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DaVita (NYSE:DVA)

Q4 2010 Earnings Call

February 10, 2011 5:00 pm ET

Executives

LeAnne Zumwalt - VP of IR

Kim Rivera - Vice President, General Counsel and Secretary

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.

Shelley Gnall-Sazenski - Goldman Sachs Group Inc.

Frank Morgan - RBC Capital Markets, LLC

Unknown Speaker

Justin Lake - UBS Investment Bank

Gary Lieberman - Wells Fargo Securities, LLC

Jeff Hoernemann - Feltl and Company, Inc.

Darren Lehrich - Deutsche Bank AG

Mark Arnold - Piper Jaffray Companies

Gary Taylor - Citigroup Inc

Ilan Chaitowitz - Redburn Partners LLP

Kevin Fischbeck - BofA Merrill Lynch

Operator

Ladies and gentlemen, thank you for standing by, and Welcome to the DaVita Fourth Quarter 2010 Earnings Conference Call. [Operator Instructions] Mr. Gustafson, you may begin your conference.

Jim Gustafson

Thank you, Beverly, and welcome, everyone, to our fourth quarter conference call. We appreciate your continued interest in our company. I'm Jim Gustafson, Vice President of Investor Relations. And with me today are Kent Thiry, our CEO; Luis Borgen, our CFO; and LeAnne Zumwalt.

I'd like to start with our forward-looking disclosure statement. 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 the 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 and undertake no duty to update these statements for any reason.

Additionally, I'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'll now turn the call over to Kent Thiry, our Chief Executive Officer.

Kent Thiry

Okay. Thank you, Jim. Greetings to everyone. Thank you for your interest in DaVita. The fourth quarter reflected solid operating performance on two different levels: A, the results from sales; and B, our work to prepare for the bundle. I will cover four topics: clinical outcomes, our recently announced acquisition, bundling and our outlook.

Let me start with clinical outcomes. We always put that first because it must come first. We are first and foremost a caregiving company, serving more than 125,000 patients. First, with respect to adequacy, which is essentially how well we are doing in removing toxins from our patients' blood, this past quarter, 96% of our hemodialysis patients had a Kt/V greater than 1.2. Second, with respect to vascular access, 67% of our patients have fistulas, which is the preferred form of vascular access.

Third, with respect to anemia management, physicians have managed 73% of our patients to hemoglobin levels between 10 g/dL and 12 g/dL over the last three months. For these and virtually all other clinical measures, our patient outcomes compare very favorable to the national averages. And this quality care not only results in healthier patients, but also drives reductions in hospitalizations and surgical procedures and therefore, drives significant savings to the U.S. taxpayer.

Next, a few words about our recently announced acquisition of DSI. As always, we have received some questions about the price and expected return. The short answer is that there is a high probability that we will earn a satisfactory return when we apply the same return on capital discipline to this transaction as we have to the many, many large and small acquisitions we've done over the past 11 years. And one distinctive feature of this asset is that it has some particularly attractive geographies and physician group affiliations as well as many, many excellent caregivers and other employees. And we are very excited that we're going to be able to offer our much broader range of integrated services to these wonderful centers, improving clinical outcomes, improving service offerings to patients and physicians and reducing the overall cost of care for payers.

As you know, this transaction is subject to antitrust review. We will have to divest a fair number of centers. We are already seeing strong demand for whatever divestitures we will make, and we're even contacted by a number of potential buyers. There will be minimal operating income impact from this deal in 2011 because the transaction is likely to close in the second half of the year. And we will, of course, incur some transaction and integration costs in the first few quarters post close, and it will take some time to achieve the ultimate synergies.

Next subject is bundling. As of January 1, we are in the bundle as most of you know. You will also recall that we are being subjected to an annual cut of approximately $140 million in Medicare reimbursement for our 2010. We are working hard to fill this gap and are making solid progress. There are still also a few uncertainties under the new reimbursement itself. We do not yet know how the clinical changes that physicians are implementing will play out across our entire patient population. We will not receive our first payments for a couple more weeks, and we continue to have to work on being able to identify and capture case mix and outlier adjusters. This is one of the frustrating exceptions to the otherwise collaborative process we have had with CMS in implementing the bundle.

They were told by the entire community ahead of time that not only do we not have the data for many of the proposed adjusters, but also no one has obligated to give it to us, period, much less on a timely basis. And so these adjusters will create a lot of operating issues and will also mean we will not receive the reimbursement level that CMS has projected.

Putting all of this together, our current outlook is that 2011 operating income will be flat or modestly down. The cryptic summary of why a lot of the good things are offset leading us for that directional guidance is the following five items: A, the Medicare cut just alluded to; B, Medicaid cuts; C, VA cuts or more likely reduction in VA patient volume as we can no longer afford to take more government-paid patients at reimbursement that is less than the cost of taking care of them; D, commercial mix changes; and then E, an unusual surge in our G&A expenses driven primarily by IT investments and our investment in international growth.

One other variable that significantly affects the G&A, in fact, our third variable, is the growth of some of our non-dialysis units is well above our treatment growth rate and this drives the aggregate corporate G&A expense as a percentage even though it does not represent any unusual G&A growth in and of itself.

Before I turn it over to Luis, a couple other thoughts. We continue to believe that our company is well positioned to operate in the bundled dialysis world. We still believe that if they fix the problems in the implementation, the bundle will be good for patients and good for the overall system. And we do intend to hold our capital markets day in Boston on May 3 in conjunction with our Q1 earnings call. And at that time, we hope very much to be able to give you more specific 2011 guidance and provide more color about how the bundling transition is going. We hope to see many of you there and answer every single question you have.

Luis?

Luis Borgen

Thanks, Kent. Here are some specifics on the quarter. Non-acquired growth was 4.4%. When normalized for the calendar, our non-acquired growth in the quarter was 4.2%. This past quarter, dialysis revenue decreased $8 per treatment.

