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DaVita (NYSE:DVA)

Q2 2010 Earnings Call

August 02, 2010 5:00 pm ET

Executives

LeAnne Zumwalt - VP of IR

Richard Whitney - Chief Financial Officer

Luis Borgen - Chief Financial Officer and Senior Vice President

Jim Gustafson - Vice President of Investor Relations

Kent Thiry - Chairman and Chief Executive Officer

Analysts

Andreas Dirnagl - Stephens Inc.

Gary Lieberman - Wells Fargo Securities, LLC

Justin Lake - UBS Investment Bank

Charles Ruff - Insight Investments

Kevin Ellich - RBC Capital Markets Corporation

Darren Lehrich - Deutsche Bank AG

Mark Arnold - Piper Jaffray Companies

Gary Taylor - Citigroup Inc

David MacDonald - SunTrust Robinson Humphrey Capital Markets

Kevin Fischbeck - BofA Merrill Lynch

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the DaVita Second Quarter Earnings Call. [Operator Instructions] I would now like to turn the conference over to Mr. Jim Gustafson. Sir, you may begin.

Jim Gustafson

Thank you, Paula, and welcome, everyone, to our second quarter conference call. We appreciate your continued interest in the company. I'm Jim Gustafson, Vice President of Investor Relations. And with me today are Kent Thiry, our Chief Executive Officer; Luis Borgen, our Chief Financial Officer; as well as LeAnne Zumwalt and Rich Whitney.

I'd like to start with our forward-looking disclosure statements. During this call, we may make forward-looking statements within the meaning of the Federal Securities laws. All of these statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For further details concerning these risks and uncertainties, please refer to our SEC filings, including our most recent quarterly report on Form 10-Q and annual report on Form 10-K. Our forward-looking statements are based on information currently available to us and we do not -- intend to undertake no duty to update these statements for any reason.

Additionally, we'd like to remind you that during this call, we will discuss some non-GAAP financial measures. A reconciliation of these non-GAAP measures to the most comparable GAAP financial measures is included in our Form 8-K submitted to the SEC and available on our website.

I will now turn the call over to Kent Thiry, our Chief Executive Officer.

Kent Thiry

Thanks, Jim. This was a tough quarter in which we were able to offset the revenue per treatment declines with operating cost management to deliver on slight operating income as we told you to expect last quarter. Luis will, as usual, offer more commentary on the quarter. I'll cover three topics: One, clinical outcomes; two, bundling; three, outlook.

First, clinical outcomes. We always present them first because that is what must come first. We are, first and foremost, a caregiver company now serving more than 122,000 patients. A, with respect to adequacy, it is essentially how well we are doing at removing toxins from our patient's blood. This quarter, 96% of our hemodialysis patients had Kt/V greater than 1.2. This is 90-day data. B, with respect to vascular access, 66% of our patients have fistulas, which is the preferred form of vascular access as many of you know. That's also 90-day data. And third, anemia management, physicians have managed 67% of our patients to hemoglobin levels, between 10 and 12 over the last quarter. For these and virtually all other clinical measures, our patient outcomes compared very favorably to national averages, consistently the best or among the best. Our quality critical care, we remind you, not only results in healthier patients, but also drives substantial reductions in hospitalizations and surgical procedures, and therefore, generate significant savings to the U.S. taxpayer.

Subject number two, the bundle. CMS released it, as I'm sure all of you know, last week. I'll just make a couple of points, and no doubt, you'll have some questions during Q&A. It was very disappointing to see that CMS selected to keep the transition adjustment in the way they did. The 3.1% cut in reimbursement, we believe, is based upon bad assumptions and logic that takes us far beyond the 2% cut that Congress intended. This larger cut will increase our losses on Medicare patients and put more pressure on private insurers to subsidize these Medicare losses.

However, there were many other areas where CMS did listen to the community's concerns and comments, and we don't want to ignore or give short shrift to those. There is still a couple of areas that came out in the bundle, two of which we're putting more analysis on the table. And so, it will be some number of weeks before we're prepared to make our decision and to give 2011 guidance. Likely, we'll do that on our Q3 call. And independent timing, we continue to work on ways to offset the overall cut. It is too soon to get precise estimates on how much that will be.

Third and finally, on our outlook, we have narrowed our operating income guidance for 2010 by increasing the bottom end of the range. That new guidance is for operating income of $970 million to $1.02 billion. We're also increasing our cash flow guidance to $725 million to $825 million. This is, of course, based on the strong first half and rolling 12-month performance. One other positive development that's noteworthy is that we have successfully established a higher level of stability into our go-forward private rates by signing long-term contracts with two large payers at reasonable compromised rates.

I'll now turn the call over to Luis, our new Chief Financial Officer.

Luis Borgen

Thanks, Kent. Overall, the second quarter was characterized by a significant revenue per treatment decline that was partially through solid cost management. Throughout it all, we continue to produce very strong cash flows.

This past quarter, dialysis revenue decreased $9 per treatment from Q1 2010. $5 of the decline was due to a decline in revenue for physician-prescribed pharmaceuticals, primarily a decline to utilization, with about $0.50 due to the previously announced decline in ASP. Remember, a decrease in pharma utilization impacts both revenue and cost, with costs offsetting much of the revenue decline. $2.50 was primarily a decline in mix, somewhat offset by commercial rate increases. The remaining $1.50 in decline, from seasonally high Q1 lab revenue.

The decline in pharma utilization was driven by independent physician prescribing decisions. So this is also showing more conservatism with regard to hemoglobin greater than 12 and/or re-evaluating vitamin D dosing in response to KDOQI. We expect pharmaceutical utilization to continue to decline in the back half of the year.

The mix shift continues a trend that we have been discussing for more than a year now. Our commercial mix now rounds down to 11% of patients. As a reminder, this shift is due to two main factors: One, declining commercial mix of new patients, largely driven by the economy and declining commercial insurance population; two, improved mortality of our patients, which leads to a higher share of our patients on dialysis greater than 30 months.

Dialysis operating expense decreased $5 per treatment sequentially. A majority of the decline was due to the utilization of physician-prescribed pharmaceuticals. The remainder was primarily due to strong productivity and a decrease in payroll tax from seasonally high Q1 levels.

