Description

Overview

I recommend DaVita Inc. (DVA) as a long with a target of $105, ~50% above today’s price and a 6-12 month timeframe. The elevator pitch is: DaVita is divesting a non-core division by the end of 2018 that contributes no profitability for $4.9B (tax basis $4.4B) and using the vast majority of the proceeds to buy back shares. Pro-forma for the sale, it trades for 6.6x EBITDA vs. a historical average of 9.4x (both 5- and 15-year averages); at this level, it overly prices in the multitude of negative headlines regarding DVA and dialysis industry in general, creating an asymmetric risk profile. With uncertainty clearing by year-end, the stock should rerate back toward historical averages.

The long thesis is predicated upon the following:

1. Completion of the $4.9 billion divestiture of DaVita Medical Group to Optum (UNH)
   1. PF for DMG sale, DaVita trades for 6.6x EBITDA vs. historical average of 9.4x (5- and 15-year averages) [Appendix A]
   2. Despite HSR’s second data request in June 2018, the deal does not appear to be contentious given the massive managed care market size and level of competition, with most major insurers having a platform
   3. Management is using the majority (I model ~75%) of proceeds from the DMG sale for share repurchases; as part of this, they have added an incremental $1.0B term loan to perform a levered buy back before the sale is completed, acquiring >$1.0B during Q2 alone, before the market catches on (Appendix A)
2. DaVita operates in a positive market environment against a favorable demand and recently stabilized reimbursement backdrop, which the Street is overlooking; this is important because 115% of profit, and 33% of revenue, come from the 10% of patients with commercial insurance
   1. Volume has grown at a steady 3.8% CAGR from 2000-’15 (last year of data)
      
   2. DaVita has secured long-term (~5-year) contracts with all major payers, providing stable pricing underlying that segment after a six year assault from major insurers on dialysis reimbursement
   3. In 2015, seeing an opportunity, DVA attempted to provide charitable premium assistance (“CPA”) to patients for public exchange insurance to boost reimbursement; this was, not surprisingly, shut down. However, a full 2.0% of total patients were receiving CPA for exchange plans which has been running off over the past ~1.5 years
      
      
      1. Assumptions about continued pricing pressure given the past six years
      2. Depending on how CPA for exchange plans is modeled, it makes commercial pay pricing appear to continue its former rapid decrease
   4. Street expectations about commercial pay to remain depressed. This is due to:
3. Headwinds from regulatory impacts are more than modeled in, and resolution should prove they’re overblown; these include:
   1. The California assembly and senate passed SB 1156 on 8/30; the stock dropped 9% despite a likely EBITDA impact of no more than 3%, which was seemingly already priced in [Appendix B]
   2. California’s union (SEIU-UHW) push on a ballot initiative is feared to render the state largely uneconomical; management has guided to $100-250M of impact on operating profit, but industry sources indicate it is likely to be below the low end given California is, per an industry source, a “horrible, absolutely horrible” reimbursement state today
   3. The American Kidney Fund’s (“AKF”) operations continue largely unimpaired (<15% total EBITDA impact); the Street has priced in a major wipe-out of the AKF, which would lead to massive access shortages due to facility-level economic losses; this is unlikely as the AKF effectively subsidizes government payers, which is well known in government circles and federal legislation (PATIENTS Act & Opioids Bill) are extending dialysis reach
   4. Management is conservative in filings and press releases, using them to push their current agenda and combat potential negative industry developments vs. pump their shares in the short-term

Company Description

DaVita Inc. provides dialysis treatment to patients with End Stage Renal Disease (“ESRD”), primarily from its own branded and operated outpatient facilities. ESRD patients are among the most acute and require 3.5 hour treatment 3x / week, with alternatives being a kidney transplant or fatality. Due to the increasing prevalence of certain risk factors for ESRD (aging, obesity, hypertension, and diabetes), dialysis patients have grown at a 3.8% CAGR from 2000-’15 with low variability. 87% of revenue and >100% of DVA profit come from the US dialysis market. The dialysis market in the United States is highly concentrated, with DaVita and Fresenius (FME) equally splitting ~80% of the market (next largest, American Renal, is 3%).

DaVita also operates DaVita Medical Group, which is held for sale to Optum for $4.9 billion. That business unit was acquired for $4.4 billion in 2012.

Valuation

DaVita currently trades at 8.5x on a headline basis (using covenant EBITDA from their press releases), 6.6x PF for the DMG divestiture, and has levered to 3.99x in Q2-18 as it aggressively buys back its own shares ahead of the DMG divestiture. CapIQ screens show it at 9.4x EBITDA, which would not make the Company appear as overtly statistically cheap for screens.

Note: assumes minor transaction cost and tax cash leakage from DMG (for convenience and illustration, equal to balance sheet assets held for sale – liabilities held for sale)

If DVA returns to 9.4x EBITDA (15-year and 5-year averages) without too significant an impact to the AKF and California ballot initiative, shares should appreciate ~50% to the price target ($105); clear of these issues, the stock could also re-rate higher in the market or be bought out at a premium, which could drive to a 100% return.

