Near-perfect waves are thumping the beaches where I live, to the point where I risked my neck trying a little surfing this week. After a couple of wipe-outs, I was content to watch my surfing buddy (my eleven-year-old daughter) show how surfing is really done, while I thought about a near perfect wave in the stock universe. That wave is dialysis franchise DaVita HealthCare Partners, Inc. (NYSE:DVA), a stock that just caught some air and took a jump (3.4% rise on December 18). DaVita is a Berkshire's high-conviction pick, but it gets very little qualitative analysis, so it's timely to write about.
What's a perfect wave in the stock universe? Funny you should ask ...
True success for a surfer is finding your perfect wave, and in many ways, we are all surfers in search of the perfect wave in investing. What we're looking for are stocks that accumulate enough energy to provide an effortless ride for what seems like an eternity. Like stocks, ocean waves just keep on moving -- perfect waves can virtually circumnavigate the globe. And also like stocks, many complicated forces come into play to create these amazing ocean waves.
So is DaVita the perfect wave?
Warren Buffett and one of his two portfolio managers, Ted Weschler, think so. Warren Buffett's insurance behemoth Berkshire Hathaway (BRK.A) (BRK.B) has been scooping up shares in DaVita almost non-stop. Berkshire even bought 3.7 million shares of DaVita after the company's dreadful 3Q conference call in which CEO Kent Thiry said the outlook for 2014 was worse than anticipated. More recently, Berkshire bought 1,314,170 additional shares of DaVita in a transaction reported on December 9. The increase happened in a series of four separate transactions, with a price range of $57.11 to $59.87 per share. This represents a 6.77% increase to the existing holding, raising Berkshire's ownership to about 17% of DaVita's outstanding shares.
We've had a couple of nervous weeks on the market, and many investors are sitting on their hands right now. After more than 20% gain in the S&P 500 this year, with stocks within a few percent of all-time highs, investors are naturally very concerned about where they should be putting their money.
Following the actions of a "master of the universe" isn't the worst idea in this kind of a market, but it should be noted that Warren Buffett makes no bones about what he does the vast majority of the time. On September 6, 2013, he said, "I just sit in my office and read all day." It's how Warren Buffet gets smarter. It's also one of the reasons Firstpost reported yesterday morning that he is making $37 million dollars a day.
It should also be pointed out that DaVita is not specifically Buffett's trade, but that of Ted Weschler. Weschler is a long-timer in DaVita, having owned it in his hedge fund before he joined Berkshire. At Berkshire, Weschler's allotted management capital is approximately $1.7 billion, and DaVita is a huge chunk of it, representing about 34% of his funds.
DaVita being Weschler's pick is not necessarily a negative. "Intrepid Ted" has the Oracle of Omaha's blessing, and even without it, Weschler is no slouch himself in the reading and research game. Weschler has publicly stated that he never spends less than 500 hours investigating an investment before he places a trade.
DaVita's stock has had an excellent two-year run, and with the recent stock price jump, is it too late to buy in? There's always another opportunity, if you're a patient investor. And in a market awash with mushy junk, this is a stock that won't peter out on the beach. Instead, it's likely to keep on coming.
There are two reasons many analysts and not a few billionaires are so in love with DaVita. The first reason is obvious. DaVita and its major competitor, Germany-based Fresenius Medical Care (NYSE:FMS), own the United States market in kidney treatment. Fresenius Medical Care is larger than DaVita, with nearly 3,200 dialysis centers across the world. Together, the two companies command more than 70% of the U.S. market in dialysis. DaVita operates more than 2,100 dialysis centers in the U.S. and 10 other countries.
Dialysis is not a discretionary service, patients with end-stage kidney disease need treatment three or four times a week. If those patients don't get the treatment they die. Period.
The second reason is less grim. While many analysts treat DaVita strictly as a Medicare-paid dialysis stock, that's because they're missing the major reason DaVita should continue to outperform in 2014 and beyond. Candidly, if treating end-stage kidney disease was the only gas in DaVita's tank, I wouldn't be interested in the stock. Outpatient kidney dialysis centers faced a 9.4% reduction in Medicare bundled payments as recently as last July.