Non-acquired growth was 4.1%, while total treatment growth was 5.5% year-on-year. We added 23 centers in the quarter through acquisition and certified 18 de novos.

Q2 was a very strong cash flow quarter. Operating cash flow was $296 million, and free cash flow was $250 million. A two-day reduction in DSO to 64 days and the timing of other working capital items contributed to the strong operating cash flow.

Our quarter-end cash balance was $575 million. This reflects the redemption of $200 million of senior notes as previously announced. We spent $91 million in dialysis center acquisitions in the quarter. Additionally, we repurchased $100 million of stock in the quarter. Our priorities for cash remain the same, with our first priority being investment in growth at attractive returns. In fact, we are currently in discussions to do a medium-sized dialysis acquisition.

Finally, as you know, we have significant debt maturities in 2012. We are exploring our options and are likely to execute some form of refinancing within the next three to nine months.

Operator, let's go ahead and open up for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Kevin Ellich of RBC Capital Markets.

Kevin Ellich - RBC Capital Markets Corporation

Kent, I was wondering if we could start off with bundling. Just wondering what you thought was positive in the final reg. You commented on the 3.1% transition being negative. Anything else that you thought was negative?

Kent Thiry

Well, I think the first part of your question was on positives. They significantly reduced number of case mix adjusters. That was a positive. The transition adjustment was a negative. I'll flip it to LeAnne to list a couple of the other puts and takes, who shall be more articulate than me.

LeAnne Zumwalt

As you know, the list of labs has now defined 53 tests, and we'll be able to bill for other tests with a modifier above that. Oral medication is probably one of the biggest areas of positive. We are going to be providing oral equivalent, but not the expended oral medications. Does that answer your question, Kevin?

Kevin Ellich - RBC Capital Markets Corporation

Yes, that's kind of what I was thinking too. Just wanted to confirm that. And then, Kent, in the prepared remarks, you mentioned the long-term contracts that you signed with two large payers. Could you give us any more detail on those payers, and what type of rate increases that we're looking at?

Kent Thiry

No, I thought that we can't do that, Kevin. It just wouldn't be in your or the other shareholders' best interest to start discussing individual contracts. And it was also the contracts that are, of course, baked into our guidance. But the good news is that it creates a lot more go-forward stability in that part of our revenue structure. And of course, what increased stability means is that you eliminate some downside, but you also eliminate some upside. That's why the other side agrees. So we think it was a good move for our shareholders. But more detail beyond that would make sense, suffice it to say we traded up upside for limiting downside.

Kevin Ellich - RBC Capital Markets Corporation

And then, actually, could I ask it in a different way? When you say long term, are we talking five years or three years or 10 years?

Kent Thiry

Fair question, again, won't disclose exact terms for individual contracts. But when we say long term, that typically means at least two. And if we ever did one longer than five, we'd let you know. And so, I would just say that these two fall into that range.

Kevin Ellich - RBC Capital Markets Corporation

Then last part of this question, on the contract, is it safe to assume you guys have shifted to a bundle payment with these payers payors or not necessarily the case?

Kent Thiry

In both those cases, it's a bundle.

Kevin Ellich - RBC Capital Markets Corporation

And then, Luis made a comment about in discussion with a medium-sized dialysis acquisition, just wondering if there's any visibility on timing of that transaction?

Kent Thiry

No. A deal is a deal is a deal. It may happen, it may not happen. We bring it up only because we anticipate questions about what we're going to do with the cash in our balance sheet. And so, we just wanted to give you that heads-up. But it's a normal deal with all the vicissitudes around terms and timing of completion risks. And I want to go back for one second. Well, it was two big contracts that we signed were both bundle, I just want to repeat. It isn't a requirement in all our new payer contracts that they be bundled. It is a preference, but in some cases, our shareholder economics will be better served if we do not do bundled payer contracts. It just so happened that these two, it was in both parties' best interest to do it that way.

Kevin Ellich - RBC Capital Markets Corporation

Just one last quick question, on the pricing, average revenue per treatment decline, Luis indicated the pharma utilization was one of the main factors. And I think you've said that to decline in the second half of the year. Is that correct?

Luis Borgen

That's correct.

Kevin Ellich - RBC Capital Markets Corporation

Can you quantify that or provide any more color behind that?

Luis Borgen

No. It's going to continue to decline from what we've seen, consistent with that pattern we've seen in the last quarter or so.

Operator

Your next question comes from Darren Lehrich of Deutsche Bank.

Darren Lehrich - Deutsche Bank AG

I had a question just as it relates to the 3.1% transition adjustment. And maybe, LeAnne, you can provide us a little help thinking about this. I guess CMS made a variety of assumptions to get to that number. And I'm just wondering in the rule making cycle, I guess this would be for 2012, how you'd expect them to revisit that analysis? And any thoughts there in just helping us thinking about the process to correct that number if it was an incorrect assumption on the part of CMS? How we might think about that playing out?

LeAnne Zumwalt

Sure. In the rule, they didn't give us a specific process. But most of us believed there'll be a process as there is today come, which is through the physician fee schedule rule or another independent vehicle that'll address several components of the bundle and as it relates to updating that for 2012. Does that answer your question?

Darren Lehrich - Deutsche Bank AG

Yes. So you think it may be in the physician fee scheduled or the separately promulgated, I guess bundling rules again for next year, is that what I'm hearing you say?

LeAnne Zumwalt

Yes.

Kent Thiry

Yes. Actually, in the rule, they'd made an affirmative comment saying that they would review it.

Darren Lehrich - Deutsche Bank AG

Okay, so that's something we'll have to be on the lookout for next year. I guess just a question about the refinancing. You mentioned at the tail end of your prepared remarks for us to expect something in the next three to nine months. So I'm wondering if you can just give us any update at all on structure for the refinancing and how we should take that into consideration over the next few quarters. I don't think you'd let the term loan B go current in Q1 of next year. So any more comments there would be helpful.

Luis Borgen

Sure. The structure will be pretty similar to what we have in place today, term loan A, term loan B with some sort of senior bonds. We may upsize depending on our capital structure needs in terms of acquisitions or share repurchase considerations. But it will be a very similar structure to what we have today. And we do intend, within a three- to nine-month period, to refinance well ahead when we need to. So we're valid in the market opportunities, and we'll tap the market up when the time is right.