[Audio Gap]

2011. Our effective tax rate attributable to DaVita was lower than previously expected this quarter, primarily due to nonrecurring tax benefits associated with close examinations and statutes. We expect our effective tax rate for 2011 to be in the range of 39.5% to 40.5%.

We have entered into interest rate hedges that have effectively fixed our interest rates through September of 2014. As a result of these hedges, we expect interest expense in 2011 to be between $235 million to $240 million. Cash flows remain strong. In 2010, we generated $840 million in operating cash flow and $597 million in free cash flow.

Looking ahead, I want to remind you of a few things for the first quarter. When we began on January 1, which means a sequential drop in Medicare revenue per treatment from Q4. The first quarter is shorter at 77 treatment days, which means fewer overall treatments and fewer days over which to amortize fixed expenses.

Payroll taxes are higher in the first quarter, which is about $2 per treatment sequential increase to expenses. For these reasons, you should expect a sequential decline in revenue per treatment and a sequential increase in expense per treatment, meaning a decline in operating income from Q4 2010. You should also expect there will be some short-term collection delays as Medicare contractors and secondary payers process our initial bundled claims. This will impact our cash flows in the first half of the year.

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

Kent Thiry

Wait one moment, operator. We're getting some feedback that the phone may have blacked out for a short period. And you know...

LeAnne Zumwalt

I think a few moment or two of Luis' commentary was cut off. And if that's the case, I think what we could do is handle those questions in Q&A. So apologize for that, but understanding that there was a technical issue.

Kent Thiry

Okay. Operator, can you please open up for Q&A?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Gary Lieberman with Wells Fargo Securities.

Gary Lieberman - Wells Fargo Securities, LLC

I guess going back to Luis' statements, I think it was probably cut off for, it seemed like about 45 seconds. So Luis, I guess you probably discussed the cost per treatment in the quarter. I don't remember hearing that, so maybe if you go back and discuss your comments on that, that would be helpful.

Luis Borgen

Sure, I'll read that. Let me just reread it to you, a short paragraph. Essentially, dialysis operating expense per treatment decreased $8 from the prior quarter. There were three factors: lower utilization of physician prescribed pharmaceuticals, savings and the unit costs for pharmaceuticals and that was partially offset by some labor and benefit costs.

Gary Lieberman - Wells Fargo Securities, LLC

That's helpful. And then I guess to your comments about revenue per treatment declining further in 1Q '11, could you provide some more color about that? Is that specifically from some of the issues that, Kent, you mentioned about the coding of the new patients or anything? Anything there would be helpful.

Luis Borgen

Primarily, it's related to the Medicare revenue per treatment as we enter into the bundled environment, coupled with the fact that the quarter is shorter by 77 days and payroll taxes are also higher in the first quarter. Those are the three comments along the Q1 sequential drop.

Operator

Your next question comes from the line of Justin Lake with UBS.

Justin Lake - UBS Investment Bank

First question just on the revenue per treatment. For some reason, I still haven't picked up exactly what you were saying as far as the decline this quarter. Can you just give me the split between the different components?

Luis Borgen

Sure. The primary reason for the decline was lower utilization of pharma, and the commercial mix was offset by the increase in private rates. So part of what declined was pharmas.

Justin Lake - UBS Investment Bank

Can you give us any specifics on the commercial mix and outlook in the quarter? I think you had said it was actually accelerating the deterioration in the third quarter?

Luis Borgen

In the third quarter, we did say that commercial mix was decelerating. In Q4, we had a decline from Q3.

Justin Lake - UBS Investment Bank

And was that decelerating even within the same rate, or it looks you might be seeing signs of stabilization there?

Kent Thiry

Let me clarify, the decline or deterioration in Q4 was less than that in Q3.

Justin Lake - UBS Investment Bank

So your mix was better in Q4 than Q3?

Kent Thiry

No, the rate of decline was less in Q4 than in Q3. But thanks for forcing the clarification, Justin.

Justin Lake - UBS Investment Bank

Going into 2011, if I could just ask a point-specific question. Is the revenue per treatment going to be down, and can you give us a ballpark as far as how much to help us model this? And what is the expected revenue per treatment in the first quarter?

LeAnne Zumwalt

Yes, Justin, we're not providing detailed guidance, as you know, at this time. Safe to say, the Medicare revenue per treatment is going to be down because of the implementation of the bundle.

Justin Lake - UBS Investment Bank

On the cost side, you had another decline in pharma. Should we expect to see that continuously go through 2011?

LeAnne Zumwalt

Are you saying utilization declines?

Justin Lake - UBS Investment Bank

Yes, performance intensity?

LeAnne Zumwalt

Yes, Justin, we are in the process. I think Kent mentioned implementing various protocols and changes. How those will take effect when you have hundreds of physicians making daily decisions, we're not yet ready to put a stake in the ground.

Justin Lake - UBS Investment Bank

Can I just ask one last question on the minority interest? Looked like it was a little bit higher than what we expected in the quarter. Can you just give us any color on how that's expected to look in 2011 and why that continues to grow?

Luis Borgen

Yes, it fluctuates quarter-to-quarter, but it's primarily driven by more JVs and higher profitability of those JVs. We think that it's a reasonable number for Q4 heading into 2011. It will be in that range.

Justin Lake - UBS Investment Bank

So this is a good run rate?

Luis Borgen

It could vary up or down.

LeAnne Zumwalt

Yes, Justin, clearly, it's going to vary slightly as we implement Medicare and the results of all that. So it will fluctuate just with our forecast as you might expect.

Operator

Your next question comes from the line of Shelley Gnall with Goldman Sachs.

Shelley Gnall-Sazenski - Goldman Sachs Group Inc.

I was wondering if you could go back to the comment on the VA rate cuts. Did I understand correctly that it's going to be more -- the impact to DaVita will be more in lost volume rather than natural rate cut?

