David: Thanks again for coming and sharing your expertise with us. Let's jump right in to the market with 3B Medical itself. Tell us a little bit about your company and when you entered the CPAP supply market.

Susan: Actually, 3B Medical is the North American arm of BMC Medical Company, which was founded in China in 1996. Our CPAP devices have been present in about 120 countries around the world for the past seven or eight years. We launched the product here in the United States in September of 2012, so we're fairly new here in North America.

David: Great, and for our viewers, we should mention that 3B Medical is getting a lot of attention out there with analysts and investors as an emerging competitor in the CPAP market. Susan, could you talk about the CPAP equipment industry and give us a brief overview of the other players that are out there in the market?

Susan: I see the other three key players as being Philips Respironics, ResMed and Fisher Paykel. All of them have done a really good job and they all have very high quality products. Entering the market at this point, I think we have a high quality product, as well as a good price point. That's where we're going to have an edge. But all of them have developed great sales teams that are well-known in the market. They're known as the big three, and we're not planning to dethrone any of those.

David: You're relatively new to the US market, entering in September 2012. What's the opportunity for a new entry like 3B?

Susan: It's really terrific. You and I previously spoke about Medicare reimbursement and that's where we're getting some PR, some interest as well from the DME's [Durable Medical Equipment suppliers] that are trying to remain financially viable while providing a good product for their patients. I think that's where we come in, and we're a natural fit.

David: Tell us a little bit more of that so that our viewers can really understand this change. What's the change in the marketplace that presents the opportunity for 3B?

Susan: Well, there are several things changing. Round one and round two competitive bidding with Medicare reimbursements has provided an opportunity for somebody like 3B to come in. The round one bids were a test, and Medicare saw that they reduced their cost by about 30%. I mean, that's huge. That's when round two came in. They thought that they were basically going to mirror the results of round one. It kind of threw everybody in to a loop because the cuts have gone much deeper than expected.

With somebody selling a high-priced CPAP, the DME's aren't going to be able to support that because the cuts are so deep. They're going to have to find ways to stay in business. That's where we come in once again.

David: You've mentioned the quality of the product and you've mentioned your lower price points; so I imagine that that's driving business now. How are things going so far? Can you tell us a little about whether or not you're gaining traction?

Susan: They're going excellent. We've doubled our sales every 90 days since we launched in September, so I see that as a really good sign. We are very, very busy.

David: Let's bring in some discussion on the leading competitor out there, ResMed, for a bit. What has been the secret of their success? I mean they're a leader. Is it their products or is there something else that's driving market share?

Susan: Well, they have done an excellent job of branding their products, and they do have good products. Their sales reps have done a really good job for the company, whatever their mission is: working with the sleep labs and the physicians, encouraging them to write prescriptions for their products. They've done a better job, I think, than anybody else in the industry in doing that. They have developed relationships with the doctors, with the sleep labs, and those are the ones that are going to write prescriptions and drive you to the DME to buy a ResMed product.

David: So for the CPAP products, are there really big differences from a patient preference standpoint?

Susan: There's not a huge difference. The 3B products compare very favorably with ResMed, Respironics and Fisher Paykel. We have the RESmart, our registered trademarked CPAP line. This is a very advanced technology. It tracks the patient's respiratory conditions. We have what's called RESlex that makes the sleep therapy more comfortable by reducing the pressure of exhalation and returns to the therapeutic pressure. We've got some software developed in our systems that provides a very comfortable situation for the patient. We have the RESlex in on our base models. I don't think there is base model out there from ResMed or Respironics that can compete.

David: So these products are mostly comparable. What about from the price standpoint, how do you guys compare to the branded products?

Susan: We are well below the branded products actually. We come in 30% or 40% below the branded CPAP products.

David: That sounds substantially less expensive. I want to just talk about the masks for a minute. There's been a new CMS rule that limits when masks used for sleep apnea patients can be replaced. [Mask replacement is a key revenue driver for CPAP manufacturers (think razor/razorblades), and CMS has provided stricter replacement protocols] Has that slowed the growth of mask replacement to your knowledge?

Susan: Probably a little bit. Patients used to replace their masks on kind of a schedule, like an auto-ship type situation. The Medicare changes have negated that opportunity. Now, the DME has to make contact with the patient to find out whether or not they need a replacement. So, yes of course, that has added a little bit to it, but you know, I'm sure the DMEs have figured out a good way to work with that in order to have it work for everybody.

David: I do have a question about the customer. Who is the customer? Is it the physician or is it the Durable Medical Equipment supplier? Who is the actual buyer in the market place?

Susan: That's a good question because I think that's kind of in flux too. Reimbursements have created a different scenario there. If the doctors are writing prescriptions for the branded product, I think they're going to get a little push back from the DME's and HME's because they're not going to be able to stay in business if they are going to be filling these orders with branded CPAP products. I think they're going to be looking more -- in order to stay economically and financially viable as a business -- they're going to have to push back a little bit on that. So, I think that's in flux.