Darren Lehrich - Deutsche Bank AG

And relative to the current interest cost that you have in your existing structure, any guidance for us just broadly on how much more expense so you think it might be in the current market?

Kent Thiry

It will be more expensive, probably in the range of -- right now, we're at LIBOR plus 150. And the indicative price when we've had is LIBOR plus 300 to LIBOR plus 350 on the floating rate facilities. And on the bond side, it's around 7% or so. And that's our current market information for the toughest structures we're looking at.

Darren Lehrich - Deutsche Bank AG

And then, my last question here, can you provide an update on the Amgen re-contracting negotiation and whether you reached an agreement for your ESA procurement beyond 2010 at this point?

Kent Thiry

We haven't yet reached agreement with Amgen, and we don't really have much comment beyond that.

Operator

Your next question comes from Kevin Fischbeck of Bank of America.

Kevin Fischbeck - BofA Merrill Lynch

I was wondering if you could talk a little bit about just the dynamics on the managed care pricing. And I know historically, you haven't really given out a percentage bundle contracts. But theoretically, if there is a bundle contract, if you improve efficiency, you can keep some spread under that contract, whereas if it's unbundled and you push down drug utilization or switch to more cost-effective drugs, you may not be able to capture all of that economics in unbundled contracts. So how should we think about that dynamic when you look at your contracts of bundled versus non-bundled. Do you think that net-net, those two factors equal out? Or let's say, a slight positive or a slight negative? How should we think about that dynamic getting into 2011?

Kent Thiry

I think what we can offer for you is that our percentage bundle continues to go up. So we're making progress there. And we remain comfortable with where we expect to be as we go into 2011 in terms of the percentage of our book that is bundled versus not. For sure, we'll go into 2011 with some that's not, but we think we'll be in a good position in terms of managing that balance.

Kevin Fischbeck - BofA Merrill Lynch

And it sounds like you guys have not yet decided how you're going to deal with the bundle, whether you go all in to the rate or not. But I guess if you could give us some thought around your decision there, is it the potential that you would shift some of your business in to the rate while others not? Or do you kind of view this as we have to run the company consistently across the business, so either everyone's going to phase in or everyone's going to go directly to the rate?

Luis Borgen

Now all options are available to us now. One thing that will always be the same as our approach to our clinical performance, independent to the reimbursement format. So that will be handled one way. But as to which reimbursement system we choose, that's subject to some more analysis.

Kevin Fischbeck - BofA Merrill Lynch

And then, when we think about how you might deal with the bundle, certainly, we'll get more color next quarter, but I think in the past, you talked about it several quarter adjustment period to get used to the bundle. I mean, how do you think about that? Does that require investments from the SG&A line? How should we be thinking about what the transition period might look like? Is it more of just operating costs slowly evolving over time or is there investment that has been made?

Kent Thiry

At this point, we wouldn't anticipate any dramatic change in SG&A or any dramatic expenditures in CapEx. Having said that, they won't be zero either. The primary dynamism is going to be in the other category you mentioned, which is just what exactly changes in operating costs and when. Well, there's a function of any operating innovation and as a function of some of the inherent cost of managing this kind of massive change process. But a lot of those expenses will be people who'll be redeployed to work on it from other stuff, as opposed to a whole bunch of new people hired on a temporary basis. So it's much more that third category of redeployment of operating costs versus any dramatic new cost. However, let me just be redundant and say that the cost will be nonzero on the operating side. They're just not going to be dramatic.

Kevin Fischbeck - BofA Merrill Lynch

And then, going back to the commentary about a potential deal. I mean, you guys have talked about looking at a regional chain for quite some time. It sounded to me a little bit like your commentary's a little bit more definitive. Are we getting closer to a point where you feel like we'll have an answer around whether a deal happens or not -- a sign not to take away that we're getting closer to a yea or nay on this?

Kent Thiry

I'm sorry but the answer will be inherently ambiguous because the reality is inherently ambiguous. It's a little bit like if you're in a football game, when you move from the 30-yard line, you're in 30-yard line, to the other guy's 30-yard line. Yes, you closer to a touchdown? Yes. It that all certain that you get to score one? No. So we thought it was worth mentioning because there would be useful information for you to have on multiple levels. Having said that, we unfortunately have to immediately qualify it by saying we're not in the end zone yet.

Kevin Fischbeck - BofA Merrill Lynch

And then last question, as far as the revenue per treatment being down sequentially, it sounds like the lab seasonality is one thing to kind of take into account, but as far as the lower drug costs go, that's $5 is a good place to start. We should actually see continued pressure on the revenue line from that as the year goes on. And then, the mix, I guess it makes sense to use that as the starting point for the rest of the year. Am I thinking about that correctly?

Luis Borgen

Well, the RPT goes up and down within a reasonable level. So there may be changes to some of our commercial rates. The mix has been trending down, and the utilization has been trending down. So I can't quantify exactly how much it'll go up or down. But I think within that range, it's a reasonable starting point.

Operator

Your next question comes from Justin Lake of UBS Investment Bank.

Justin Lake - UBS Investment Bank

First on the commercial payer mix, you mentioned down to around at 11%. That's obviously declined from, if I remember correctly, 13% to 12%, now to 11%. I'm just curious if you can give us some color there on how that trajectory looks over last quarter or two? And whether you're seeing it continue or is it, where you came out the quarter might be helpful. And then just give us some historical perspective on have you seen that type of payer mix change before in that short a period?

Luis Borgen

I would start with your second question first. The decline in the commercial mix has been steady and consistent. There was nothing unusual about the current quarter relative the past one. Just been kind of a general trend. And what was your first question again, please?

Justin Lake - UBS Investment Bank

I guess just looking at the 13% to the 11% coming out of the quarter, is it even as -- I would assume that number is lower than the average for the quarter. Is that 11% of quarterly average? Is it the end of the quarter? Can you just give us some perspective there?

Luis Borgen

It's a quarterly average. The ending number is right around that level, not materially different than that.

Justin Lake - UBS Investment Bank

And do you see that continuing to decline through the second half?

Luis Borgen

Our guidance assumes that there will be some continued decline in that into Q3 and Q4.