Kent Thiry

It's impossible to predict until we know exactly what the VA does. They have the right now to assert Medicare rates, but a provider doesn't have to accept a new patient. And so in a whole lot of cases, in order to, say, give veterans the access and quality that they will probably want to, they're going to need to negotiate a non-Medicare rate. And so given there's going to be a lot of negotiating out there, it's impossible to predict exactly what's going to happen. What is clear is we have a lot of centers that can afford to take more patients where the reimbursement is less than the cost. And in particular, and that reflects the conscious decision by the government to do so after being forewarned.

Shelley Gnall-Sazenski - Goldman Sachs Group Inc.

If I could ask also on the managed care contracts, I understand in the third quarter there was a shift to move more managed care contract to a bundled payment methodology. Can you give us any update on your progress on that front, any color?

Kent Thiry

We haven't been doing any kind of quarter-by-quarter reporting rather than what we've been doing for last 15 months or so is saying that we are satisfied, on track, making progress and that the net results are incorporated into our guidance. And I think we're just going to stick with that for now.

Shelley Gnall-Sazenski - Goldman Sachs Group Inc.

One more if I could. Any update on your priority uses of cash now given this is going to be a pretty -- that there's a lot of moving parts in 2011? Any thoughts on repurchase?

Kent Thiry

Really no change in our long standing philosophy that every single quarter, we take a look at buying back stock versus investing in growth versus holding cash versus paying down debt. And those dynamics, as you just mentioned, change a lot. And so we can't really predict. I guess the only thing we can predict is we're going to put it through the same sort of analytical template we have for the last 10, 11 years. And as the record indicates, that leads to a lot of different decisions at different points in time.

Operator

Your next question comes from the line of Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

Question for you on the guidance. I appreciate the Q1 color there. It seems like a lot of it that you were guiding us to had to do with just the seasonality that we normally see, but obviously, the rate cuts involve as well. But when we think about the guidance of operating income being flat to down modestly, is it right then to think that the first half of the year we have the rate cut off all of a sudden and it takes some time to get your cost structure in place, means that then the second half of the year is probably going to be flat to up modestly. Is that the right way to be thinking about it?

Kent Thiry

To be honest, we didn't anticipate that particular question, so I'll be speaking out of school a little bit here. But it is certainly the case that we take lots of the revenue hits immediately, and it's certainly the case that some of the adjustments take time. And so the net of those two big tectonic plates shifting would suggest exactly what you said the second half of the year would be better than the first half. Having said that, we've not reflected on everything else out there, and I don't know if there's anything else that would cut in a different direction. So you're probably right, but we don't have an analytical answer to that.

Kevin Fischbeck - BofA Merrill Lynch

Well, the thing that would jump out to me in the second half of the year item potentially would be the Amgen contract. I mean, is there any assumption in your guidance around that?

Kent Thiry

Well, the uncertainty around the Amgen contact is one reason why you're getting the breadth of guidance that you're getting. In addition, one other variable that does push the other way more second half dynamism than first half dynamism is the VA. We have a lot of contracts with the VA. Those expire at different times. And so over time, there's a greater cumulative effect of whatever is going to happen with the VA. And so that would be one example where you wouldn't want to rush too quickly to the conclusion that the second half will be better than the first.

Kevin Fischbeck - BofA Merrill Lynch

And I think you mentioned in your comments that you guys are facing $140 million Medicare rate cut, which, if I do the math and assume 80% of your patient treatments are Medicare, it gives me about $9 per treatment. Is that the right way to think about it?

LeAnne Zumwalt

That's a reasonable way to think about it.

Kevin Fischbeck - BofA Merrill Lynch

Kent, the other comments you made at the beginning was that the quarter was good in part because of all the progress you made for bundling. Where do you feel like you are right now as far as what you need to do to prepare and to react to bundling?

Kent Thiry

Oh, boy. There's about 12 different initiatives under that category, and to try to apply some sort of quantitative score on what percent is done with each one; and in particular, when you kind of don't know where the end line is, you don't know how much you're going to be able to adjust. So I think I just have to punt. We're not 90% done. We're not 10% done. But I get pretty queasy about going a lot further than that even though that's not terrifically useful for you.

Operator

Your next question comes from the line of Darren Lehrich with Deutsche Bank.

Darren Lehrich - Deutsche Bank AG

Just a few things, really to follow-up on your comments previously, Kent, on VA. Can you just help us think about what percentage of your VA contracts or business, I should say, is contracted in 2011? And just maybe give us a sense for that, because it seems like you have some visibility into the VA cuts given that there is a bunch of it that's contracted?

Kent Thiry

Yes, we haven't disclosed that. And for competitive reasons, we don't think we want to. We feel more pressure to if we thought it would help you get to a better answer. But in this case, it doesn't because even in places where we don't have a contract, it could very well be that the VA does not have a high-quality alternative to our center. So it does not mean that that's going to move to Medicare if we don't have to keep that patient or take the next one. I say all this of course because we like to take care of every veteran in America with a warm embrace. But when the government intentionally implements a policy where they're going to try to force us to take reimbursement that they know is less than expenses, we have to, at some point, pushback somewhat in self-defense. And so given it's not as if there's one clear result with a non-contract situation and the opposite result with a contracted, it's really of no analytical value for you to know the mix. And for us, representing you, it's better that it not be known.

Darren Lehrich - Deutsche Bank AG

Next question just relates to anemia management. We have seen a pretty dramatic improvement in your metrics that you're reporting now of 10 g/dL to 12 g/dL over the last year or so, even sequentially. But you've called out a number of times over the last few quarters just about the dramatic reductions in pharma utilization. So I guess maybe just help us better understand, have your protocols already begun to go in place and is that the result? Or is there still more to come relative to rolling out the protocols for 2011?

Kent Thiry

Well, certainly, what you saw in the fourth quarter was not a coincidence. And certainly, we are not done. Could you push the question further in some way where I can be incrementally useful?