David: It sounds like ResMed has been successful due to the heavy marketing of its branded products. So are they targeting physicians or DME's when they do their marketing?

Susan: I think they have the reputation for marketing to the physicians and the sleep technicians in the sleep labs as well. So, that's going to be difficult for them.

David: So there's an opportunity to be talking to the DME's, that's what I'm hearing, because now they have the cost pressures from the Medicare cuts and now they are likely to push back on the doctors who are prescribing the expensive branded CPAP products; is that fair?

Susan: Yes, absolutely. I would agree with that.

David: Let's talk about branded versus the unbranded CPAP equipment in the market. What really gets the DME's to use other products besides the branded products, like ResMed products?

Susan: I think that with their patient in mind, I would imagine that they are looking for a high-quality product at a price point that will keep their business intact, you know financially viable. I think a lot of times it does come down to price. Again that's where 3B comes in with the unbranded product.

David: So, this is the unbranded segment. And by that, we mean what?

Susan: The unbranded segment, we're talking about generic brands like 3B. Not ResMed or Respironics - not the big three or big four. Branded means that they're writing a branded script, they are writing specifically for a ResMed product or a Respironics product. Unbranded, of course, means that you can go out in the market and use any brand, like a 3B product to fill the order. The DME has a patient come in, and they can say, "OK, show me your CPAP prescription," and then they choose which product to use. Just like generic medications. Probably about 45% of the market is branded. And for the CPAP mask components, it's a little bit higher, about 65% of the market is branded.

David: When it comes to the unbranded again, it's really an economic decision on the part of the DME. They obviously have an incentive to use the lower-priced products so they can make a higher profit, right?

Susan: That's right, or even to stay financially viable with the Medicare reimbursements being slashed.

David: Do you happen to know, of the unbranded segment, approximately how much share ResMed or Respironics has? In other words, that portion of the market where DME's could fill a prescription with either a branded or an unbranded product.

Susan: My educated guess would be that about 80% would be the big players like ResMed and Respironics. They have about 80% of the unbranded market.

David: Interesting. That sounds like a lot of share that could go to unbranded suppliers like 3B if price is really a driver?

Susan: Oh, yes.

David: Back to the Medicare reimbursement cut that we talked about before. As you mentioned, round one was about a 30% cut, which geographically, was only for a small part of the country, maybe 10 or 20%? I think this next cut, round two, affects about 80% of Medicare territories. Is that right?

Susan: Right. So round one was kind of a test, and they had such good results that they thought that they could create a similar scenario in round two. It's kind of turned everybody off because I believe some of the DME's put in really competitive bids on the low end. It's creating a stir in the market place. And it's creating an opportunity for companies like 3B.

David: So, round two, which is now a much larger geography, and is also a much higher cut -- 47%. Now, when it comes to reimbursement, there's Medicare and then there's private health insurance companies. It's strange but in this market, private health reimbursement has actually traditionally been lower than Medicare. Now with Medicare coming down, do you think that the private health insurers are going to try and lower their cost further and get down below the new Medicare rates again?

Susan: I would imagine they'll make a slight adjustment. I don't know if that will be drastic but that's just my feel for it.

David: But the bottom line is, reimbursement is coming down and putting more pressure on the DME's.

Susan: That's exactly right.

David: So what are the DME's doing about this?

Susan: Well, they're going to have to be clever and creative and look for alternatives -- other more attractive prices such as the 3B products. With our products, they can still keep themselves financially viable and their doors open. They can only cut back so many places. The DME also has to provide a good CPAP device in order to make a patient compliant. There's a lot of hand-holding that goes on. You have to have the whole patient care system, services and equipment all adjusted properly. You have to make sure that they're using it.

If you want to get medical reimbursement, [patients] have to comply with the usage of it. You can't buy the machine and put it in your closet. It has to be used. It's not like somebody else can use it or you can turn it on and leave it on your bedside table. You have to use it, which is to your health benefit. That's the biggest problem with the CPAP, is to get patients to be compliant.

To answer your question, the DME's can't cut back on their hand-holding and their respiratory therapists. They have to find other ways to cut back, and one of the ways they can is by not having to spend so much on the CPAP device in the first place; to find an alternative to some of the bigger brands.

David: Are you having a lot of dialogues with DME's about this? What's the level of urgency that they're coming to you?

Susan: Some are wanting to order yesterday. It varies. We have people that want to start using our devices tomorrow and exclusively. We're getting very positive feedback.

David: Now, I understand there's kind of a distinction between the smaller DME's, which have a lot of trouble absorbing the reimbursement cuts and costs, and then the larger national DME's. Are you getting calls from both sides of the industry?

Susan: Yes, we are.

David: Could you say they have a pretty good level of urgency to get started with new products?

Susan: Yes, some of them have already.

David: Let's move to the branded side of the market. As you said, 65% of masks and 45% of the CPAP air generators are branded products. First of all, let's talk about the physician referral. The bigger companies, Respironics and ResMed, market to the physicians. The physicians write a branded script that goes to the DME, which is called the physician referral. How important is that to the DME?