Should the AKF be impaired, it will most likely be <15% of EBITDA impact (assumes insurers' power to reject patients be expanded nationally in a ways similar to California SB 1156) and California’s ballot initiative provide $100M headwind (low end of management's conservatively guided range), DaVita still currently trades close to 8.0x EBITDA PF for the sale of DMG. This should bound the downside at somewhat flat, as it is unlikely the stock would depreciate much further permanently once the reimbursement uncertainty cleared. In the bear case, the multiple could re-rate to 7.0x in that case, implying ~15% downside.

This creates an asymmetric payoff ratio of a 50% base case: -15% downside case (>3:1) with probability skewed to the positive. An unlikely upside exists up to ~100% in a buyout of DaVita, though this is hardly worth banking on.

Thesis

Market volume dynamics for dialysis are incredibly stable with multiple tailwinds:

• The patient base is inelastic (mortality without treatments 3x / week) and grows at a 3.8% CAGR 2000 – present due to an aging population burdened by risk factors common in the US (hypertension, obesity, etc.)

• Duopolistic competition, with DaVita and Fresenius (FME) splitting ~80% of the US market

• Little new entry due to lower cost to operate and serve for incumbents (DVA and FME)

In addition, for the first time in a half-decade, the commercial reimbursement outlook has stabilized:

• For the past five years, major insurers have been attacking dialysis reimbursement by requiring pre-authorization, in-network treatment, and pressuring outright reimbursement per treatment
• Over the past year, this has abated, with the five major commercial insurers signing long-term agreements (~5 years) with what management describes as ‘stable’ pricing
• This stability has been obfuscated by the run-off in exchange patients who received CPA (materially complete), although the street continues to model pricing headwinds, meaning operating results are more likely to continue to surprise to the upside

DVA trades for a low multiple due to negative sentiment on the magnitude, but not likely outcome, for what may happen to the AKF and California ballot initiative, especially after the SB 1156 vote in the California assembly and senate

• Negative results in CA and for the AKF have largely been priced in, and were especially so after the passing of SB 1156
• Post DMG sale, and with some clarity around forward reimbursement, DVA could re-rate to the positive as it will be the only scale pure-play dialysis provider with a profitable international growth story

DVA is selling DMG to UNH’s Optum for $4.9 billion, which it bought in 2012 for $4.4 billion; this is a major value driver seems very likely to pass HSR examination and DaVita expects to close in 2018:

• DMG contributes materially no EBITDA and provided numerous negative earnings surprises
• The subsidiary also took capital for acquisitions and a good amount of management resources
• DaVita plans to use the cash for buybacks, which could retire 25% of CSO (33% ex-BRK shares)
• DaVita took out a $950M term loan to buy back shares ahead of the deal closing while the market focuses on HSR requests and AKF scrutiny

The Company is a buyout candidate, with high certainty cash flows in an industry with a history of private equity activity

• The business model lends itself well to the private equity model; relatively quick 20% ROIC on greenfield opportunities and highly accretive acquisition candidates
• Low-to-no cyclicality implies higher ability to leverage and therefore higher valuation
• Berkshire Hathaway owns 22% of the CSO, which does open the possibility of a buyout from them or voting their shares to do so
• Leonard Green, Centerbridge, and many others have successfully completed dialysis deal

International is a potential major upside driver, and importantly for operating results, was a positive contributor for the first time in Q2-18

• Creating the international division has taken a long time to build and at great expense as management entered 10-15 countries over the past five years
• The Company has begun to exit unprofitable territories and double-down where they’ve had success, turning this from an earnings tailwind to a headwind on a $400M revenue business line
• No success of international dialysis seems to be priced in, but should the division continue to grow >40% / year profitably to reach $75-100M of EBITDA by 2020, that segment could be valued at 15-20x EBITDA given the growth characteristics

Risks & Mitigating Factors

The economic model is highly concentrated with the AKF as a potential single point of failure due to reimbursement dynamics.

• 115% of DaVita’s profit comes from the 10.5% of its 200,000 US patients with commercial insurance; every patient must switch to Medicare after 33 months on dialysis

• ~50 of operating income is attributable to patients who are covered by the AKF
• Many patients who can’t afford commercial premiums are paid for under CPA from the AKF, which is largely funded by DVA, FME, and the states that it subsidizes
• Market sentiment has turned extremely negative with the AKF under scrutiny due to the magnitude (~40% of cash flow if abolished), but not probability (<25% per industry sources), of any broad-based impact

It is highly unlikely that the AKF would be completely shut down; this is due to:

• Access: AKF shut down would make up to 50% of clinics unprofitable and therefore close down
• Costs: patients would then be driven into the hospital at a 3-4x cost increase
• Incentives: states and Medicare are subsidized by private insurers today
• Consistency: keeping other types of funds operational (e.g. Ryan White), while eliminating the AKF, unfairly plays favorites and opens up the possibility of discriminations lawsuits

California's Ballot Initiative could have an impact on the state (AZ and OH have also proposed their own, but OH's never made it to the floor before being scrapped), and SB 1156 is a headwind