Darren Lehrich - Deutsche Bank AG

Well, it just strikes me that your EPOGEN is coming down and your anemia management numbers are improving. So I guess that's the point, maybe less of a question. I am curious to know if Amgen has indicated to large customers like yourselves whether they will continue to be on a biannual cycle with their price increases. Do you have any certainty on that?

Kent Thiry

We'd like them to go to a once-a-decade price increase or so and maybe skip a decade every now and then. They made no comments on that to us. Don't know what they said to others. They do know that there are few more visible issues in the healthcare than the price of that drug, and that now providers have an absolute fixed Medicare reimbursement cap. And so exactly what they're going to do, only they know, but there certainly are a lot of people watching.

Darren Lehrich - Deutsche Bank AG

Last question, I think you said yourself that the growth in G&A was maybe a little bit unexpected, maybe I just misheard you. But could you comment a little bit about what's accelerated in your G&A spending? And maybe as a corollary to that, did we start to see any international investment in, I guess, the other segment in Q4? Because you did slip a little bit sequentially. You were sort of breakeven last quarter, so just curious about that.

Kent Thiry

First on the IT, it is an unusual surge and a nontrivial one. Let me just give you two examples. One is, we're putting in a new human resource system, which we haven't done for eight years or so. And if you compare '11 to '10, that's going to be about a $6 million, $6.5 million incremental G&A investment, which will then fall by about $2 million to $3 million in '12 and then further in '13. Second material example, we're putting in a new clinical management system first time in eight years. And that also is leading to plus or minus to $6 million incremental spend in '11 versus '10, and there will be a diminution of a couple million in '12 versus '11 and then somewhat more diminished in '13 versus '12. So those are a couple examples that explain a big chunk of the unusual surge, which will then start to work its way down. And who knows what other investments we may decide to make, but these two are big and very, very mainstream. As to Q4 international, I don't know the specific numbers. But certainly, in Q4, we spent enough on the P&L internationally that it would have moved that dial a little bit. And if Luis or LeAnne want to amend that, they can. So it did play a role. I'm not sure it was a huge one.

Darren Lehrich - Deutsche Bank AG

Have you made any definitive decisions about your initial markets, geographies that you plan to pursue?

Kent Thiry

We're still thinking it's in your best interest not to say what they are, but we are a multinational company now in the sense that we have expenses. We hope to move on to the second half of that equation as soon as possible in a couple of carefully selected spots.

Operator

The next question comes from the line of Ilan Chaitowitz with Redburn Partners.

Ilan Chaitowitz - Redburn Partners LLP

This is Ilan Chaitowitz from Redburn Partners in London. I just got two. The first is about your cost per treatment. And I noticed there was about an $8 decline quarter-on-quarter, and you gave a rather conservative estimates of about $9 hits to your revenues from the bundle. Is it wrong to say that you've already nearly mitigated the entire impact of the bundle on your revenues before it's actually hit your P&L yet? That's the first question. And secondly, I was just wondering if you could give us some sort of probability or your best guess as to what the likelihood is of a transition adjustment revision or update within the first quarter of 2011?

LeAnne Zumwalt

Yes, so the first part of your question, Ilan, I'll answer it. The year-over-year gap in Medicare is the $140 million number we gave you. As Kent said and as you relate that to our entire forecast, there are puts and takes to major offsets to growth, including the specific things that you mentioned, which was the Medicare bundle, impact from government reimbursement in the VA and the Medicaid type programs, some increase spending in G&A and in our international investments. Those are things that we mentioned. Does that answer your question?

Ilan Chaitowitz - Redburn Partners LLP

It kind of pushes the question further out. It means that those other expenses that you're referring to either with VA or other SG&A expense are going to be over and above any incremental cost savings you are likely to generate over 2011, because you already neutralized much of that $9 hit that you quoted?

LeAnne Zumwalt

Yes, I think you can't look at that as a standalone. The $140 million is a revenue hit. We have been working on improvement in protocols and things like that as you saw in the fourth quarter, don't completely offset it. And in fact, probably the $9 isn't quite right. But that said, directionally, we've offset some of it and we'll be working obviously through the year to continue improvement.

Ilan Chaitowitz - Redburn Partners LLP

And on the probability of a transition adjustment revision in the first quarter of 2011?

Kent Thiry

That probability is low. Not zero, but low.

Operator

Your next question comes from the line of Gary Taylor with Citigroup.

Gary Taylor - Citigroup Inc

I guess, one, just going back to the transition payment adjustment. Is there any color you think would be helpful for us to have? I know at one point last year you were hopeful there was a legislative solution. And at other points, you were, maybe hopeful isn't the right word, but hopeful of an administrative solution. Kind of where do we stand now, and maybe more specifically as we head into 2012 and we head into the summer when presumably we get a ESRD proposed rule, what's your outlook on a correction of this mathematical error as we head into 2012?

Kent Thiry

Yes, let me take a cut at it. I mean, there's three buckets. As to a legislative solution soon, despite the fact we have a lot of support, it's unlikely because they're so dysfunctional. As to legislative pressure leading to a regulatory solution soon, not in the first quarter but soon, we have a shot. As to an ultimate satisfactory regulatory solution, we have received positive indications but getting positive indications nine months before something actually is going to supposedly happen and all the processes they go through at that time is, well, much better than getting negative comments not nearly as reassuring as we'd like it to be.

Gary Taylor - Citigroup Inc

Fair enough, and you warned us last quarter on this. When would you anticipate an ESRD proposed rule out on CMS?

LeAnne Zumwalt

Yes, looking forward to 2012 bundle, you mean?

Gary Taylor - Citigroup Inc

Yes.

LeAnne Zumwalt

Yes, in the same time frame as we expect in most years, release of the preliminary in the June time frame with finalization around November 1.

Gary Taylor - Citigroup Inc

I'm sorry to go back to the G&A. I just want to make sure I understand it. So I understand there are some new IT initiatives having impact on that. I understand that there are new international operations having an impact on that. Are we to take from that though that this $158 million is kind of a right quarterly jumping off point for '11? Or is there still the possibility of some typical, or maybe atypical, but some quarterly volatility in that dollars spend?

Luis Borgen

I expect to be typical volatility in that spend. But as Kent mentioned earlier, we do plan on making some investments in IT and some HR systems as well as international.

Gary Taylor - Citigroup Inc

And then moving to the DSI acquisition. Given your comments about the geographies, et cetera, I mean, is there any reason to believe that ultimately you don't do a similar operating margin on that group of assets? And if you can get there, what's a fair assumption on how long it would take?

Kent Thiry

Gary, is this about stuff overseas?

Gary Taylor - Citigroup Inc

DSI.

Kent Thiry

DSI. Okay, I apologize. I missed the first part of your question. So will DSI end up with a comparable margin to us?

Gary Taylor - Citigroup Inc

Right.

Kent Thiry

I do not know the honestly correct answer to that question. I know what I said is true that the probability that we get a satisfactory return is comfortably high. I know that math well. I actually don't know the margin math because of course, you can't eat margin and you can only eat long-term cash return on capital. So I apologize, but that's the best I can do. If I just sort of intuit, you would think that if there is a gap, it would narrow because there are some synergies. But become identical, I don't know enough in my head about the geographic mix, and we wouldn't have necessarily taken a look at that because it wouldn't have affected our business decision.

Gary Taylor - Citigroup Inc

Fair enough. Since you judge it on a cash return metric, any chance you could tell us what sort of return you think this generates?

Kent Thiry

No. That would not be prudent, not in your best interest. What we can say in the spirit of trying to be useful, however, is that the way we've thought about after-tax cash return on equity capital is that if you think of a spectrum and say at one end for highly strategic deals how low are you willing to go, and at the other end for pure vanilla deals, no strategic benefit whatsoever, what would you really like to see, that range for us is from $8 million to $16 million and this deal falls within that range.

Operator

Your next question comes from the line of Mark (sic) Frank Morgan with RBC Capital Markets.

Frank Morgan - RBC Capital Markets, LLC

Actually, it's Frank Morgan with RBC. I was hoping I could get a little bit more color on the -- you mentioned earlier on the impact of having to deal with case mix and outliers. I was just curious about if you could go back and give me a little bit more color on why that is an issue. And then the second question was on this anticipated delay in payment from your intermediaries. Could you quantify that how long do you think that takes? Have they given you any feedback specifically as to how long they think the payment process maybe slowed?

LeAnne Zumwalt

Yes, it's LeAnne. I'll take those questions. On the case mix adjusters, a couple of core issues here. Number one, the fixed acute and chronic conditions are required for us to get documentation from the source, so either from a hospital or a referring physician who made those diagnoses. And unfortunately, there is absolutely no requirement that those institutions work with us to get the documentation. So the set up of the rule itself is quite cumbersome and really quite impractical, and we kind of warned them off it. I think there's some other level of issues within that between the original data that the CMS contractor did in the final rule and some of the codes and things that changed and became much more restrictive. So although we did a nice job of working with CMS to get a number of comorbidity adjustments down, we did not make it all the way to get them to a policy that was really implementable by the dialysis providers. Did that answer your question on case mix?

Frank Morgan - RBC Capital Markets, LLC

Yes, and how about with the outliers?

LeAnne Zumwalt

Yes, on outliers, that's just simply a matter of data capture and calculation as well as the details of the formula within CMS. We've identified some pharmaceuticals and things that did not get included in the final rule, so won't count towards that goal, and some other issues that's more of a technical nature that I think will prevent CMS from paying out the full total.

Frank Morgan - RBC Capital Markets, LLC

Does this investment you're making in clinical management in 2011, did that in anyway help address all these issues with documentation for case mix or for outlier?

LeAnne Zumwalt

No, it really doesn't. It's an independent issue.

Frank Morgan - RBC Capital Markets, LLC

So what will the clinical management investment actually do and will it have a nice return on it?

Kent Thiry

It will help us improve the quality of care for 125,000 people, and in some cases, incrementally improve our productivity in doing so.

LeAnne Zumwalt

And then I think you had a follow-on question on billing?

Frank Morgan - RBC Capital Markets, LLC

Yes, just the delays you said you may be experiencing. Have these fiscal intermediaries kind of given you any indication of how long this may be slowed down?

LeAnne Zumwalt

So no, we're really early in the process, and we're just really -- we bill monthly, that's how dialysis is billed. So we've just billed January and, so we're kind of waiting to see how that comes back. That said, a couple of issues have been identified and they're universal to all of the mass that we deal with, some issues with the logic on paying for home claims. And so those are going to get unheld and that would get corrupted. We probably -- we anticipate some other glitches. CMS knows about the first one, and it's clearly working on it. So we'll keep you posted. Again, we think that's a short-term issue, not a long-term issue. So until we really get a quarter or two under our belt, it's hard to predict.

Frank Morgan - RBC Capital Markets, LLC

In terms of just when you look at where you are now with basically being the month end of this, are there really any long-term issues that you worry about with bundling? Or is it just this initial period maybe, call it, two or three quarters? Or do you see anything that's just a structural problem that will be with you forever?

Kent Thiry

Fair question. As long as they fix the stuff that needs to be fixed, then the system should work for everyone, and in fact, work better than the old one. It should save the government money. It should lead to some improved care, and it should leave providers solvent.

Operator

Your next question comes from the line of Gary Lieberman with Wells Fargo Securities.

Gary Lieberman - Wells Fargo Securities, LLC

In talking about the acquisition and the FTC review, it seemed back when you did the merger or the acquisition of Gambro, that even if there were relatively high concentrations in the market, a lot of the acquisitions were allowed to go through, I think primarily because of barriers to entry were low. Can you talk maybe about what you think has changed, if anything, in the way the FTC is looking at deals or, if anything, in terms of barriers to entry or anything has changed dramatically?

Kent Thiry

A very fair question, and we simply have no visibility into that. And there are people who claim visibility into it, and some say things are going to be stricter now because the industry is more consolidated. Others say that shouldn't be the case because of the rise of home modalities and the fact that there's a lot of proven interest on the behalf of the capital markets in these segments. So clearly, attracting new investment in new competitors. And so some very smart people end up drawing diametrically opposed conclusions, and none of them actually gets to talk to the people that they're talking about. So we just don't know. When we apply the more or less principles and practices of the past, we end up with a range of outcomes that we find very acceptable in the context of the transaction, particularly because there's such healthy demand for anything we have to divest. And ironically, the bigger the number you divest, the higher the multiple is likely to go. But beyond that, there's just isn’t much we can say because we don't know.

Gary Lieberman - Wells Fargo Securities, LLC

And then looking at the -- going back to the average hemoglobin number and the nice increase you've seen in the patients between 10 g/dL and 12 g/dL, is it possible to get some color? Is that more patients coming down from above 12 g/dL or patients coming up from below 10 g/dL that gets you there?

Kent Thiry

It's more coming from above 12 g/dL, because there's always such a small percentage below 10 g/dL. So that's why the answer is what it is.

Gary Lieberman - Wells Fargo Securities, LLC

And it sounds like you're confident you can continue to drive that number higher. Can you give us maybe any kind of rough range for target?

Kent Thiry

No, I'm afraid not.

Gary Lieberman - Wells Fargo Securities, LLC

And then would you expect to give guidance at some point this year maybe after you see the claims for the first quarter, or should we expect that you probably won't give guidance for the remainder of the year?

Kent Thiry

We are hoping to be able to be a lot more helpful to you on May 3 at our capital markets day in Boston, which will be simultaneous to the actual earnings release for those who can't be in Boston live. So that is our hope that we can deliver that to you then.

Gary Lieberman - Wells Fargo Securities, LLC

The helpfulness being that you think there's a pretty decent chance you will be able to give us some guidance in May?

Kent Thiry

Exactly.

Operator

Your next question comes from the line of Mark Arnold with Piper Jaffray.

Mark Arnold - Piper Jaffray Companies

Just a couple of clarifying ones. Just back to the SG&A comment, maybe to ask the question a little differently. Should we look at Q1 as the SG&A line being sequentially up or flat from the fourth quarter? Or is there enough variability there that, that could be down?

Luis Borgen

There is enough variability for it to be up or down. But I think directionally, it'd be similar to our Q4 number.

Mark Arnold - Piper Jaffray Companies

And then I've asked this before but remind me, I think you guys mentioned that at some point during 2010 that you're going to get merit increases this year. Can you remind me how those increases flow throughout the year? Is it heavily weighted toward the beginning of the calendar year? And then I guess maybe as just a follow-up to that, can you remind me or can you give us a sense for where those increases are likely to be this year relative to the last two years?

Kent Thiry

What we actually said was we're going to have higher merit increases in '11 versus '10. As to whether or not it's evenly spaced throughout the year or skewed, it is moderately skewed towards the beginning of the year. And was there a third question?

Mark Arnold - Piper Jaffray Companies

No, I think that answers it. And then just one last question for me on the VA. I think when you guys reported your second quarter numbers last year, you talked about coming to agreement with the VA on certain contracts. And I assumed that the commentary from earlier here in the call, should we expect then that at least a decent portion of those VA contracts will expire at some point either late second quarter or early third quarter?

Kent Thiry

A very decent percentage will expire in the calendar year 2011. As to the concentration, I am not sure how the mix is across quarters, so I can't go there. Perhaps we can provide some guidance on that on May 3.

Operator

Your next question comes from the line of Frank Miller [ph], a private investor.

Unknown Speaker

My question relates to the DSI acquisition. Your comments indicated that you felt confident that some divestiture would be required on any FTC review. I'm curious as to what geographical areas you think those divestitures might relate to.

Kent Thiry

I don't have them memorized, and I don't think it should affect anybody's valuation of our company or its prospects. And so I think we'll probably stay away from that because it will cause much more trauma than it will add any value for you guys, and trauma is not in your best interest.

Unknown Speaker

The press release indicated that there would be Hart-Scott-Rodino filing. Has that filing been made? Or if not, when will it be filed?

Kim Rivera

Sorry, the filing has to be made within a prescribed statutory period. And I believe if we have not made it, we will be making it shortly.

Kent Thiry

And that is Kim Rivera, our General Counsel. But the speakerphone wasn't close to her, hence the delay.

Operator

Comes from the line of Jeff Hoernemann with Feltl and Company.

Jeff Hoernemann - Feltl and Company, Inc.

Just thinking about the case mix adjusters. Again, does the $140 million reduction include your ability to capture case mix adjusters, or is that just kind of a top line number assuming you can capture all the case mix adjusters?

LeAnne Zumwalt

Can you repeat that, I'm sorry.

Jeff Hoernemann - Feltl and Company, Inc.

So $140 million cut for Medicare, does that include the assumption that you can capture every case mix adjuster? Or would it be more if you can't capture the clinical case mix adjustments?

LeAnne Zumwalt

Yes, it would definitely be more depending on how we'd be there. So the exposure could be more.

Jeff Hoernemann - Feltl and Company, Inc.

And then secondly, maintenance CapEx also is a pretty big plump quarter-over-quarter. And actually, if you look at fourth quarter versus second quarter, it's pretty big. Is that also IT-related, and is that kind of a run rate? Or you think it will decrease back to more traditional levels?