Justin Lake - UBS Investment Bank

Second question on bundling, and can you talk about the transition adjustment? And you specifically mentioned that CMS's estimates on provider behavior likely have some error there. While this drives a disappointing rate in 2011, I'm just curious if you have an opinion on how much of that you would think might revert back to you given your opinion of what that error might be when CMS recalculates the adjustment 2012?

Kent Thiry

Yes. Our hope is that they do good analysis and a bunch comes back if that's appropriate, which is what we'd expect. This is all if they don't adjusted it between now and then, since they're objective is to get a lot of providers in the bundle. And they're really getting it away of that objective with that currently contemplated transition adjustment. But if it stays the way it is, we can only hope for a very high-quality analysis on a look-back basis, the subsequent year. Handicapping that is so difficult. I don't know what qualitative adjectives to use, but I just couldn't throw out -- I guess the use the word hope is the best we can do for you.

Justin Lake - UBS Investment Bank

And Kent, you mentioned that there might be a process underway where they may re-evaluate that. Can you elaborate there?

Kent Thiry

I don't know of any particular process. I just know the entire community is intensely disappointed.

Justin Lake - UBS Investment Bank

Last question on commercial bundling, I think you told us at some point last year that you had a two-year plan to increase commercial bundling, the rate or percentage of payments going into 2011 and the bundle. I know you haven't given a number there. I know a lot of people are trying to squeeze that out of you, but can you at least tell us whether you are on track to get -- to meet your internal target while heading into 2011? Whatever that might be?

Kent Thiry

Now I would use words comparable to what Rich used, which is that we are comfortable with where we are, which more or less means that we're on plan if anything were a tad ahead.

Kent Thiry

I will would go to the mixed issue, that's been brought up a couple of times appropriately. The reason we have a hard time forecasting is the same reasons that economists of our time forecasting the economy on once employment, unemployment starts to decline and employment starts to increase, particularly if it's quality employment with benefits, then number of people with private insurance will start to go up. And we don't have any particular expertise in forecasting broader employment trends, and that's why we have to be so careful in our answers to your questions about our particular mix. It's very much a reflection of the macro environment.

Operator

The next question comes from Gary Lieberman of Wells Fargo.

Gary Lieberman - Wells Fargo Securities, LLC

Maybe one quick follow-up on that last point that you made, Kent. Is there any way to quantify the factors on payer mix? Is more of it coming from fewer new commercial patients? Or is more of it coming from the increase in mortality or the decrease in mortality.

Richard Whitney

This is Rich. It's still about 50-50 as it has been in the past. No dramatic change there. And I should note because there's been confusion over the last couple of quarters. But just to be very specific, in terms of how we define our government and private mix, that included in our government mix is both VA, Veterans Administration, as well as Medicare advantage. So when we talk about it, a decline in private mix, by definition, exclude those two things. So if you try to compare us to other providers, that's an important thing to note.

Gary Lieberman - Wells Fargo Securities, LLC

And then, since you brought it up, maybe an update on where you guys are in terms of the VA contracts?

Kent Thiry

On the VA, we have reached a bunch of new agreements where we took a rate hit. And only time will tell if these agreements lead to a long-term relationship or not. If the VA wants to get even lower rates, then we'll have to do what we have zero desire to do, but to turn down patients, particularly those in remote locations because we simply can't afford to take more patients at a loss. And so, we're hoping we'd reach a new equilibrium and can move forward in a positive way from here.

Gary Lieberman - Wells Fargo Securities, LLC

How should we think about the agreements versus I guess the rule that VA could at some point put out? Would the agreements take precedence over the rule? Or how do think that works out?

Kent Thiry

They can decide that, and so if unfortunately fits to that category, time will tell. We know that a lot of people in the VA responded positively to our flexibility. And we assume the flexibility of others, that's certainly the indirect communications that have been offered to us. On the other hand, we just don't know enough to be certain about what will happen next. And we think they understand the reality of significantly decreased access for veterans if they put us in a position where just like the rest of Medicare, we lose money on virtually on every patient.

Gary Lieberman - Wells Fargo Securities, LLC

And did the new rates have an impact on revenue per treatment in the quarter? And is there any way to quantify that?

Kent Thiry

I think the most important thing is that new rates are baked into our go-forward guidance without parsing through exactly what happened to this quarter or not.

Gary Lieberman - Wells Fargo Securities, LLC

And then, you've been talking about acquisitions for a while, but it seems like this is the first time that one might be done in the near term. Can you talk about what impact you think the bundle is going to have on acquisitions going forward, maybe for yourselves and even for the rest of the industry?

Kent Thiry

I think the uncertainty around change like this, which of course is reduced in many ways now that the rule is out, but still there because of all the things that might happen with the innovation that the rule will provoke. I think that will lead to more deals getting done, particularly smaller ones. And we, in fact, have done more small acquisitions in the first six months of this year than we have for sometime. It's is not a big enough difference to really move the dial from your perspective, but that sort of trend might continue. And so, it's a nice little bump both in terms of current economics and long-term strategic positioning.

Gary Lieberman - Wells Fargo Securities, LLC

Where should we think about stock repurchases in the scheme of doing the refinance? And in the acquisition, should we just assume that those might be on the back burner for a while? Or do you think you still have some fairly significant capacity to repurchase your share?

Kent Thiry

We have remaining authorization as well as cash on our balance sheet to do so. So the share repurchase on there, where that continue to evaluate and execute as appropriate.

Luis Borgen

What I would add to that is our long stated point of view on what's right for shareholders in terms of our capital structure has been to be between the 3.0 and 3.5 numbers, and that point of view has not changed for a long time. Although at different times, we've been both above it and below it. And so I think that remains the best way for you to think about what we're going to do over the intermediate and longer-term.

Operator

Your next question comes from Andreas Dirnagl of Stephens Investment Bank (sic) [Stephens Inc. Investment Bankers]

Andreas Dirnagl - Stephens Inc.

Just to quantify on that last discussion about the VA. When you say you've reached a "bunch of new agreements." Does that mean that the sort of the proposal that the VA was taking around about a significant reduction in fees is sort of off the table for now and they may come and revisit that in the future or, I mean, how should we think about that?

