Barron's Features
Diagnosis Pending
Medicare policies, government inquiry might be the keys
to PolyMedica's health
By CHERYL STRAUSS EINHORN
There are 16-25 million diabetics in the U.S., and their ranks are
expanding by 3%-4% a year. This unfortunate growth spurt has placed
additional strain on the nation's medical system, and led to higher expenses
for diabetes patients, treatment-providers and insurers. But the escalating
prevalence of diabetes has been a boon for distributors of diagnostic
devices such as PolyMedica, the country's largest provider of diabetes
home-testing kits.
Sales of diabetes products accounted for 80% of PolyMedica's $157
million in fiscal 2000 revenues (for the year ended March 31), and have
helped drive earnings higher in each of the past 15 quarters. PolyMedica's
shares also climbed in the past year to a recent high of 62 from a 52-week
low of 14.69. Late last week, those shares were trading above 52, giving
the company a stock-market value of almost $700 million.
Barron's has learned, however,
that the Federal Bureau of
Investigation is probing
PolyMedica and its Liberty
Medical Supply operation. A
senior official at the FBI
confirmed that inquiries into
possible health-care fraud are
being conducted by the agency's
offices in Chicago, Omaha,
Tampa and San Juan, Puerto
Rico. This official says the oldest
case dates back to 1995, while
the latest was opened in the past 12 months.
Government officials in other federal agencies have also substantiated the
existence and nature of these inquiries. "I am familiar with this
investigation," says one senior official in a division of the Department of
Health and Human Services. The department investigates matters for the
Health Care Financing Agency, which oversees the Medicare system.
"It is ongoing," this official adds.
The FBI as a matter of policy wouldn't confirm or deny that an inquiry is
under way. But two government officials indicate the probe may relate to
both billing and marketing practices involving diabetic-testing products
used by Medicare beneficiaries. PolyMedica boasts a database of
approximately 265,000 Medicare-eligible persons, or 4.2% of the nation's
6.3 million seniors with diabetes, and 64% of the company's revenues are
subject to Medicare reimbursement.
PolyMedica's founder and chief executive, Steven Lee, denies any
knowledge that the FBI has been looking into the company's affairs. "We
are the White Knight in the [diabetic] industry," he says, referring to
PolyMedica's business practices. "I am not aware of any investigation."
When asked a second time whether the FBI was probing the company,
Lee responded, "Of course not."
PolyMedica, through the Liberty Medical brand, primarily sells -- or more
often gives away -- a diabetes test kit called a glucometer. Patients use the
device to test their blood glucose levels, some as frequently as one or more
times a day. The company's growth, and its hefty 20% operating margins,
have derived from the same razor/razor-blade model that propelled Gillette
to prosperity: glucometer users perpetually must replenish their supplies of
paper strips, creating a steady income stream for PolyMedica.
PolyMedica has relied on an aggressive
advertising campaign to attract test-strip
customers, most of whom receive their glucose strips by direct mail. CEO
Lee brags that "PolyMedica pioneered the use of national television
advertising as a medium to reach consumers in their homes." The company
advertises in both English and Spanish, and its diabetes ads feature actor
Wilford Brimley.
This year, PolyMedica also has added radio to its mix, launching its first
national radio campaign featuring veteran talk-radio personality Paul
Harvey. The company employs unusual, but legal, accounting practices
with regard to its advertising spending, capitalizing costs rather than
expensing them. But more about that in a moment.
Let's take a closer look, first, at a pair of controversies swirling around the
diabetes test-strip market. Senior government officials close to the matter
note that the FBI has been made aware of two studies, published in June
by a division of Health and Human Services, that relate specifically to
widespread Medicare-payment problems as well as marketing practices in
the diabetic-testing industry. The studies detail inappropriate Medicare
payments to makers of blood-glucose test strips, as well as questionable
marketing tactics relating to the sale of these strips to Medicare
beneficiaries. "We found both documentation and utilization problems,"
says Rob Vito, the Philadelphia regional inspector general for the federal
Office of the Inspector General, under whose direction these studies were
conducted.
To begin with, the studies assert, industry advertising can be misleading, in
part because some companies have offered inappropriate sales
inducements, such as free glucose-monitoring kits, in an attempt to sell
more paper strips. Moreover, some glucose-strip suppliers have continued
to mail customers unsolicited products, in direct contradiction to a 1998
law banning such practice. Almost 60% of Medicare beneficiaries
interviewed in a 1997 study, for instance, indicated they had received test
strips from suppliers on an automatic basis, rather than on request. Six
months after the law's passage, almost 50% were still receiving automatic
shipments, according to a follow-up study.
The Inspector General's Office initially collected data from 555 Medicare
beneficiaries and glucose-strip suppliers, whose claims for test strips were
paid in 1997. Not only were beneficiaries filling out their Medicare
paperwork improperly, but "people were getting more supplies than they
needed," Vito says.
