Consolidation TrendsNovember 2nd, 2007 | Income Approach & Methods
In the June 2002 Business Valuation Review, I had an article addressing the crossover of fair market value and strategic value in consolidating industries. In that article, I looked at the history of the Physician Practice Management Companies and how the buying frenzy of the 1990s had driven up the price and lowered the perceived risk of physician practices. My article with Ken Patton of Mercer Capital in the current (Fall 2007) edition of CPA Expert addresses a similar issue with respect to the purchase of Home Health Agencies in the Deep South during the mid-1990s in anticipation of the replacement of Medicare’s cost-cased reimbursement system by a PPS.
A variety of market conditions can lead to consolidation. One such circumstance appears to be developing now with respect to Imaging Centers. The dramatic cutbacks in MR, CT and PET from the Deficit Reduction Act have significantly reduced the revenue and therefore the profits of physician-based imaging. Not widely recognized is that the practice expense component for imaging under Medicare’s RBRVS assumes that imaging equipment is utilized only at 50% capacity; the House version of the vetoed SCHIP legislation would have raised the volume assumption to 75%. Thus, the high fixed overhead of expensive imaging technology is recovered over a low volume of procedures, resulting in a high revenue per unit! This type of structure makes high volume providers very profitable, while low volume providers – and particularly those below breakeven – may be big losers. The impact of the DRA has been to raise the breakeven volume requirement for imaging and to make sale to a higher volume, or combination with another low volume, facility a more likely course of action.
Thus, I think we are seeing a developing trend of consolidation of low volume providers by financially stronger entities who can take advantage of the low marginal cost of imaging beyond breakeven volume. A principal issue for the selling entity is the capital invested in the equipment and whether the selling price is sufficient to pay off outstanding debts, such as long-term equipment leases common to the industry. Those potential sellers facing the choice of investing in new (or refurbished) equipment may find selling more desirable, particularly if the buyer has already invested in the newer technology. The buyers will find the added volume very attractive of course, particularly given some of the indications that future cuts may be forthcoming, resulting in lower margins per unit beyond breakeven volume.
The valuation analyst has to consider what normalization adjustments are appropriate in such a circumstance. As I noted in the Caracci article “it might be appropriate to value a subject in a sector that is being consolidated on the basis of consolidator transactions if the consolidators are active in the subject’s service area. In that case, otherwise strategic adjustments such as a lower cost of capital, higher growth rates, and lower operating costs might be appropriate normalization adjustments in an income approach.” This is consistent with long-established if not well-understood valuation theory about the meeting of strategic and fair market value.
You can follow any responses to this entry through the RSS 2.0 You can skip to the end and leave a response. Pinging is currently not allowed.