When word of the reduction got out, it was like a nuclear hit to the dialysis industry. The news temporarily massacred both DVA and FMS. DVA had its biggest yearly one-day decline of 5.9 percent on July 2. Fresenius fell even more, 9.7 percent to 49.71 Euros in Germany.
The draconian cut meant most dialysis centers would lose even more money on Medicare. In general, dialysis centers only stay afloat on payments from commercial insurers and individuals, who represent a small minority (about 15%) of the market. A further drastic cut to Medicare payments was almost unthinkable.
Fortunately, for dialysis patients and dialysis franchises, U.S. regulators subsequently scraped the cut in Medicare payments, reducing it to less than 1%.
I don't know about you, but I don't consider a company whose profit margin can be destroyed by a single stroke of a pen in Washington D.C a good bet. Especially since these cuts are made to people who will never have lobbyists in Washington D.C. to "plead" their cause. (End stage renal disease patients are overwhelmingly from lower income, minority communities.)
In addition, Medicare cuts (and threats) to dialysis are hardly a new phenomena. Drastic cuts already in place have wrecked so many small operators in dialysis there are hardly any decent acquisition candidates left in the dialysis field. DaVita is known as the most efficient provider in the field, giving it that moat Buffet likes so much. But how exactly is DaVita supposed to keep growing as a company when it is running out of dialysis centers to buy, other than overseas, where the business environment for dialysis is even more fraught with government regulation?
Turns out, it may not need to.
Last year in September, DaVita made an extremely shrewd acquisition that signaled a major shift in the company's strategy. DaVita's surprise acquisition was HealthCare Partners. In a move that still has a lot of people scratching their heads, CEO Kent Thiry announced he'd found an entirely different way to grow DaVita. He was about to kick DaVita out of the quagmire of dialysis and squarely onto the health-reform train.
Thiry's goal is nothing less than redefining DaVita entirely. The acquisition he made will lift DaVita out of the highly limited field of being a pure play on renal disease and put it squarely in the forefront of a paradigm-shifting model engulfing health care. The deal is valued at about $4.4 billion, and it's likely the "Health Care Partners" section of DaVita will soon be growing faster than the dialysis business. At the very least, it will allow DaVita to greatly expand its reach.
How exactly does Health Care Partners signal a major shift for this formerly stodgy dialysis franchise? Health Care Partners is huge departure for DaVita, because HCP is not about kidneys, it's about serving the whole patient. HCP's network of 2,000 doctors provides integrated medicine based on Accountable Care Organization models (ACO). By purchasing this unlikely partner, DaVita is relying on Accountable Care Organizations eventually replacing the fee-for-service model in health care. This is a health care trend I wrote about in a Seeking Alpha article on Obamacare on November 30, so I won't belabor it here. But make no mistake, with the passage of Obamacare; health care is moving swiftly away from fee-for-service payment to rewarding providers for outcomes rather than volume. The unsustainable rise in health care costs mandates the change.
Purchasing HealthCare Partners shows where Thiry believes health care is going in the United States. He is betting his company's future on health care reform eventually forcing the entire medical profession to accept performance-based programs. "By being one of the companies to embrace this trend," he said recently, "DaVita will expand its services and markets by drawing on its newly acquired population and health capabilities to better serve pre-dialysis patients."
Translation? Thiry is planning on more acquisitions in the primary care, hospital service, wellness program, outpatient surgery and Accountable Care Organization field. Bet on it. They're coming in the near future.
DaVita's CEO Kent Thiry has seen the Obamacare handwriting on the wall. And he's going to make certain DaVita has somewhere else to go besides a broken Medicare system before it's too late.
Already in the works for DaVita is an Accountable Care Organization program for end-stage renal disease patients. That model will shift financial incentives from providing outpatient dialysis care to offering home-based dialysis and other less-expensive options. DaVita acquisition means it has moved from being a provider of nephrology services to being able to provide a full spectrum of care and contract with commercial insurers on a capitated basis.
Waves Come in Sets, So Could Competitor FMS Be a Better Play?
DaVita is not without risk. It's impossible to know how all the new health care issues will play out in Congress. If there are drastic payment reductions in the works, DaVita may simply have to close centers that don't make economic sense.
Honestly, I'd like to be able to recommend the larger dialysis provider Fresenius as a contrarian play. It would be an elegant way to avoid the temporary air pocket that could follow the 3.4% bump that happened to DVA on December 18th.
