Description

Investment thesis

This risk arbitrage opportunity has arisen (we believe) in the wake of the contested AT&T/Time Warner deal. NxStage (NXTM), a US-based developer, manufacturer and marketer of home dialysis machines for patients with kidney failure, is being acquired by its customer/competitor Fresenius Medical Care (Fresenius). Fresenius offered $30.00/share in cash to NXTM shareholders, in an approx. $2bn transaction. The spread has widened from 2.5% the days after announcement and 8.8% after FTC’s “second request” to 22.1% now. In our view the antitrust risk, while significant, has not increased as dramatically as the spread and we’re being compensated for assuming it.

Downside

The takeover premium is practically gone. NxStage is now trading around the closing price on August 4, 2017, the last trading day prior to the public announcement of the execution of the merger agreement, adjusted by the breakup fee ($23.14 + $1.50). NxStage’s volume weighted average trading price for the 180-day period ended August 4, 2017 was 9% higher from here (adjusted for breakup fee). The 52-week low is down 11% from here (adjusted for breakup fee) ($20.45 + $1.50). Concurrently with the deal announcement NxStage reported disappointing financials but this was somewhat offset by FDA clearance of its System One for solo home hemodialysis, without a care partner.

US antitrust risk

NxStage shareholders approved the deal and German antitrust regulators cleared the deal quickly but FTC issued a “second request” on October 18, 2017, which remains the main hurdle. Fresenius will be required to pay a $100 million (5%) breakup fee if antitrust approval is not obtained (approx. $1.50/share). Fresenius will not be required to litigate or divest assets other than certain (presumably irrelevant) NxStage assets.

Market concentration

The key to NxStage’s business and to this deal is the System One portable dialysis machine sold to clinics that in turn provide it to patients for home treatment. DaVita HealthCare Partners (DaVita) and Fresenius split 2/3 of the dialysis clinic market in the U.S. and are NxStage’s two largest customers for products used in the home. Collectively, they provide treatment to around two-thirds of NxStage equipment users.

Dialysis patients have a variety of available treatment options. Although they differ in how they work, all provide the same basic function: removing waste and fluids from the body when kidneys no longer can. By far the most common is in-center hemodialysis (HD), accounting for 88% of the US market. The market for in-center equipment is concentrated with Fresenius and Baxter accounting for over 60% of the global equipment market with B. Braun with 5-10% and a variety of smaller players making up the rest. Peritoneal dialysis (PD) is the most common home dialysis treatment, allowing patients to dialyze at home, at work or on vacation. It’s another concentrated device market with Baxter and Fresenius as the leading players. NxStage is developing its own system for this market. Home hemodialysis (HHD) is another home treatment method, more difficult and not always suitable for the patient and the smallest slice of the market. System One is the only FDA-approved portable home hemodialysis machine, though there are other systems under development. Fresenius itself has the only other alternative machine that can be installed in the home (not portable).

Precedent

Medical devices and dialysis are areas of intense scrutiny for the FTC and few are more experienced at dealing with antitrust issues than Fresenius. The FTC looks at whether the combined company can unilaterally exercise market power, customers would be forced to pay higher prices and customers would experience lower levels of innovation. There’s a variety of options for dialysis, much more widely adopted than HHD, and you can substitute them, which will mitigate pricing power. While NxStage has been the only innovator lately there are at least two new well-funded HHD entrants with portable, consumer-friendly machines that are working toward FDA approval.

EU has debated as to whether to consider HD and PD one or separate product markets until in 2013 EU in its review of the Baxter-Gambro deal stated that three “separate products markets” exist: (i) peritoneal dialysis ("PD"), (ii) hemodialysis ("HD"; NxStage was included in this market) and (iii) continuous renal replacement therapy ("CRRT"). The latter market was presumably not recognized as separate by the FTC in 2013 when it granted Baxter-Gambro early termination of waiting period. We are unaware of the FTC recognizing any sub-markets to hemodialysis thus far.

While the HD market is concentrated and Fresenius already has 30-40%, the increment of absorbing NxStage is <2% and likely doesn’t alter the competitive dynamic. Baxter is a strong competitor and B. Braun has meaningful share also. EU has determined that barriers to switching are generally low. Chances are the deal closes if this market definition is used.

The combined NxStage-Fresenius would account for the whole HHD segment and if this were the defined product market the deal would likely fail.

NxStage also sells its machine for use in the Critical Care setting for CRRT. The small machine has fewer advantages there given a variety of competing manufacturers such as Baxter, Fresenius, Nikkiso, B. Braun Medical and NxStage has little share. NxStage’s In-center segment sells blood tubing sets and needles with a variety of competitors. Additionally, NxStage operates 21 loss-making dialysis clinics that could be divested or shut down.

Insiders

One insider, SVP and General Counsel Winifred Swan, has kept his Rule 10b5-1 trading plan going under which he’s been selling 3.5k shares monthly since September 2016. But a few others have stopped their plans such as President Joseph Turk (last sale Oct 2017) and CFO Matthew Towse (last sale Sept 2017). 

Timing

The deal is expected to close during 2018.

Risks

The biggest risk is the antitrust review.

Catalyst

Deal closing.