In total, Medicare paid out $79 million for blood-glucose test strips in
1997 on claims with flawed documentation. The government paid out $33
million in test-strip claims with insufficient documentation, and $46 million
in claims that lacked incomplete order information or supplier delivery
records.
These studies, it should be noted, didn't mention specific suppliers by
name. "A number of companies came up as we conducted the studies,"
says Vito. "And while we did not focus on companies-our job was to look
at the system-we found problems with many companies. Liberty is clearly
large and they are expanding from diabetic test strips into inhalation
[respiratory] products, another area where we have been saying Medicare
is paying too much money."
With regard to glucose test strips, he says, "Medicare is paying too much
for diabetic strips."
Medicare could decline to pursue fraud cases against glucose test-strip
marketers. The government might blame itself instead, for paying out
money on insufficiently documented claims. In any case, though, a cut in
reimbursements would crimp if not cripple PolyMedica's margins, as 70%
of the company's revenues in its most recent fiscal quarter derived from
Medicare billings on behalf of customers.
PolyMedica's Lee says he is unaware of problems in the glucose-testing
industry relating to Medicare reimbursement or marketing to Medicare
beneficiaries. "Never in diabetes, not a single case," he says. "I have not
seen anything."
When Barron's pressed the issue, citing the studies discussed above, he
acknowledged having heard "summaries" of them. But he added, "We
never have those problems. I think Medicare is extremely pleased with us.
We welcome better scrutiny."
As for findings of misleading advertising and automatic shipments common
in the industry, he denied that PolyMedica ships strips without prior
authorization or engaged in any wrongdoing.
PolyMedica's method of accounting for advertising spending raises
interesting questions. Instead of expensing ad outlays as they are incurred,
as most companies do, PolyMedica capitalizes its advertising costs as an
intangible asset on its balance sheet called "direct response advertising,
net." This enables the company to delay the recognition of expenses, and
makes reported earnings higher than they would otherwise be if
management used a more conservative- and more customary-accounting
treatment.
PolyMedica's approach is by no means illegal, although, as noted, it's
hardly the norm. But the Securities and Exchange Commission has
frowned on such accounting treatment in the past. Notably, regulators
encouraged America Online to write off its capitalized advertising costs a
few years ago. As a result, a compliant AOL was forced to take a big
charge against earnings.
PolyMedica notes in its own SEC filings that it is subject to similar risk.
Under the heading "factors affecting future operating results" in its
September-quarter filing, the company discloses that "shortening or
eliminating amortization of our direct-response advertising costs could
adversely affect our operating results."
In fact, the document notes, it "could result in accelerated charges against
our earnings."
In the fiscal year ended March 31, PolyMedica capitalized $21.4 million of
direct-response advertising, while amortizing and charging to selling,
general and administrative expense $9.0 million of advertising capitalized in
previous periods. The difference, $12.4 million, is equal to 46% of
PolyMedica's income from operations for the year. PolyMedica earned
$1.27 per diluted share in fiscal 2000 and is expected to earn $2.08 in
fiscal 2001 and $2.44 in fiscal 2002. In the latest quarter, the company
capitalized $7.8 million of advertising, while amortizing $4.6 million
capitalized previously. The difference of $3.2 million is roughly equal to
30% of Polymedica's income from operations in the quarter.
As of September 30, "direct response advertising, net" totaled $35.9
million, almost as much as the company's $36.1 million in retained earnings.
In other words, most of PolyMedica's historical earnings exist because of
the capitalization of its advertising expense. Lee explains that the company
capitalizes its advertising expense because "PricewaterhouseCoopers
[PolyMedica's accountant] said it was the only appropriate way to do it. If
we expensed it, it would understate our current earnings and overstate our
future earnings.
"I consider the ads an asset," Lee adds. He claims they serve two
purposes: they've made the Liberty Medical name into a national brand,
and they act as a "guilt reinforcement," reminding negligent diabetics to test
their blood-sugar levels.
Lee considers PolyMedica's customer base of "sick seniors" another asset.
The fact that "our customers have stayed with us," he says, validates the
accountants' opinion that capitalizing advertising expense is "the correct
way to treat it."
That may be so, but many companies, from McDonald's to Procter &
Gamble, spend huge sums on advertising and have established global
brands. No one doubts the value of these brands in attracting and retaining
customers, but the cost of advertising them doesn't appear on the
companies' balance sheets.
PolyMedica's customers might be a loyal bunch indeed, but shareholders
are another story. According to Federal Filings, which tracks insider
transactions, four company executives, including Lee, sold a total of
89,825 PolyMedica shares, at prices ranging from $55 to $60.07, in the
final week of October. Depending on the outcome of the FBI's
investigation, any reduction in Medicare reimbursements regarding glucose
strips, or a change in the company's accounting methods, other
shareholders eventually might opt to sell their shares, as well. |