Positioning is everything when surfing, and the DaVita wave is frothier than it was a few days ago. When a wave rises rapidly, whether it's in the ocean or in the stock market, it gets top-heavy, and there's a lot more wave landing on you if you fall.
Unfortunately, Fresenius just don't hold up that well as an alternative. Fresenius has a 20.79 billion market cap, compared to DaVita's 13.09 billion cap. DaVita has higher growth potential, based on its lower price-to-sales. (DVA is at 1.08 and FMS is at 1.32.)The five year PEG of DVA at 1.24, and FMS is at 4.44. DaVita also has much stronger top line growth, mostly thanks to its acquisition of HealthCare Partners. Last quarter, HealthCare Partners generated $803 million in revenue, accounting for 27% of DaVita's top line.
DaVita also had revenue growth of 54.20% last quarter, while Fresenius was a comparatively paltry 7.2%. DaVita's bottom line growth lags Fresenius, however.
The acquisition of Health Care Partners also gives DaVita a great buffer against any forthcoming drastic Medicare payment cuts, something that Fresenius lacks. DaVita closed its acquisition of HCP in November 2012, and that year about 86% of the company's net revenue came from dialysis and related services, according to its annual report. But if HCP had been part of the group for the full year, DaVita estimated that dialysis would have represented just 68% of its 2012 revenue.
One of the major differences is global exposure. Both companies are mostly dependent on the United States market, but 32% of Fresenius' dialysis revenue comes from Europe, the Middle East, Africa, Asia or Latin America. DaVita has made some international expansion efforts, acquiring new dialysis centers in Portugal and Poland last quarter. But it's a recent trend and it lost $26 million in expansion efforts.
There have been long-standing accusations of Medicare fraud against both companies. The United States Department of Justice dismissed a lawsuit against Fresenius for running a scheme to overcharge Medicare in January of this year. DaVita has been investigated numerous times in the past several years. It has emerged largely unscathed, but I'm not sanguine that this will continue for either company in the future.
In 2012, DaVita settled a whistle-blower case on overuse of a kidney care drug. $300 million was set aside to settle kickback probes. The case stemmed from a Texas lawsuit that said DaVita deliberately wasted medicine to reap hundreds of millions of dollars in extra payments from Medicare. (Last January, Medicare stopped paying separately for drugs accompanying dialysis treatment. The amount of drugs used suddenly lessened radically, providing a case study of how financial incentives can radically alter supposed essential treatment.)
"Three hundred million is a big number," said Piper Jaffray stock analyst Kevin Ellich, in analyzing the kickback. He also pointed out that the amount is only a portion of the company's estimated $1.5 billion in operating cash this year.
About a week ago, Merrill Lynch unveiled its top ten stocks to buy for 2014. DaVita is the only health care play in the list. Merrill Lynch sees the stock as under owned on Wall Street and "very inexpensive valuation wise." (Many analysts won't agree about the valuation with good reason.) The Merrill Lynch price target was $70, and the consensus target is posted at $63.
Could Berkshire-Hathaway buy DaVita outright? Berkshire certainly has more than enough cash at hand to buy what it doesn't already own. And to be sure, infusing some Buffet-minded stringent economy into DaVita might keep the company's management from blowing the bank on questionable acquisitions overseas.
But DaVita, as a medical operating company, is well outside the comfort zone of Berkshire. It seems unlikely that Ted's marvelous adventure will stop without him continuing to buy more shares -- he's been buying DaVita for more than 12 years. One thing is certain: he's willing to bet big on this stock, and hold it for a decade or more.
I'm not an "all Warren, all the time" investor, but it rarely pays to bet against Warren and his cronies. Very few investors are as long-term oriented as Buffet and Weschler. Fewer still are as focused. DaVita should be a good opportunity to drop in on a Buffet-wave and draft along. You'll have to be patient, but if you pick the right entry point, the thrills will come.
If you happen to be headed for a beach with great breaks this holiday season, consider trying surfing yourself. If you aren't, catch a classic surfing film like "The Endless Summer," or even "The Perfect Wave," while you're sipping eggnog and toasting your feet by the fireplace.
Despite how simple it looks, surfing is actually extremely complicated, and the parallels to investing are legion. As we say in Hawaii, the best surfer out on the water is the one having the most fun.