• SB 1156 passing was largely discounted into the price of the stock before the 9% drop upon it passing; this outsized drop seems to be largely due to fear of state-to-state contagion, but there isn’t much evidence of this gaining the same level of traction in other states (see Ohio ballot)
• The reimbursement attacks on dialysis are being pushed by the SEIU-UHW Union, which lost mandatory teacher dues in California last year and is looking for incremental unionization in order to make up the revenue shortfall, and has been picked up by insurers as well
• Unclear that this is constitutional (voters determine what two third parties can agree upon to pay for a service)
• If the Ballot Initiative caps reimbursement at 115%, much of CA will be unprofitable and the facilities closed. As CA is a poor reimbursement state, profitability lost would be relatively low vs. DVA average ($100-250M bottom-line headwind net of offsets, and likely at or below the low end), although a settlement is possible, which would add workers to facilities and/or allow unionization at a lower all-in bottom line hi

DMG acquisition does not pass HSR (seems to be a very low likelihood)

• Request for follow-up information was received in June; closure is still guided to 2018
• This is a large and fragmented market and there were multiple large strategic bidders (many of the large insurers with managed care divisions)
• DaVita levering to acquire its own shares shows management’s confidence in likelihood of the deal closing

Each of the above risks has been overly discounted into the shares to send the PF level to 6.6x, helped by management’s willingness to fuel negative sentiment to protect its strategic interests (the AKF) by presenting a doomsday scenario without guiding to it

• Multiple sources that have been close to management confirm their conservatism and use of filings for their agenda (keep the AKF and CA reimbursement) vs. for stock promotion
• The stock effectively gives the DMG divestiture zero value despite guidance for a 2018 close
• A stabilizing reimbursement environment and potential takeout as upside levers are ignored

Business Model & Economics

DaVita owns & operates ~2,800 dialysis centers globally which can be built or acquired at a high ROC

Economic Overview

• Each facility costs ~$2.1M to build and the average facility today generates $0.8M of EBITDA and $400-500K of unlevered free cash flow (EBITDA – taxes – M. CapEx) at steady state, which takes 3-5 years to reach; centers are breakeven within 1 year
• This implies a steady-state incremental ROIC of ~20% for opening a new facility
• DaVita has invested ~$500M per year on average in new facilities, which leaves almost $1B of free cash flow to make acquisitions and buyback shares
• Center openings have remained steady, but will reach saturation at a point in the United States; even at saturation, growth can still be expected at 3.8% per year
• 110% of profits and 1/3 of revenue come from 10.5% of patients with commercial insurance

With the US market approaching saturation, and DaVita and Fresenius giving the market >3x the HHI that the DoJ considers competitive, large acquisitions are becoming more difficult

• Industry sources believe that buying American Renal (ARA, #3 player) or US Renal (owned by Leonard Green, #4 player) would result in the need to divest ~1/2 of the clinics acquired due to local market share

International is oft-overlooked due to its historical challenges and expense, but is now breakeven

• Internationally, DaVita reached breakeven for the first time in Q2 and should be profitable from here
• International is a potentially overlooked long-term value driver; should the business get to $75-100M in the next 2-3 years, that business could be valued at a higher multiple in a sum-of-the-parts

Reimbursement

• Kidney disease reimbursement is unique among disease states for several reasons:
  • Treatment payments are bundled (the ‘dialysis bundle’)
    • Medicare list prices are $232 / treatment, increasing 1.7% to $235 in 2019
    • Commercial payments come in at >$1,000 / treatment
  • The Medicare dynamic, established under Richard Nixon in 1972
    • Kidney patients may switch to Medicare at any time, which will cover 80% of the cost
    • Kidney patients must switch to Medicare after 30-months + a 3-month waiting period
• The cost of treatment is almost identical to Medicare’s list rate, at ~$240 / treatment, primarily:
  • Wages: inflating 2-3% p.a. due to shortages and overall employment level
  • Supplies: drugs and medical supplies, which are seeing minor price deflation
• The AKF provides CPA to patients, helping them meet commercial premiums and deductibles
  • CPA helps patients remain on costlier commercial insurance for the allowed 33 months
  • Primary AKF funding sources include, DaVita, Fresenius, and states attempting to keep patients off of Medicaid; this is a ‘wink-wink, nudge-nudge’ agreement dating back to the 1980s
• Over the past five years, dialysis reimbursement has been challenged on both the government and commercial sides, but this is stabilizing due to long-term contracts with commercial insurers
  • Medicare bundle rate is going up 1.7% in 2019 after years of <1% increases, which are below the level of cost inflation
  • DaVita has entered into long-term contracts with most commercial insurers, providing a more stable blended reimbursement rate than has been the experience the past 5 years

Appendices

Catalyst

DaVita is divesting DMG to Optum, a UnitedHealth division, for $4.9B and using the bulk of the proceeds to aggressively buyback shares (currently at 6.6x PF EBITDA)

California: SB-1156 being signed into law (or vetoed) and the Ballot Initiative in the midterm elections

Clarity on the AKF’s future, especially as a large-scale impairment is priced in