Proving it can be done

Proving it can be done

Yesterday Alere (NYSE:ALR) reported second quarter results and during the call Dave Teitel, CFO stated the following:

“Diabetes net product revenues were $74.9 million in Q2 2013 compared to $36.8 million in Q2 2012. Included in Q2 2013 revenues were $56.2 million of mail order diabetes sales compared to $22.8 million in Q2 2012. Q2 2013 revenues include $29.5 million of revenue related to our late April acquisition of a diabetes business from Liberty Medical .Because of the timing of the Liberty transaction, we reached only about two thirds of the Liberty patient base prior to the end of the quarter and have begun serving the balance of the patient base during the third quarter.

As many of you know, effective July 1st, as a result of the CMS round 2 competitive bidding process, reimbursement rates for diabetes strips were cut by approximately 70%. The impact of this rate reduction on revenue will be somewhat offset by our ability to access the full patient base acquired in the Liberty transaction and, as a result, we expect revenues from our mail order business to decrease to approximately $25 million in the third quarter. Despite the decrease in revenues, as a result of negotiated reductions in strip costs from third party suppliers and the addition of incremental personnel to service ongoing patient fulfillment requirements in a low cost setting, we expect the business to remain profitable in the third quarter and beyond. Our cost basis, which we believe to be the lowest in the industry, will position us to compete very effectively for the supply requirements of the significant number of patients who become available as others exit the industry.”

The call also featured the following exchange;

“Anthony Petrone – Jefferies LLC, Research Division

Great, and a couple of follow-ups for Ron. Ron, can you just touch again on where you are in the Diabetes strategy? Did Liberty in April. Are there still assets out there still to be acquired to position the business to be really in line with what your strategy is for Diabetes?

Ron Zwanziger – Chairman, Chief Executive Officer and President

Well, we — as you must have noticed, we’ve not been active in Diabetes. And at the moment, it’s hard to see why we would actually make any more moves, because as we already commented in the quarter, our cost bases for being a supplier is improved no end because we’ve taken, obviously, advantage of the pricing pressure caused by the CMS move and have had tremendous pricing now, enabling us to compete more effectively, therefore, taking down the need to be a direct supplier ourselves. I mean, if we have a dramatic — if we could somehow end up with a dramatic cost basis, I suppose that will be different. But in practice right now, we’re pretty comfortable where we are. We have a number of internal programs to expand further, and we think that in the difficult environment that’s been caused by the CMS decision, we’re very well-positioned to see considerable expansion. And in the short term, that’s where our focus is.”

These statements explain in a nutshell the problem facing every major BGM company. As Diabetic Investor has noted for some time companies like LifeScan, a unit of Johnson and Johnson (NYSE:JNJ), Abbott (NYSE:ABT), Roche and Bayer arte no longer control of pricing and there is little incentive for a company like Alere to acquire any of these units as they now hold the upper hand.  The fact is Alere is following a strategy that worked very well for Liberty before they acquired by Medco.

Back in the day the Medicare business was basically an arbitrage play, the government set the reimbursement rate for diabetes testing supplies and it was up to DME’s like Liberty to buy these strips as cheaply as possible. The lower the strip acquisition cost the larger the profit margin. Liberty played this opportunity to the hilt using their huge installed customer base to play strip manufacturers against each other in order to extort the lowest possible price. Desperate for the volume that Liberty provided the strip companies basically capitulated to Liberty’s demand for lower prices.

The situation isn’t all that different today the main difference being what the government reimburses for test strips. As Mr. Teitel correctly noted this does not mean a company can’t make money in this environment provided they are able to operate efficiently.  It also makes little sense as Mr. Zwanziger noted for a company like Alere to become vertically integrated by buying a BGM company.  Having deep experience in this space Mr. Zwanziger also knows that pitfalls of strip manufacturing and sees no reason not to play all the existing players and many offshore players against each other. What’s the point of spending billions to acquire an ailing BGM company when Alere is in such and advantageous position?

Alere also knows that should they change their mind and want to acquire a BGM company the cost of acquisition will only decrease over time as companies like Abbott, Roche and Bayer become more desperate to sell. Like Diabetic Investor they know that there are lots of anxious sellers but few, if any, willing buyers. Now it doesn’t take an advanced business degree to know that when a situation like this occurs buyers have the advantage.

Even better for Alere they know that while selling diabetes testing supplies may not be as profitable as it once was Medicare patients don’t only need testing supplies. About the only area Diabetic Investor sees Alere acquiring businesses would be additional DME’s.  While there are some larger DME’s the industry is still dominated by many smaller Mom and Pop type outfits that will be unable to compete in this new environment where scale is everything. In an ironic twist Alere is basically duplicating Liberty’s original strategy with the main difference being they will be able to acquire patients at a much cheaper rate and selling these patients testing supplies is only part of the plan. Once the patient is captured Alere can then try and upsell these patients everything they need and that Medicare reimburses for.

Thus companies like Abbot, Bayer and to some extent Roche are facing a major dilemma, lacking the scale of market leader LifeScan and with no one willing to pony up billions to buy their trouble units how do they keep margins somewhat reasonable while at the same increase strip usage. Again as we have noted to date about the only answer these companies have come up with is to slash costs. But here too as we have noted before cutting costs is a temporary fix and does nothing to solve the other side of the ledger, actually increasing strip usage. It will be interesting to see how desperate these companies become and if any or all will eventually just throw in the towel and sell their units at deeply discounted prices.

While it’s true diabetes testing supplies are not the cash cow they once were but this doesn’t mean a company can’t make money here. The key is to have a strategy and vision that fits today’s environment, something Alere has and the branded BGM companies don’t. The fact is most of the major BGM companies are in a state of shock and are ill-equipped to deal with current market dynamics. Rather than change with the times they continue to be live in some sort of fantasy land falsely holding onto the belief that the government will adjust Medicare reimbursement upward and that new product introduction will magically increase strip usage. Put more bluntly more of the same strategies that got them into this mess in the first place.

Once again leave it to Ron Zwanziger to be leaded the charge when it comes to understanding the diabetes testing supply market and adopting strategies that actually work. Welcome back Ron and thanks.