Luis Borgen

The increase is primarily IT-related, and we haven't given CapEx guidance. So we do expect to make additional investments to go along with the G&A investment on IT. So the P&L investment would go along with some additional CapEx. So I would think it to be more in line with the number you saw in Q4.

Jeff Hoernemann - Feltl and Company, Inc.

And then lastly, the international plans. Compared to when you first announce your intentions, is there any change on the thought of whether your movement will be more gradual or potentially one quick entry into any given area?

Luis Borgen

Yes, we don't have any change in our thinking or plans since we last spoke about it.

Operator

Your next question comes from the line of Andreas Dirnagl with Stephens.

Andreas Dirnagl - Stephens Inc.

Kent, as usual, I just want to clarify some of the comments you made to make sure I'm understanding what you're saying. I think you were pretty clear, but I just want to make sure. Under the VA, when discussing the VA, were the VA to decide to move to Medicare pricing, what you're saying is that you would be forced, therefore, to no longer be able to take VA patients. Is that correct?

Kent Thiry

We would take them in some cases and not in others, and I assume other providers would be the same.

Andreas Dirnagl - Stephens Inc.

Is the dynamic, therefore, that where the VA potentially has other, as you put it, high-quality options, you would think that perhaps you might lose the patient. But in those areas where they don't, you have the ability to negotiate a rate that you'd be satisfied with?

Kent Thiry

That's certainly one of the primary fulcrums, but there are a bunch of other ones: our institutional relationships, our physician relationships, what we think is going to happen in the year or two or three. So I think it's pretty situation-specific, fact-specific, with one of the major fulcrums being the one you identified.

Andreas Dirnagl - Stephens Inc.

But then bottom line, it's really no different than any commercial payer negotiation that you enter into?

Kent Thiry

I guess it feels differently to us because they are veterans, but that maybe -- so I guess it is not the same, although I can see how some people might think it would be.

Andreas Dirnagl - Stephens Inc.

Kent, I don't know whether you will, but I'm going to ask the question anyway. Can you provide any color just sort of on the Amgen contract negotiations? And specifically, it is perhaps a little bit unusual to just sort of extend what was a long-term contract by another six months. And I'm wondering, was that sort of at DaVita's behest? Was that at Amgen's behest? Was it sort of a mutual decision you came to? Just any sort of color that you can provide would be helpful.

Kent Thiry

Sure. It was mutual, that's the answer to the narrow question. And as to the broader question, the good news is I would characterize the discussions as intelligent, measured, thoughtful, constructive, that neither side wants to do something that benefits a lot in the short term but creates huge chaos or uncertainty or all sorts of trauma downstream. And so I think the quality of the discussion is among the highest we have had with them, which could be a reflection of us being more thoughtful or them or both in the past, no finger-pointing here. But I think the good news for the community is those are the right adjectives as opposed to either side having an excessive emphasis on some short-term victory that just creates a lot of risk and messiness for everyone. Is that helpful?

Andreas Dirnagl - Stephens Inc.

Actually, that was surprisingly helpful, yes. Is this the sort of process that is now ongoing in terms of negotiation? Or is this sort of a mutual decision where you said, "Okay, let's come back at a certain point in time and see where we stand?"

Kent Thiry

Well, first of all, I'm not going to try to do a good job of clarifying things that even when I do it, you act so surprised. But on that subject, I think both sides want a long-term arrangement, and so that is the goal.

Andreas Dirnagl - Stephens Inc.

And then just two more quick clarifications. On your pharma utilization, I'm curious, you're obviously making clinical and operational changes preparing for the bundle, and that was partially what drove or is what drove the majority of the decrease in utilization in the quarter. I'm curious, is it a factor of you fully were able to make some changes to all of your clinics to see that decrease? Or was it that some of your clinics have taken the changes or started to do the changes and you need to expand the number of clinics?

Kent Thiry

I would say that there are virtually zero clinics that have not done some changing, probably zero, but the degree of change differs quite dramatically. I'd also say the other end of the spectrum, virtually no clinics are done changing.

Andreas Dirnagl - Stephens Inc.

And then finally, either for you or Luis, in terms of the pop that we saw in the SG&A expense, was there anything in there that was unexpected in terms of, "Oh, we literally didn't expect that we needed to spend this money" or was it more of a timing issue that perhaps it showed up a little bit earlier and more accelerated than you expected?

Luis Borgen

We were not surprised. G&A is something that we track very closely. Of course, there are some things that are timing related. But for us, G&A came in line with where we thought it would come in within a reasonable range.

Kent Thiry

Yes, I think, Andreas, we just did a bad job of thinking ahead and adding together a bunch of stuff that we were getting pretty sure we were going to do x months ago. And it wasn't until the annual budgeting and forecasting that we said, "Gee, it really is going to add up to an unusual amount." And then we went back and stared again at whether or not we wanted to postpone any of it in order to smooth things out, and we just decided that would be a dumb business decision and we hope you would understand.

Andreas Dirnagl - Stephens Inc.

In terms of the potential for any change to the transition fee, I'm just curious, is it sort of appear to be the situation that CMS is taking the position that in order to do something before 2011, that has to be legislated, but once we get into 2011, it becomes regulatory and CMS can make the change themselves? Is that the dynamic?

LeAnne Zumwalt

I didn't catch that.

Kent Thiry

Let me go ahead. Yes, you pretty much got it right, Andreas, that although we believe CMS could change the decision right now and we feel that it's a pretty clear rifle shot, so they are right to do that. Some of the important people there disagree and say we ought to wait until what they see is the normal window for them making the regulatory change, which is out there in the future a bit. Is that responsive?

Andreas Dirnagl - Stephens Inc.

Yes, thank you very much.

Operator

Your next question comes from the line of Justin Lake with UBS.

Justin Lake - UBS Investment Bank

First, on the case mix and the outliers. Can you remind me, I think the Medicare rate that was published was somewhere in like the $239 range on average. How much of this is supposed to come from case mix and outliers on average?

