Description

Shares of DaVita are a buy for the following reasons:

• The company has an amortization charge due to the purchase of HCP in 2012 against earnings of roughly $0.50/year (2015 was $0.41/share).  This is unrelated to the reinvestment needs and economic earnings on the business going forward.  Reported Adjusted EPS in DVA 8-Ks and via Bloomberg did not remove this charge, neither do consensus.  These charges are tax deductible as well, so on an after-tax basis the charge is $100mm/yr (~$167mm pre-tax) for the 14 years beginning with the 2012 HCP acquisition.   

• In the past two years, very large litigation payments have depressed Operating Cash Flows by about $300MM each year (inclusive of tax effects).  The pretax amounts are ~$400mm and .~$500mm.  Run-rate OCF going forward is much higher.

• Dialysis business remains a strong business with 3-4% organic growth and 4.5%-5% growth inclusive of tuck-in acquisitions, steady reimbursement rates.

• HCP has underperformed but is being address and may benefit from new rules (June 2016) that will enhance shares savings payments under the Medicare SSP for health delivery networks like HCP.

• Share buybacks of 4%+ per year.  In the first three months of 2016, DVA bought back 4% of outstanding shares and exhausted half of its buyback plan.

Overview

Davita is the largest owner operator of dialysis facilities in the United States, under its Kidney Care division.  DVA had 190,000 patients, 26 million treatments, and 2,369 centers for 2015.  For comparison, the other 800 lb gorilla in the industry is Fresenius Medicare care, which had 2,200, 27.7 million treatments and 183,000 patients.  Through its HCP division, the company also owns and operates a healthcare delivery network largely through an ACO structure where HCP primarily receives fixed or capitated payments or bonus payments in the form of share savings its produces for payors – commercial/managed care, Medicare, and Medicaid. HCP has $5.0 billion care dollars under management, and 800,000 patient lives.

The company’s stock trades at $76/share currently, with a 52-week range of $61 to $82 and shares outstanding of 206.5 million, for an equity cap of $15.7 billion.  Cash is $1.4 billion. Total debt is $9.1 billion and non-controlling owners represent $1.1 billion of book capital. DVA historically earned impressive returns on capital.  ROIC was consistently 11-12% and ROE low to mid 20%.  Then in 2012 HCA was acquired.  The business is now in aggregate a high single digit ROIC and mid-teen ROE.  In the first 3 months of 2016, DVA bought back 4% of its total share count at an avg. price of $67, leaving half of its ~$500mm repurchase plan remaining.

DVA has generated more than $800MM in FCF (CFO less CapEx) in each of the last 3 years.  Moreover, 2014 and 2015 FCFs are depressed due to $410MM and $494mm litigation-related payments, respectively.  Operating Cash Flow guidance implies FCF of more than $900MM for 2016, or ~6% of market cap.  DVA equity trades at 20x trailing EPS, 19x 2016 consensus and 17x 2017 EPS.   DVA has about $7/share of cash.  2016 consensus PE is 17x adjusted for cash.  The business will grow EPS at the high end of its longer-term EPS forecast of 5-12%. 

Optically, there are few catalysts within this company.  The stock has moved around a bit but is largely unchanged over the past two years.  There’s no dividend and a decent amount of debt.  Its HCP (or now Davita Medical Group or DMG) has underperformed since the time of acquisition in 2012 and Dialysis is a major budget item for Medicare at a time with health costs are a political lightning rod.  The little international exposure DVA has (124 dialysis centers of its 2,402 total) is operating at a small loss in 2016, guided at -$40MM).  Furthermore, shortly after Berkshire acquiring a stake (more a Weschler decision than a Buffett decision by the way), the company signed a standstill agreement to prohibit BRK’s ownership above 25% of DVA capital stock.

However, the company is on pace to re-accelerate its capital compounding.  Dialysis continues to be a remarkably steady, consistently growing business.  ESRD patients are living longer, new incidences continue, and aging demographics could accelerate dialysis volume.  HCP is being fixed by management and CMS recently pushed through rules that will increase share savings payments (within the Medicare Shared Savings Program or MSSP) with ACOs, more so than under the previously written set of rules.   The company is cash and cash generation rich, with $1.4 billion on its balance sheet and likely to hit $1.0 billion in FCF in the next year or two.  It’s share repurchase program of approx. $500MM is half exhausted, enticing the Board and Mgmt to put in place a new, larger program in the near future.

The future demand for hemodialysis is as follows. 

• Diabetes and hypertension are leading causes of ESRD, both cited as a primary factor for more than 2/3rds of ESRD incidences. 

• Hispanics are 1.5x more likely and African Americans 3.5x more likely to develop ESRD than whites.  Regardless of ethnicity, chances also increase with age.   According to ESRD data, the median age to begin ESRD therapy (primarily dialysis) is 64.  This figure has been perfectly unchanged over the past 10 years, yet over the same period the median age of prevalence has risen from 57 to 59.2 because dialysis and other measures have allowed ESRD patients to live longer.  Likewise, the incident rate per million has been largely flat while the prevalence rate per million population (in the U.S.) has risen from 1,513 to 2034 over the 10-year period ending 2013.