Kent Thiry

Yes. I know don't know exactly what words to use, because they're not terrifically explicit zone, on the table or off the table. I don't know if you can use the metaphor. Maybe it's off the table in front of the cover for a moment but it could be put back on the table at anytime and so we just -- we do not know as it could be that they don't know yet. They're looking at the fact that they have achieved some substantial savings and they're looking at the fact that there could be widespread disruption in some bad clinical and economic things that happen if they insist on mandating even lower rates. And exactly what they are thinking about that trade-off literally, we don't know.

Andreas Dirnagl - Stephens Inc.

Kent, maybe you can just help me more from a philosophical perspective. Having spent a number of years following the industry, declining pharma utilization were always sort of bad words to hear because it had an impact on revenue and then obviously an impact on profitability. As we head into the bundle though, if we would be under a bundled rate already, I mean technically declining pharma utilization would then be a positive, correct? In terms of your profitability?

Kent Thiry

Correct. And if you recall, Andreas, you should remember this, that going way way back, we went to the government and said, we would much prefer that you pick any system other than ASP plus six because we do not want to taint associated with having any kind of margin of that type of cost plus margin on a drug because it leaves us open to such suspicion. And so in that sense, moving to a bundle is philosophically wonderful. Now we can't be naive about that. We'll now be accused of underutilizing. And so we will continue to do what we've always done, which is have very transparent clinical protocols that are developed by physicians, most of them have although zero knowledge of the nature of our contracts and the subtleties of reimbursement because of the way we design the process. We want that to be a clinically pure decision.

Andreas Dirnagl - Stephens Inc.

But again, just because we have to change what is really a fundamental, perhaps of our thinking, while it potentially is a negative impact for the next two quarters of this year, as soon as you shift into the bundle, starting with the lower utilization rate given the fact the rate is now set is clearly beneficial there?

Kent Thiry

No, that's absolutely true. And one metaphor that I use is that if the government reimbursed nurses, that average salary plus 6%, we would all have more nurses because you would not have anything to trade off against and you'd want to play it absolutely safe. And so it's sort of almost ridiculous to ask and answer the question. But if you take something that's useful, like a nurse or a good drug, and make it free, then physicians who prescribe that drug are operating executives who decide, I mean, nurses to have -- will err on the side of having more up to but not anywhere near the point of putting anyone at risk, of course. Once you move to a world in which nurses are not free. And in fact, if you hire another nurse, you will have fewer technicians or have a tougher time renovating a center or a tougher time buying new chairs or a tougher time building a new center. Once you're in a world that having to trade that off against other things, you'll end up finding some other things that are better incremental uses of time and money. And that same thing is going to happen in the pharma utilization world, that there are going to be innovations that take place because it's no longer free.

Andreas Dirnagl - Stephens Inc.

Well, since you brought it up, I guess the assumption that as you're seeing sort of decreasing from utilization, which I have to assume is a decrease in EPO utilization. Are you seeing sort of a concurrent tighter control of other measurements such as iron and vitamin D, is that sort of the genesis of Luis comments on reevaluating vitamin D?

Luis Borgen

Could you say the question again Andreas, so that we...

Andreas Dirnagl - Stephens Inc.

Yes. I mean, as you said if you have something that is essentially free and easy to sort of clinical pathways just to use more of that. Are you now seeing physicians taking different clinical pathways that might require a tighter control over differing things in order to reduce the need of the EPO?

Kent Thiry

Yes, because that's the rational thing for people to think about and lots of people are doing that and exactly what answers will merged that are clinically equivalent or superior, no one knows yet but there's a lot of good brains working on it.

Andreas Dirnagl - Stephens Inc.

Just in terms of this whole transition adjustment, I'm trying to put the logic chain together, Kent, because clearly you've stated that you believe that, that CMS has made sort of an error in their estimates. And that's an error in estimating what percentage of clinics are going to transition and the rate is relatively high because I think the assumption is that what 40-some-odd percent of clinics are only going to transition as opposed to going over -- 47% are only going to opt in as opposed to going through the transition. So in other words, what you're saying is that CMS is underestimating the number of clinics that are going to opt in immediately, right?

Kent Thiry

I guess it's a little bit of a simultaneous equation that when you come up with calculations like the transition adjustment, if you're not careful, you do dramatically decrease the number of people who go into the bundle. So you kind of have to iterate back and fourth between those two assumptions. If the transition adjustment were less onerous, you would probably get a lot more people in the bundle than you would otherwise see or then you will otherwise see. Does that answer your question?

Andreas Dirnagl - Stephens Inc.

Well, but nevertheless, you've made some comments that you would be hopeful that CMS would revisit the transition payment in 2012. And the only way that the industry is going to see a reduction in the transition adjustment or even get money back from the transition adjustment is if more clinics than what they have estimated actually opt in, correct? We're looking for a higher number of clinics to opt in under that scenario?

Kent Thiry

Correct. That is most likely correct.

Andreas Dirnagl - Stephens Inc.

Can you just provide some color and some thinking on the announcement about the new headquarters?

Kent Thiry

Can you make the question more specific?

Andreas Dirnagl - Stephens Inc.

Well, in the past you have not had a sort of single headquarters building and one of the reasons was that I guess, economically, it was never worth spending, what I think is now an estimate of $100 million. I'm just wondering sort of what benefits that you see or what changes have occurred that caused you to think about doing that?

Kent Thiry

There's two different questions embedded in that. There's no change in our go forward expense structure. We've got a certain number of people in corporate overhead, if you want to call it that, and they got to be in a building somewhere. And we're going to have to pay rent on that building. And so the actual P&L economics are virtually identical in this new world we're moving into, where we put a lot of people in the same building and it's dedicated to be the building so it can hold our DaVita University, where thousands of our leaders will pass through each year, which we think will yield some very healthy productivity, retention and capability benefits. So on the P&L front, there's no change in philosophy because the economics are virtually identical. On the philosophy front, it is a change when we just decided what our emerging size and complexity, the economic value intangibly of getting a lot more of us in the same building, so that it's easier to remain tightly integrated as we have in the first decade. But that was just a very big deal. And it's already -- even as we're moving more and more people into the interim headquarters, the economic power of being together more often and having some of our people travel less often already exceeds our expectations. So two buckets. Economic, there ain't no change of any significance because you had the same number of bodies that you would otherwise in the same amount of rent per square foot and you pick up some savings in airplane travels and things like that, but we'd never want to market that as being material. And then on philosophical side or the intangible side, we think the benefits are immense. If you think about it, just a tiny, tiny adjustment in our labor productivity per hour equals millions of dollars annually. And we think by consolidating more of our professional development, we're going to get that.

