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By Bill Buhr

With regulatory changes afoot in the dialysis space, it's critical that investors understand the dimensions around the new bundled payment system, and what it means for industry stalwarts Fresenius (FMS) and DaVita (DVA). We've touted both of these firms as intriguing investment opportunities at various times in the past, and would recommend them again--Fresenius more so, given its vertically integrated business model and non-U.S. exposure--if either one were to return to 4- or 5-star territory. Before we talk about the two companies individually, let's quickly recap the current reimbursement structure, as well as the Centers for Medicare & Medicaid Services' (CMS) final proposed changes to the payment system.

Regulatory Changes to the Current Reimbursement Structure

Dialysis is somewhat unique in that Medicare is the primary payer for all patients with End-Stage Renal Disease after a period of 33 months, regardless of age. Once Medicare becomes the primary payer, it pays for 80% of the cost of treatment, with the patient, Medicaid, or supplementary third-party insurance is responsible for the remaining 20%. Medicare payment rates are considerably lower than commercial rates, which mean two things: Dialysis centers depend on higher commercial rates to subsidize Medicare rates, and centers actually lose money on Medicare-reimbursed treatments, as payments are lower than a typical center's average cost per treatment.

The current Medicare payment system provides dialysis centers with an adjustable composite payment for each treatment, plus a separate payment for certain drugs administered during treatment, the most critical of which is Amgen's (AMGN) anemia drug Epogen. Due to the fact that the government provides separate Epogen reimbursement to clinics, a de facto profit center has developed for many dialysis firms, much to the chagrin of regulators. Epogen now represents around 20% of dialysis services revenue in North America for both Fresenius and DaVita, and an even greater amount of profits. CMS has become increasingly concerned that the current system encourages overuse of Epogen, particularly due to the drug's high profitability for dialysis centers and recent safety concerns that may be tied to Epogen overuse.

Bundling and its Impact on Fresenius, DaVita

Partly as a result of these concerns, the government will now administer one payment for all dialysis services provided, including pharmaceuticals. The new payment system, which begins next year, will cover services and certain drugs, including Epogen, with potential adjustments based on age, body measurements, and total time spent on dialysis. This base rate has the potential to be roughly 10% lower than what the payment would have been under the old system. CMS is also introducing performance standards to ensure that quality of care for ESRD patients is satisfactory, with clinics facing a potential 2% rate reduction beginning in 2012 if quality of care is deemed subpar. We've been fairly steadfast in our opinion that dialysis providers in general, and the larger chains in particular, will not suffer materially from these changes, but we want to specially discuss our assumptions for each company in the wake of the new bundling era.

We believe Fresenius is in a fairly strong position to absorb a more punitive bundling outcome. The firm has nearly 800 dialysis clinics outside of North America, which won't be affected by CMS' bundling decision. Secondly, Fresenius has a vibrant dialysis products business that generated $2.9 billion in 2009 and provides some diversity to its operating structure. With its vertically integrated business model, as well as its significant scale, we think the firm will be able to stomach any short-term issues related to bundling. In our base-case model for Fresenius, which yields a fair value estimate of $59 per share, we are currently projecting average revenue per treatment in North America to increase by 2% in 2010 to $349 per dialysis treatment (a blended rate of Medicare and private payers). However, we are projecting 1% reductions in this metric in 2011 through 2014 based on the introduction of bundling, as we expect private payer reimbursement levels to mitigate the negative bundling reimbursement changes. While it is unclear whether Fresenius will opt in fully on Jan. 1, 2011 or more gradually over the four-year period, the company has indicated to us that the longer the delay around the final rule lingers, the harder it could be to opt in fully next year. We currently assume the firm opts in over a four-year period. Including our revenue growth estimate of around 8% for 2010, we project a five-year compound annual growth rate of nearly 6% through 2014.

Our downside scenario assumes more drastic outcomes to revenue per treatment, with the metric falling by 4% annually from 2011 through 2014, yielding declining growth in North America dialysis care revenue over our five-year forecast period. Under this scenario, our overall compound annual growth rate for Fresenius revenue amounts to 2% annually. Even in this bear-case scenario, with lower growth and declining margins, our fair value estimate is $43 per share, about 20% off where Fresenius currently trades.

We think DaVita faces greater uncertainty and an elevated risk profile given the firm's lack of diversity, as the company possesses neither a products business nor international exposure on the services side. Our base-case scenario for DaVita assumes a compound annual revenue growth rate of 5% through 2014, including 7% revenue growth for 2010, and we estimate declines in average revenue per treatment for DaVita that are similar to Fresenius (1% revenue per treatment reductions beginning in 2011). This yields our fair value estimate of $71 per share. Our downside scenario for DaVita incorporates a 5% decline in average revenue per treatment from 2011 through 2014, yielding a compound annual revenue growth rate of roughly 1%. This scenario also assumes margin declines of 150 basis points to 13.8% of sales by 2014, and assumes DaVita is not able to realize cost savings on Epogen through its negotiations with Amgen. In this bear-case scenario, with lower growth and declining margins, our fair value estimate falls to $41 per share.

Overall Investment Takeaway

While there are still some uncertainties around how specific components of the new bundling rule could affect each firm's overall business model, we continue to believe that new regulations will not cause any substantial hiccups operationally for either company. Furthermore, given Fresenius' vertically integrated business model, and its international presence that partially serves to insulate it from potential domestic regulatory hurdles, we think the company is a great overall business for investors to hitch their wagons to--but only at the right price. (Click to enlarge)

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Source: Why Dialysis Is Still an Attractive Business