• More than 100,000 new ESRD cases each year (117,000 for 2013).    The CDC estimates more than 20 million Americans have Chronic Kidney Disease (CKD), which can lead to ESRD.

• Dialysis is a 3-4 hour procedure that patients must undergo 3x per week for life aside from the very select few that receive a kidney transplant.  Accordingly access to care is critical and familiarity with a provider is important.

• The table below shows the trend in reduced mortality rates and longer ESRD patient lives, continued growth in new incidences and resulting prevalence growth.

The investment thesis pitch for legacy DVA (dialysis only, pre HCP acquisition) was always this:

• Steady organic growth of 3-4% per year.  Kidney disease prevalence in the U.S. grows at a steady 3% per year.  In-center hemodialysis represents ~92% of treatment modality.

• Recurring, non-discretionary demand. Dialysis is obviously a very non-discretionary, highly recurring treatment.  Patients must undergo dialysis 3x per week for life, unless they’re the select few that receive a Kidney transplant.

• Low Reimbursement Rate Risk.  Dialysis is essentially a single reimbursement code, meaning if CMS squeezing rates too much, the smaller 1/3^rd of the market that are mom  & pop operators could vanish. 

• Larger, high volume operators realize scale economies.  The 2014 Medpac report on dialysis showed that the lowest quintile volume dialysis facilities operate at a -13% Medicare margin while the highest operate at 9.4%.  cost per treatment were as little at $220 (in 2012) for the highest volume facilities and more than $310 for the lowest volume sites.  In aggregate, medpac cited that the two largest operate at a 4.2% Medicare margin (this excludes commercial pay of course) while all others were slightly below at 3.5% margin.  The lowest 40 percent volume facilities operated at -3.4% margin or less.

• Immaterial bad debt.  Medicare provides essentially universal coverage, regardless of age.  If you are 35 and covered by a commercial payor, they will cover you for 30 months and then drop you, after which you can sign onto Medicare.  Naturally, bad debt is particular low relative to hospitals.

• Acquisitive growth opportunities for another 1-2% per year in volume gains and high synergy opportunities.  DaVita has about 1/3^rd of the U.S. dialysis market, Fresenius has about a third, and the other third is smaller, inefficient (higher cost) “mom & pop” operators.   DVA and Fresenius often consolidate facilities which makes perfect sense.  Labor within a single facility is largely fixed, either helping a patient on a dialyzer or sitting idle.  The more throughput a facility has, the lower nurse and tech idle time.  Scaling of G&A overhead is another more obvious synergy.

The results were 3.5-5% per year in non-acquired growth (organic to the extent that facility new builds and expansions capture volume and in some cases market share).  Supplemented by financial leverage, cost savings on tuck-in and large acquisitions, and share buybacks, EPS grew even faster year after year.

At end of year 2015, DaVita had 2,402 facilities serving 192,000 patients.  All but 124 are in the United States.  In the quarter ended 3/31/16, DaVita’s dialysis operations performed 85,236 treatments per day representing 6.6 million treatments over the quarter.

In 2012, DaVita, which had always expressed supreme conviction and confidence in the future prospects of the U.S. dialysis industry, did an about-face.   They made a major non-dialysis acquisition when they acquired the healthcare delivery network that was HCP or now known as DaVita Medical Group.

HCP is an interesting business especially considering the push to quality based care versus fee for service care.  HCP largely contracts with payors under a share-savings model.  HCP operates typically on a capitated or risk-based contract basis, for payors. HCP was one of the so called Pioneer ACOs in the Medicare program.  The capitated payment structure is similar to the insurance industry, where float exists as revenue payments are received before costs are realized and paid.

Essentially, HCP pays primary care physicians to leave acute slots open so patients with low-acuity health needs don’t need to rush to the Emergency room.  The also pay physician practices for longer office hours, for the same ER reasons.  HCP proactively checks prescription refills and prescription medication adherence, since failing to take meds is often a driver behind some admissions.  HCP lowers (not raises) the cost to physician visits via low deductible so patients seek care sooner rather than later (ounce of prevention…). Finally, HCP does not own Acute Care hospitals, because these are the highest cost sites of care in a cost-focused model.  HCP pays to have their own hospitalist, rather than to rely on the Hospital’s hospitalist, because it knows its own people will discharge patients sooner (if appropriate).  The results are proven in HCP’s Chronic Obstructive Pulmonary Disease case study: Drug costs up 3% (a small cost to incur), physician visits up 30%, Hospital admissions down 30%, Bed Days in hospital down 39%, Emergency Department visits down 23%, all-in cost of care down 34%.