Andreas Dirnagl - Stephens Inc.

Luis, on your comment. I guess you said that you saw an improvement in sort of labor productivity, and I was wondering if you can give a little color around that especially considering that I think during the first quarter call, Rich, sort of highlighted the fact that would mandatory tax certification, you might actually see some pressure on the labor line?

Luis Borgen

We could not see the pressure on that line, but just contingency great operational execution by the folks out in the field.

Operator

The next question comes from Gary Taylor of Citi.

Gary Taylor - Citigroup Inc

Just thinking about this decline in the pharmaceutical utilizations, sequentially, I mean it's a pretty steep sequential decline that rivals some of the impacts you were seeing back in '07 when the FDA label was being put under a little more scrutiny. So I'm just wondering what do you think is driving that? Do you think that increased visibility of some of the trials that have been out there for a couple of years now, is it positioned actually proactively, thinking about bundling? Any more color on why that driver?

Kent Thiry

You actually don't think. Bundling has much to do with it. That it's much more a function of some of the increasing visibility of the bound clinical issues, surrounding some of the drugs. And that it is virtually 100% that we just don't think a lot of physicians are out there thinking a lot about the bundle when they're deciding how much EPO to give you and me.

Gary Taylor - Citigroup Inc

On the mix issue, the $2.50 sequentially. Is there an estimate on the year-over-year drag on revenue per treatment?

Kent Thiry

We don't have any handy. We'll see if we can dig it out and get back to you.

Gary Taylor - Citigroup Inc

On the VA contracts, I know I guess you don't want to tell us exactly when those became effective. They are included in guidance. Guidance only goes through the end of the year. So is it fair to say those new rates due take effect sometime in 2010?

Kent Thiry

Yes. And I don't want to be -- let me just drill for the right words here for a moment because I do want you to -- in terms of I might answer that they could be December 27. The rates are either in effect or going into effect soon. And so it's not something that's delayed over four, five, six month that you have to worry every time you have to do head fake [ph] by saying they're incorporated into 2010 guidance. But the dominant economic effect will be felt soon. And so our answer is not an end around.

Gary Taylor - Citigroup Inc

I guess maybe to press a little more, understanding there's still uncertainty around us. But I think part of the investment community was always on edge to just wake up and see 2% of your revenues down 40%, down to the Medicare rates and understanding that, that risk isn't completely gone. It sounds like it is fair to say you feel a little better about it at least in terms of this holding at these new rate levels for a while?

Kent Thiry

Well, I am pausing because I'm think a literal answer to your question, which is a well considered question, do we feel a little better? The answer to that precise question is yes. We feel a little better.

Gary Taylor - Citigroup Inc

On the long-term contracts with two big payers. I guess on the commercial side, I guess I'm not used to hearing you talk in those sort of terms. Is that a number of state and regional contracts renewed under bundled structure to take payers or has there been any sort of change in terms of elevating the levels at which those contracts are being done? Are those national contracts or?

Kent Thiry

Yes, again, very fair question and they are above average contracts in size. Otherwise, we wouldn't brought them up.

Gary Taylor - Citigroup Inc

But you won't say if that's different than how those contracts were constructed historically or not?

Kent Thiry

One of them was at the high level of aggregation, the other one wasn't, but both well above the average size and so they did represent a reasonable continuation of our trend towards longer term contracting, more bundled contracting and since we've sometimes had to frustrate you necessarily the last couple of quarter's by staying totally qualitative in our comments, we thought we would pounce on this opportunity to give you a more tangible sense to the fact that we're making good progress in reducing our risk profile.

Gary Taylor - Citigroup Inc

Is the increased level of aggregation a trend that I don't know that I fully understood that you've talked about, but seems like maybe a little bit of that historically, but is there any significant change there we should be thinking about in terms of level of aggregation of revenues to certain payers?

Kent Thiry

I would say over the long-term that the transfer's aggregation, which we've talked about maybe every year or so for the last four years will continue. Will it pick up in speed? I think there's a very reasonable chance it will. I don't know that that's going to lead to any material near-term difference in competitive dynamics of the business. But I do think the long-term trend that we've talked about over five years will continue and it might pick up a little bit. And in general, that plays to our advantage.

Gary Taylor - Citigroup Inc

A lot of investors thinking about home dialysis whether that's hemo, whether that's PD [peritoneal dialysis] some of the incentives that exist on the bundling to do more home dialysis, a lot don't completely understand that you offer both home hemo and PD. So maybe just 30 seconds on your outlook for trajectory of growth in both of those services?

Kent Thiry

Absolutely highly qualified because we're not sure our PD population is growing modestly. We expect that to continue. Our HHD population is small and growing modestly and we don't really expect that to accelerate at this point. And so that's a pretty narrow answer. Is that sufficient?

Gary Taylor - Citigroup Inc

I think so, I mean, it doesn't just sound like there's necessarily a shift that's in mind more of a -- that will continue to be a pretty small piece of business going forward. So...

Kent Thiry

Exactly, so I think it's enough for you to categorize. It is not very material within the relevant investment timeframe, most likely.

Operator

Your next question comes from Mark Arnold of Piper Jaffray.

Mark Arnold - Piper Jaffray Companies

Just back to the payor mix question, as we think forward the next two, three, four years, let's assume the economy is going to continue to gradually improve, to what extent is the improvement in mortality something that you expect to continue to see? And do you think we can see 12% or 13% of your payer mix coming from commercial again?

