Description

INTRODUCTION:
In late 1999, DaVita (formerly know as Total Renal Care) began a turnaround under a new CEO: Kent Thiry. (Thiry was formerly at another dialysis service provider named Vivra, which he sold to Gambro AG for 13x EBITDA in June of 1997). During the past two years at DaVita, Thiry has sold the company's non-continental U.S. operations, significantly reduced debt, improved collections, improved the quality of dialysis treatment, and delivered strong operating results. Despite the fact that DaVita's stock has soared from under $5 to roughly $18 over the past two years, we believe that a significant margin of safety exits today relative to its intrinsic value.

COMPANY/MARKET/COMPETITION:
DaVita is the second largest provider of dialysis services for patients suffering from chronic kidney failure, also known as end stage renal disease (ESRD). Dialysis is the removal of toxins, fluid and salt from the blood of ESRD patients by artificial means.

According to US Renal Data Services, a recognized industry source, the US market is expected to grow at a 6% clip to 2010. This growth should be driven by the aging of the population, longer survival rates of patients with diseases that typically lead to ESRD (including Diabetes and Hypertension), improved technology, and growth in the minority population that have higher incidence rates of ESRD. Importantly, demand for the company's services has almost no correlation with the overall economy as if DaVita's customers don't come in for treatment 3 times per week for 3 hours per day, they die.

DaVita is the number two player with a 15% market share in the U.S. market (488 centers serving 42,000 patients. Fresenius (FMS) is the number one player in the market with an approximate 24% market share and Renal Care Group (RCGI) is the number three player in the market with a 6% market share.

DAVITA PUKES OUT CASH:
Take a peek at DaVita's historical financials, the company has gone from hemorrhaging cash with former management to puking out cash under Thiry. We are confident that this streak continued in the 9/01Q; we expect DaVita to reported 9/01Q earnings on November 5th. DaVita has approximately 22% EBITDA/SALES margin, 3% maintenance capex requirements, and low working capital needs. We estimate that the company will generate over $350mm in EBITDA in 2001 on over $1.5 billion in sales; maintenance capex is $50mm, cash interest is about $70mm, working capital is $0 and cash taxes will be approximately $80mm. Thus, cash flow from operations minus capex is about $150mm or $1.70 per share.

RISKS:
1. In February of 2001, the Civil Division of the US Attorney's office requested that DaVita cooperate with them in a review of some of the company's historical practices with respect to billing (note: this was prior to Thiry's arrival). This is not a criminal investigation. Gambro, a competitor, had a similar Civil inquiry and ended up paying roughly $100mm. We handicap this contingent liability at approximately the same amount that Gambro paid, which is less than $0.50/sh.
2. EPO Pricing - Erythropoietin is a genetically engineered form of protein, which stimulates the production of red blood cells and nearly half of all dialysis patients require EPO on a regular basis. Amgen has a monopoly on EPO, which comprises around 25% of DaVita's revenues, and has instituted price increases in the past; further price increases could hurt margins at DaVita. However, given the monopoly status of EPO and visibility to the government, further significant price increases from here seem unlikely.

VALUATION:
DaVita had $866mm in net debt at the end of 6/01Q (which we think could be up to $100mm lower by now), 84.1mm shares outstanding and 14.7mm options outstanding with an exercise price of $9/sh. With the company's stock price at about $18, the TEV is about $2.5 billion. Thus, DVA stock is trading at 7.1x EBITDA, 8.3x EBITDA minus maintenance capex, and a cash yield to the equity of about 9.1%. With private market transactions in the 10-13x EBITDA range and the company's two public competitors both trading at about 10x EBITDA, we think DaVita's valuation is compelling as a long idea. We estimate the company's intrinsic value in the high $20s to low $30 range, which is a significant margin of safety with the stock at $18. We also think shorting RCGI against the long position in DVA has investment merit as well.

Catalyst

CATALYST:

1. Florida Lab Settlement - DaVita's Florida-based laboratory subsidiary is the subject of a third-party carrier review relating to claims the lab has submitted for Medicare reimbursement. The reason that this is a potential positive catalyst is that the company is currently booking $1mm of costs per month through the P&L, without booking any revenues, so a favorable resolution is a positive for cash flow while a negative resolution is neutral.
2. For the past few weeks, there has been a large-scale seller of DVA stock (check the recent volume trends in the stock). We have learned that the seller is a large mutual fund that has recently changed portfolio managers. While we cannot determine the reasons behind the selling, significant blocks of stock have cleared at $17 per share and we think that most of the "excess" volume has been absorbed by the market.
3. We expect very strong financial results to be released on November 5th; Thiry, since his days at Vivra, has always been very conservative in financial guidance for the company and we expect net positive surprises in the future.