LeAnne Zumwalt

Yes, several dollars of that.

Justin Lake - UBS Investment Bank

So something like $3 or $4?

LeAnne Zumwalt

Yes, that's about the range.

Justin Lake - UBS Investment Bank

It sounds like you're fairly concerned as far as not knowing how CMS is going to treat your documentation. Do you expect not to accrue for that in the first couple of months until you see how they do it? Or will that not be a problem for the first quarter, you'll know one way or the other?

LeAnne Zumwalt

Yes, let me be more specific. The documentation requirements are quite extensive in the rule, well, in the supplemental transmittal. So they expect us to have original diagnosis down to a very specific sets of ICD-9 code. And then as to your revenue recognition, no, we will not recognize revenue for something we're not sure or certain that we have proper documentation for.

Kent Thiry

In other words, Justin, in most instances, you know when you submit the claim because if you don't yet have documentation for something that you know the patient has, but you don't have the right documentation, you submit the claim for the lesser amount. And then if and when you ultimately get the statutorily required documentation, you have to rebuild, which is probably what makes this just a huge administrative morass.

Justin Lake - UBS Investment Bank

So do you think you're going to get the $3 or $4 right off the bat?

LeAnne Zumwalt

We're saying no, Justin.

Justin Lake - UBS Investment Bank

And then on the Medicare revenue cut, you mentioned $140 (sic) [$140 million] was kind of a year-over-year estimate. Just given I think your investors would be more interested in the current run rate of earnings, I was hoping you might be able to give us a comparable cut estimate using a fourth quarter Medicare reimbursement per treatments as a starting point?

LeAnne Zumwalt

Justin, we think the right way to look at it is year-over-year, and the $140 million was the year-over-year number. So we're going to stop with that.

Justin Lake - UBS Investment Bank

The hemoglobin between 10 g/dL and 12 g/dL, just curious, in terms of the quality oversight from CMS on hemoglobin levels, can you remind us what kind of metrics they're going to be tracking? I believe there's a certain percentage that they're going to allow you below 10 g/dL and over 12 g/dL?

LeAnne Zumwalt

Yes, actually the performance standard comes into play in 2012. And you're right, they're measuring two aspects of hemoglobin the sub 10 g/dL population and the greater than 12 g/dL. The benchmarks for performance are that you see either or your own individual average in 8 g/dL compared to actual performance in 10 g/dL. Or the national average is 7 g/dL compared to your actual results in 10 g/dL.

Justin Lake - UBS Investment Bank

And can you tell us where those numbers are supposed to be? Like how much is allowed to be below 10 g/dL, I guess, would be the question.

LeAnne Zumwalt

Justin, it's going to be on a center-by-center performance, so I can't give you that data.

Justin Lake - UBS Investment Bank

And what percentage of your patients are below 10 g/dL right now?

LeAnne Zumwalt

Justin, we don't have a number right here with us, and we didn't disclose it. So we're just focusing on that percentage of patients between 10 g/dL and 12 g/dL.

Justin Lake - UBS Investment Bank

And then looking ahead to the Investor Day, there are a lot of moving parts obviously in 2011 like the transition adjustment, which is a pretty big headwind. And then you got this DSI acquisition, which probably doesn't impact you much in '11 but should be pretty beneficial to '12. So when you get to that Investor Day on May the 3rd, in addition to giving us more color putting a range of outcomes around 2011, will you be able to tell about what the expected earnings power of the company should be in '12 and '13 when the transition adjustment should get reversed and DSI earnings start showing up in the P&L?

Kent Thiry

Justin, as you know, for a lot of years, we did give a three-year rolling forecast with all the appropriate qualifiers, but as a way of helping you identify the most significant swing factors so you could maniacally focus on those. And we would hope to do that in May with the qualifier. If we don't think we can do it well enough to be useful, we'll wait longer before we start doing that again. But we prefer a world in which we do that just as you do. And on the $3 to $4, it's not that we're thinking that every single difficult case mix adjuster will never be billed or collected, Justin. It's, we think, a relatively realistic prediction of the instances in which we'll never be able to get the quality documentation to justify that, which is true. And as you all know that have been around, at some point, we're all going to get subpoenas, accusing us of playing games with case mix adjusters. And so even if I know you're right-handed, if I can't get all the right paperwork because the hospital doesn't have to give it to me, then I can't bill for the fact that you're right-handed. And in some cases, unfortunately, that's just exactly what's going to happen. And it's not what it was intended. But until we get the system fixed, it's what's going to happen.

Operator

Your next question comes from the line of Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

Just a quick follow-up question here. I think at the beginning, you might have said it, but if you did, I missed it. You said at the beginning capital deployment was going to depend on share repurchase and acquisitions and cash on the balance sheet and those things will move around from time to time. Did you give a baseline number for what you think you need as far as cash in the balance sheet just to run the business? And then obviously the cash flow might grow off of that. But how much do you just to run the business simply?

Luis Borgen

Yes, cash on the balance sheet, about $100 million to $200 million will be sufficient to account for the seasonal variations in networking capital in the business, Kevin.

Kevin Fischbeck - BofA Merrill Lynch

So anything above that might be deployable then?

Luis Borgen

Right.

Operator

[Operator Instructions] Your next question comes from the line of Andreas Dirnagl with Stephens.

Andreas Dirnagl - Stephens Inc.

Kent or LeAnne, just out of curiosity, when it comes to the outliers and the underlying diagnoses, are those diagnoses that are made by the nephrologist or is that made by another physician in the majority of cases?

LeAnne Zumwalt

In almost all cases, if made by an oncologist or hematologist or GI physician, that's the problem.

Operator

And we have no further questions at this time.

Kent Thiry

All right. Well, thank you, all, for your time and attention. We look forward to seeing many of you in person on May 3 and talking to the rest of you again. In the meantime, we will do our best.

Operator

Thank you for joining today's conference call. You may now disconnect.

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