Kent Thiry

Okay, two parts. A, with respect to mortality. We intensely hope to continue to improve our survival rates, and it's just gloriously wonderful how much we've done that over the last few years. We took a significant step back when we bought Gambrel and then got right back on the same trajectory marching down. So we hope that continues and it's just very unfortunate that means that we have a bigger Medicare cost deficit to fill until such time as any one on this calls has a relative on dialysis and then they're really happy that we have done that. Second, on the private side and the numerator part of the equation, history would indicate very strongly that an economic recovery will lead to a private insurance recovery, will lead to a more private patients, which will be a very nice bump for us. If it doesn't happen, then the pressure on the government to increase rates goes way, way up because when centers close down, real people get hurt, and real voters get upset. So there's a natural hedge there because we're talking about important stuff.

Mark Arnold - Piper Jaffray Companies

Over the last couple of years, I think you guys have been very consistent in saying that about half of the deterioration in payer mix has been a result of improved mortality. So what your saying I think is that you hope to see some improvement in that payer mix, but getting back to where we were a few years ago is unlikely as a percentage?

Kent Thiry

Actually, we would make no prediction as to how far it could bounce back. I would not discount the probability that if we go back to what it was in the good old days depending on how healthcare reform moves forward, could have a tremendous impact to the number of people on private insurance. At the same time, we're not predicting that it will bounce back to those levels. It just so much has to do with what happens with healthcare structurally over the next four or five years on top of whatever the economy does.

Mark Arnold - Piper Jaffray Companies

Can you just remind us of the process of how innovation, I think as you defined it earlier, in patient treatment protocols kind of works its way to your medical advisory board and how those new protocols are kind of process?

Kent Thiry

Could you do the question once more, please, Mark?

Mark Arnold - Piper Jaffray Companies

Can you just maybe explain to us the process of how any innovations in patient treatment protocols, particularly those coming out of positions in your centers working on different ways of treating patients that may or may not include changes in pharma utilization. But can you just talk about how those protocols or how those innovations that may come through work their way to your, I don't remember the term, your medical advisory board, Medical Directors? And how those things are processed at that board level?

Kent Thiry

If you had a piece of paper, you just picture four different circles. One picture, one circle is the office of the Chief Medical Officer, which is a group of very senior experienced docs that work for us 50% or 100%, and are the architects of new ideas and the trials and tests in order to compare those new ideas analytically. And second circle would be a P&T committee, which has not only physicians but also nurses, pharmacist and others that study the alternative clinical protocols with respect to any impact on the device used, the center of operations, things like that. The third circle would be our physician counsel, which is a set of physicians who don't work for us and are active practicing nephrologists, who would then debate and discuss all the observations, evidence, analysis, et cetera, from those first two circles. And the fourth circle was DCR, degree of clinical research, which is either the leading or one of the two leading clinical research organizations in the road in terms of kidney-focused pharma, biological and device trials, as well as medical informatics, which is to say the statistical analysis of all sorts of trials. And in the fourth circle that does a lot of the work to guide the conversations of those prior three. It's also an entirely separate profitable subsidiaries. So it's market tested in terms of its quality and rigor. So the process moves through those four groups iteratively, all of it under the watchful eye of our compliance team to make sure that everything that is done is documented. So the clinical validity and clinical motivation is not only pure but is well established, written down and documented.

Mark Arnold - Piper Jaffray Companies

And then, I guess just a follow-up to that, has there been any recommendation from those groups to adjust in lower pharma utilization recently that would maybe support the lower utilization that you've been seeing here for the last -- about particularly here in the last quarter?

Kent Thiry

A short answer is no, there's a lot of experiments and pilots going on, but they're not of enough size to explain any material part of the change. Hence our earlier answer to the related question saying that the changes going on is position-driven and all the data that we have suggested, it's physician responding to a lot of the journals and articles and data that's being discussed, particularly surrounding some of the drugs. So the short answer is no and those are the subpoints underneath, that's a short answer. I also add that, that the fifth group that's involved in this process throughout is all of our nephrologists in the community. So when the Office of the Chief Medical Officer or the physician counsel start seriously looking at ideas, those ideas are shared with hundreds of nephrologist out in the community for open comment periods. And so that every idea is very, very thoroughly vetted by nephrologists across the nation.

Mark Arnold - Piper Jaffray Companies

What's the amount of interest rate swaps that are still outstanding? And when do they expire and at what rate?

Kent Thiry

We'll look that up for you momentarily. Let's go ahead and go on for the next question and then Mark will come back with that answer and then two of you can stay on the line.

Operator

Your next question comes from Chuck Ruff (sic) [Charles Ruff] of Insight Investments.

Charles Ruff - Insight Investments

Back in the February Investor Day, you talked about long-term earnings per share growth of 9% to 11%. Now that we've seen the bundle, is that still seemed like a fair number to think about for the long-term?

Kent Thiry

That is still our goal. That has not changed. You please have to give us more than a weak to absorb this new regulation before we calibrate how it affects our probability of reaching that goal.

Charles Ruff - Insight Investments

A similar question, I think back then, you talked about big providers like we too fare a little better under bundling. Does that still seem fair or is it too early to say?

Kent Thiry

We still think it's fair.

Charles Ruff - Insight Investments

You mentioned earlier your target range for leverage, I think part of the region you were under that for quite a while was the uncertainty of the healthcare reform and the bundle. Are there some reasons that I'm not thinking of as to why you might still want to stay under that target for quite a while?

Kent Thiry

The short answer is no. One of the factors -- just repeat what you said, that there were a number of factors that led us to be below and a couple of the important ones were uncertainty around the bundle and uncertainty in the capital markets. And in those areas, there is less uncertainty now. Those were the only two factors but those were two of the big ones and they are different now, you are right.

Charles Ruff - Insight Investments

And there's no new ones to take your place that you can think of right now?

Kent Thiry

None that I can think of, but I'm looking around the table to see if -- no one has any to propose.

Charles Ruff - Insight Investments

And lastly, did you buy back any stock in July?

Kent Thiry

We are current -- our practices to disclose up until the date of the press release when we bought any stock back, and the answer to that is no. And that's why it wasn't in the press release.

Luis Borgen

The answer to the previous question was 350 million expires at the end of Q3 and the average rate is around 4.3%, regarding swaps.

Operator

Your next question comes from Kevin Ellich of RBC Capital Markets.

Kevin Ellich - RBC Capital Markets Corporation

Starting up with the acquisition spend this quarter, Kent, you mentioned that the environment is improving or at least you expect to close on some transactions. Do you guys spent $90 million this quarter, that's the most I think you spent in the last three years. Is that correct?