In June 2016, CMS finalized the new rule for the MSSP that is absolutely a positive for DVA’s HCP.  (The actual rule can be found here: https://www.cms.gov/Newsroom/MediaReleaseDatabase/Fact-sheets/2016-Fact-sheets-items/2016-06-06.html  Or the full 500+ page version here: https://s3.amazonaws.com/public-inspection.federalregister.gov/2015-14005.pdf ) Previously, bonus payments were largely based on national cost data and a provider’s own past results.  As an already highly-efficient provider that has practiced the ACO model for two decades – HCP’s past results were already great.  The new rule will base bonus payments on cost savings relative to FFS regional benchmarks. It’s important to note that the rule was finalized after DVA’s analyst day in May 2016, where mgmt. projected 5-9% CAGR in Operating Income for HCP for the 2016-2019 period.  Absent from this bridge of 2016’s midpoint OI guidance of $200MM to $250MM by 2019, is any numbers around the benefit of the new rule.  During its investor day, DVA mgmt. said their moving another 60,000 beneficiaries to a fully risk-based contracts, that would capture upside through the MSSP or through the spread on capitated payments.  The MSSP new rule should be favorable for HCP’s legacy contracts and new conversion.

Capital Allocation

Capital allocation has historically be very balance between debt paydown, share repurchases, growth capex, and acquisitions. Per its analyst day, over the 2016-2019 4-year period DVA says it will generate operating cash flows of $6.75 billion of operating cash flows after non-controlling distributions.  Another $2.9 billion will be allocated toward capital investment, split evenly between maintenance investment and de novo/expansion capex.  The company is forecasting acquisition spend of $1.15 billion, which leaves management with $2.7 billion of cash available for debt paydown, share repurchases and dividends.  This is quite a bit of gun powder to return cash to shareholders, given DVA’s market cap is currently $16 billion.  Recall DVA has $1.4 billion of cash on its balance sheet as of 3/31/2016 although some is float needed to service medical care expenses with HCP (now DMG) from contract payments already received.

The Amortization charge due to HCP acquisition

The 2012 acquisition of HCP resulted in a step-up of amortizable intangible assets of $1.4 billion (per page F-44 of the 2012 10-K), to be amortized over 14 years and also deductible for taxes. The after-tax effect is approximately $100mm/yr or about $0.50/share.  In 2015, it was $0.41/share.  Management does NOT add these charges back in its headline Adjusted EPS number although they do reconcile near the end of each earnings release to a figure that has no title.  See table below from the 2015 earnings release.  Note that the $3.83/share is the reported Adjusted EPS by mgmt. and also on Bloomberg, while the $4.30/share, which backs out the amort charge) is lost in the netherworld.

Moreover, these are not recurring economic charges and not indicative of reinvestment needed to sustain the business, beyond already realized cash expenses each period.

Furthermore, it does not look like sell-side gives any acknowledgement to this figure either. 

Price Target

We price DVA shares in 2019 at $124 for a 17% CAGR.  This prices DVA at 20x cash EPS (which fully backs out the noted HCP amortization charge on an after-tax basis).  

We arrive at Dialysis EBITDA (net of G&A allocation) of $2,780MM using 2,841 centers using 4.5% facility growth and treatments per facility per day of 36, for treatments of 32,000,000 and gross profit per treatment of $112 (vs $110 in Q1 and $113 in Q4 ’15).  G&A allocation falls from 8% to 7.5% revenue to reflect scale.

For HCP, we bump mgmt’s long-term 2019 OI forecast by 2.5% because 1) management has egg on its face from this business underperforming since they acquired it four years ago and they probably don’t want to set the bar too high going forward, 2) mgmt. has experience as good operators with the dialysis business and seems keen on fixing HCP, and 3) some slight uplift from new MSSP rules that should allow certain contracts within HCP to capture more economics.  For 2019, this results in OI of $250mm plus an assumed $220mm in D&A (approx. $160mm which is related to the step up amortization charge), yielding segment EBITDA of $476mm.

Total debt of $9.1 billion is largely termed out beyond 2020 and yields 4% in the market.  No reason to aggressively pay this down and as a result, interest costs are held flat along with total debt.  Taxes are 40%.

Using current price of $77, shares outstanding are reduced further through buybacks at $500MM/yr (plus $250MM for rest of this year) of repurchase spending to reduce shares by 6.5mm or ~3%/yr, leaving 183 million shares at year end 2019 or ~186mm avg for the year to compute EPS.

Catalyst

• Amortization charge related to previous acquisition, that is unrelated to go-forward economics of running and reinvesting in the business, that is no adusted for by management nor by sell-side, of approx $0.50/share
• litigation payments of 2014 and 2015 depressed reported OCFs materially, 2016 will screen signficantly higher (approx $300mm higher) vs. trailing figures.
• Mgmt (finally) fixes HCP and with less harmful reimbursement headwinds to finally grow rather than contract the segment's Operating Income.
• Shares buybacks of 4%+/yr
• Taco Bell / DaVita Dialysis partnership that brings direct and immediate revenue synergies: