DaVita Inc. (DVA) is a leading provider of kidney care in the United States delivering dialysis services to patients with chronic kidney failure and end stage renal disease. As of June 30, 2012, the company operated or provided administrative services at 1,884 outpatient dialysis centers located in the United States serving approximately 149,000 patients. In addition the company provides acute impatient dialysis services in approximately 900 hospitals and related laboratory services throughout the United States. Kidney failure is obviously a global problem and DaVita is looking to expand outside of the United States, building off its 19 operated outpatient centers in 4 different countries. DaVita is a high-return business with scale advantages, in a segment of the health care market that is likely to grow due to the aging of populations across the globe. While the valuation doesn't scream to be a no-brainer bargain by any means, DaVita is an attractive business that is likely to grow earnings at a mid-teens rate over the next several years.
Kidney failure is typically caused by Type I and Type II diabetes, high blood pressure, polycystic kidney disease, long-term autoimmune attack on the kidney and prolonged urinary tract obstruction. The loss of kidney function is normally irreversible. ERSD is the stage of advanced kidney impairment that requires continued dialysis treatments or a kidney transplant to sustain life. Dialysis is the removal of toxins, fluids and salt from the blood of ERSD patients by artificial means. Patients suffering from ERSD generally require dialysis at least 3 times a week for the rest of their lives. (Source-DaVita 10-K)
(Source DaVita 10-K)
DaVita is the 2nd largest dialysis company after Fresenius Medical Care AG & Co. (FMS), and combined, the two companies account for two-thirds of outpatient dialysis patients in the United States. DaVita serves about 32% of the total outpatient dialysis patients. Hospitals and individual medical practitioners are some of DaVita's primary competitors, but it seems likely that the industry could see some continued consolidation moving forward.
(Source DaVita 10-K)
Through a combination of acquisitions and internal development DaVita has steadily increased its presence and market share. While international operations are not currently profitable, they do offer an attractive opportunity moving forward to leverage the company's knowledge of sound treatments, and to enhance its purchasing leverage. Healthcare costs are a huge problem for governments across the world, particularly the United States, so margin pressures are a very real threat for DaVita. Medicare and Medicaid comprise 90% and 66% of DaVita's treatments and revenues respectively, while commercial and private insurance comprises 34% or revenues, and all of the company's profits. This means that commercial and private insurance payments are substantially higher, subsidizing the 90% that rely on the government programs. Costs for labor, rent, and key drugs such as Amgen Inc.'s (AMGN) Epogen have been increasing, but the company has done an admirable job of reducing cost-inflation with internal cost-cutting efforts. Because the whole dialysis and health care industry as a whole is facing some of these primary headwinds, DaVita's scale advantages should help it elbow out the lower-margin competitors in the United States. International expansion will be a higher risk/reward type situation, but management has shown itself to be quite strong, and I'm confident they are up for the challenging task.
On May 21st, 2012 DVA announced the acquisition of HealthCare Partners, the country's largest operator of medical groups and physician networks for approximately $4.42 billion. The purchase price consists of $3.66 billion in cash and approximately 9.38 MM shares of DaVita common stock. HealthCare Partners is a managed care provider with over 667,000 patients, and the company had 2011 EBITDA and operating income of $527MM and $488MM respectively. While this acquisition is quite transformative for DaVita, the price was reasonable particularly when considering the low-cost, long-term debt that DaVita has been able to issue to assist with the financing. The bottom line is that health care companies that can improve patient outcomes, at the lowest possible costs are going to be the winners moving forward. Time will tell if the combination of DVA and HealthCare Partners together will succeed in this endeavor. The acquisition in addition to DaVita's previous expansion of its dialysis center footprint makes the company a leveraged play on management's success in attaining cost-savings and growth, which should ultimately flow to the bottom line.
In the 2nd quarter, the company reported net income of $142.9MM or $1.49 per share, excluding $0.50 cents a share in legal costs from an adverse settlement. In addition DaVita increased its 2012 operating income guidance to a range of $1.275 billion to $1.325 billion, excluding the $55MM settlement. Free cash flow continues to be quite strong with the company generating $111MM in the quarter. This has allowed DaVita to buy back stock and to make accretive acquisitions. Since 2002 the diluted share count has dropped from 136MM to 95MM, while revenue has grown from $1.559 billion to $7.555 billion TTM.
DaVita has consistently generated a return on equity in excess of 20%, and returns on invested capital between 7-8%. By employing a fair amount of leverage (about 3.7x EBITDA) DaVita has seen explosive earnings growth. Incorporating acquisitions I see no reason why the company shouldn't be able to grow revenues by 7-8% a year and I'd expect to see stable margins, and returns on invested capital. If it weren't for the international expansion I'd expect for margins to improve slightly as the company's cost-savings plans, and scale advantages improve. According to Morningstar the mean forward EPS according to analyst estimates is $7.98, which puts the forward earnings multiple at around 13. I believe including stock buybacks, the company could grow earnings by 13-16% moving forward over the next 3-5 years, largely due to patient growth, acquisitions and low-cost financing.
A lot could go wrong for DaVita, so I'd wait for a pullback around the $90-$95 area before beginning a dollar-cost-averaging program to acquire the stock. Berkshire Hathaway Inc. (BRK.A) is the largest shareholder in DVA, with greater than 10% of the company, and has added to its purchases at prices around $100 per share. For someone looking to acquire a reasonable amount of shares, a program of selling the April 13 $100 puts, and then selling more puts at lower levels if the stock drops would make some sense. Be aware there isn't a great selection of options available on DVA, and spreads are wide so limit orders are a must. While buying the company at 13 times forward earnings may not provide a huge margin of safety, the business does have some durable competitive advantages, and may warrant a better multiple if it executes successfully on the integration of HCP. I'm personally waiting to get in at a cheaper price as I'd like to own the business over the long-term.