Kent Thiry

I'm not sure about the three years, but something like that. It's certainly of a high quarter. I just not sure about the three years.

Luis Borgen

And in part, it was a slow start to acquisitions as we mentioned last quarter. So you sort of, I mean, to look at it on a year-to-date basis.

David MacDonald - SunTrust Robinson Humphrey Capital Markets

What type of valuations are you seeing on the deals you're looking at?

Kent Thiry

Very consistent with what we've seen historically.

David MacDonald - SunTrust Robinson Humphrey Capital Markets

And then just wanted to get your views on home hemo, I think you cite recently you made another investment in NxStage Medical or have some more in Snow. And then lastly, thoughts on alternative forms of the assays, if you some new results a few months ago. I'm just wondering where you stand on hematide now and some other biologic out there?

Kent Thiry

On the second question, other ESAs, we've, of course, are eager for there to be more ESAs to choose from, any rational customer would be, even though EPO has now, as constituted, is a wonderful drug for our patience so on the assays, that's what we like. We're not very good at predicting how stuff unfolds in that space and so you can find other people far better than handicapping what will happen when. And then on HHD, on our NxStage, I wasn't clear about the question was, so if you could throw that at us again, please?

David MacDonald - SunTrust Robinson Humphrey Capital Markets

I guess, have your views change on home hemo? We know you're the leader in terms of the largest home hemo provider and patients on PD at home. Just wondering if you can provide any color on the investment in NxStage Medical?

Kent Thiry

Our views have not changed.

Operator

Next question comes from Darren Lehrich of Deutsche Bank.

Darren Lehrich - Deutsche Bank AG

The mean hemoglobin this quarter and the mean hemoglobin last quarter?

Kent Thiry

We've not historically disclosed that and we won't do it here today spontaneously. I'm not sure that's the right number for our shareholders to be thinking about, nor our physicians quite frankly. So let us think about when that that's the number we should start publishing each quarter.

Darren Lehrich - Deutsche Bank AG

I guess to the extent that we get new parameters, maybe above 12 might be useful if mean is something that you're not willing to disclose at this point, just I thought I'd ask. The exact percent of revenue related to the VA business. I think you've been using this sort of 2% number and on $6 billion of revenue, it seems like a pretty round number. So I'm wondering if you can just be a little more specific for us with respect to that?

Kent Thiry

I think what disappoints you on that one, Darren, that's to disclose more would create more risk for shareholders. That would offset any value in terms of incremental insight, and particularly since we've disclosed a fair amount and we haven't incorporated recent developments into our guidance.

Darren Lehrich - Deutsche Bank AG

And then revenue per treatment for non-ESRD labs, can you just give us a rough estimate of how much revenue you think you derived from those labs, not discretely identified in the list?

LeAnne Zumwalt

Yes, this is LeAnne, I think we aren't prepared to give you that number right now, thanks.

Luis Borgen

In fact, one of the problem was we didn't know how much those lab test that were proposed to being put into the bundle would cost. That's part of the reason why we commented that we needed a defined list.

Kent Thiry

And to elaborate further, just so you don't say were totally evading you on all three of your questions. The part of the difficulty was some of those other non-ESRD things is different doctors have different practices. Not only in terms of what they order but who they order it through and from. And different payers handle those things differently and so it's such a moving target. It is hard to know, which is why it would've been terrible for them to put it in the bundle and perhaps in the years to come, there'll be a lot more clarity on what that is in aggregate, much less, what our piece of it is because of course, that's all we could ever know is what piece of it is ours. I want to go back on the mean thing too, Darren, just so you didn't think we're being evasive there. We try to use clinical numbers in our conversations with you and other shareholders that are as close as possible to the ones we use internally. And mean is not one that gets much attention here, aggregate mean. If we start to use in the bunch for helping monitor what's going on in our company, then the odds that we'll start showing it publicly go way up.

Darren Lehrich - Deutsche Bank AG

Well, you have provided in the past something that differs in you is just pretty consistently disclosed. I'm not saying it's the right number to focus on but that's why I asked.

Kent Thiry

I know we have said it sometimes in the past but it's always been kind of a one-off thing and we literally calculated just to answer the question as opposed to calculating it as something we used to run the company or communicate with our physicians. And again, as much as possible, we try to avoid using different metrics and numbers with all of you and then we do it ourselves.

Operator

Your final question comes from Justin Lake of UBS Investment Bank.

Justin Lake - UBS Investment Bank

A quick question on the longer-term outlook or at least for next year, Kent, I think at the Investor Day, you said that given what you knew at that point, it was likely that it was going to take somewhere at the neighborhood of two to four quarters for you to drive enough efficiencies in the business to offset the expected Medicare cut. Can you tell us given what you know now if that still holds true?

Kent Thiry

Well, first of all, I would like to [indiscernible] slightly. It was two to four quarters to implement all the changes that we end up thinking our proved whether or not that is going to offset exactly or fully or not was and remains an open question. So with that amendment in mind, we would still say that the adjustment process, the operating change process, will take about two to four quarters and we've not yet decided when that begins. But it's either going to be at the end of the year or a bit before the end of the year, and then the clock starts ticking.

Darren Lehrich - Deutsche Bank AG

And given what you know now, is there anyway to tell us whether you think there's a probability or give us a probable aspect scenario under which you think you can actually keep operating income flat, grow it? Or do you think it will decrease 2011 versus 2010?

Kent Thiry

We're not prepared to answer that. Having said that, we don't want it to be some huge uncertain abyss. We are confident that there are going to be some innovations that will offset some of the cut.

Justin Lake - UBS Investment Bank

I would assume that you expect to give guidance with the typical range in some of the moving parts with the third quarter earnings?

Kent Thiry

Correct. That is our intense goal, because if we don't, you will be very upset.

Operator

At this time, there are no further questions. I will now turn the conference back over to management for any closing remarks.

Kent Thiry

Thank you, all for your thoughtfulness and good questions. We will work hard between now and our next call to add some value. Thanks.

Operator

Thank you. This concludes your conference. You may now disconnect.

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Source: DaVita Q2 2010 Earnings Call Transcript
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