Susan: It's very important because it's a referral source. It sends people to their DME to fill their prescriptions. Their relationships with the doctors in the sleep labs is very important, but in order for [the DME's] to stay financially viable, they're going to have to communicate with the physicians that they can't stay in business if they're writing branded prescriptions. I think they're going to have to have some dialogue, because the bottom line is that they want to provide the best for their patient but they also want to be in business. The physicians need to have a place for their patients to fill their prescriptions. So, it's all a revolving circle. Everybody has to keep healthy, so they have to determine how they can all help each other maintain a healthy economic situation.

David: Do you think 3B and other smaller companies will see a pretty dramatic shift in the marketplace in terms of share, or do you think the big suppliers have to do something about price? How do you see this playing out?

Susan: Well, I think there are lots of different variables involved. Sleep Apnea is just becoming more prevalent as far as its diagnosis goes; there's a lot of room for growth. Sleep Apnea affects every aspect of your health. So, if you look at it that way, I mean the room for growth, we really don't know where it is. Probably 40% of us have Sleep Apnea. I think that the market itself can grow by leaps and bounds. I think there is room for the big three and also for somebody like 3B to come in and create a market share for themselves. I think that the market is going to grow exponentially and that gives us an opportunity, too.

David: Yeah, it does. But I also want to point out that Medicare is clearly focused on this, coming in and changing the way masks are replaced and running the competitive bidding process on the reimbursement. It seems that Medicare is somewhat worried about this line item in their budget.

Susan: Right. And there probably was room for some correction there, too. The mask is a great example because people don't need replacement of nasal pillows every five minutes or every 30 days. Taking a good look at something is very good for the competitive market. The bottom line is you want your patient to be healthy and you want them to be served well. I think it's kind of nice that Medicare can step back and take a good look at things in the marketplace and see what's going. It shakes everybody and makes you more aware of what needs to be attended to, like checks and balances.

David: Right. So, the premium products we'll call them, about what percent of the market do you think that share looks like three or four years out?

Susan: I think they'll maintain a good share of the market, but I think with new companies like our own here in North America, we're going to see a little bit of the distribution of the market changing. I hope so, for our sake because this is what we're counting on.

David: Are you surprised that you are already getting significant calls from the DME's so far in advance of the actual reimbursement change? Can you just remind us when the actual date of the reimbursement change is?

Susan: The change is in June. I'm not really surprised, because if they want to stay financially viable, you're going to look for a way to do that. You can just Google these days and come up with CPAP equipment alternatives, and you go, "Oh, my gosh. There's 3B. Who are they?" No, we're not surprised at all, because we have penetrated market areas and are available out there.

David: It's been a great ramp for you guys. Can you talk about what is the typical replacement cycle for a mask and what has the industry been doing previously that caused Medicare to look at this?

Susan: Basically, it's a 30-day replacement on the pillows, on the different mask parts, and I think on the headband as well. Right now, the one that I'm the most familiar with is our Willow mask -- it's a nasal pillow system. Our full-face mask and our partial-face mask actually are in the works at the moment and going through the FDA process. So, I'm more familiar with the replacement of our parts for the Willow nasal mask. People like to replace this every 30 to 45 days.

Now, replacement of course has to be precedented by actual wearing out of these parts. They're made of a silicon product, so they don't wear out as quickly as one would think. They were being reimbursed at the rate of about a new one every 30 days. As Medicare found out, that really isn't necessary. You purchase a mask, you have to replace it, and they're not terribly expensive. But still, that is an income stream that's now kind of been taken away. Every dollar adds up as you know, so we have to figure out how to address that.

David: I think for ResMed that was the fastest growing component of their business. We'll see how these new rules affect that. So wrapping up here, Susan, longer-term, as a company, where is 3B in a couple years from now?

Susan: 3B/BMC, we'd like to be number four in sleep globally within five years.

David: Well great. Thank you for speaking with us Susan.

Susan: Thank you so much, David. Thank you for your interest in 3B.

Again, read PropThink's coverage of the CPAP space and ResMed in our previous report. We believe ResMed is overvalued as its core business is coming under strong pressure.

Disclosure: I am short RMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: PropThink is a team of editors, analysts, and writers. This article was written by David Moskowitz. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article. Use of PropThink’s research is at your own risk. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. You should assume that as of the publication date of any report or letter, PropThink, LLC and persons or entities with whom it has relationships (collectively referred to as "PropThink") has a position in all stocks (and/or options of the stock) covered herein that is consistent with the position set forth in our research report. Following publication of any report or letter, PropThink intends to continue transacting in the securities covered herein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. To the best of our knowledge and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable, and not from company insiders or persons who have a relationship with company insiders. Our full disclaimer is available at www.propthink.com/disclaimer.

Source: Can ResMed Grow Enough To Support Its Premium Valuation?