Fundamentally And Technically, Fresenius Wins Big Over DaVita

by: Suresh Gupta

Editors' Note: This article discusses a micro-cap stock. Please be aware of the risks associated with these stocks.

Here's an interesting question that not too many investors ask themselves often enough: What do kidney dialysis and military spending have in common? The answer is a lot. Interestingly, the two have an intertwined history. The first dialysis machine was actually born under the pressures of World War II by a Dutch physician named Willem Kolff in 1943 in the Nazi-occupied Netherlands. He made it out of sausage casings, beverage cans, and a washing machine, as there weren't too many materials available under Nazi occupation. Though it failed initially, it actually worked by the end of the war in 1945 on one patient, taking her out of her coma and extending her life by 7 years. Dr. Kolff only passed away 5 years ago, a testament to how young dialysis science actually is.

More to the point though, both military spending and dialysis are either entirely (military) or nearly entirely (dialysis) funded by the Federal government, leaving both open to much waste.

The end products, of course, are different. In the case of the military, the government pays the private sector to build weapons with tax dollars. Being that the government can always take more tax dollars whenever it wants (or just print them) there is almost no check on how much money is being spent.

In the case of kidney dialysis, the end product is, well, dialysis. For over 41 years, ever since October 30, 1972, the government funds nearly all dialysis costs, subsuming them under Medicare through the End Stage Renal Disease Program [ESRD]. Whereas Medicare typically only covers medical expenses for seniors age 65 and over, ESRD patients qualify for full Medicare reimbursement at any age.

The two sides of the argument are the same as always. On the one hand, what if people can't pay their dialysis bill? Should we just let them die? Clearly not. On the other hand, if you subsidize something, you get more of it, and the same goes for kidney disease. See the graph below from the NIH that shows the rising incidence of chronic kidney disease [CKD]. It has more than doubled in only 8 years from 2000 to 2008, for all age groups.

Be that as it may, for investors, dialysis is a dangerous game even considering the rising demand, even more dangerous than investing in the defense sector. That is because, in the military/defense sector, the end consumer is the government itself, and who is going to sue the Pentagon for wasteful spending? This means the money flow can keep going with few checks against it. In dialysis under the ESRD Program, however, the end consumer is in the private sector, and if something there gets caught committing fraud against the government, the money can get cut off.

DaVita (DVA) - Caught Red Handed

Last November, CNN published a scathing ten minute report anchored by Wolf Blitzer on the second largest dialysis company in the United States, DaVita. Blitzer begins the report by portraying DaVita executives as profligate and over-indulgent, with "even a suspended ski gondola" inside their new 9-figure office building in Denver, CO. He then continues to skewer DaVita by painting its head as a little nutty, showing the CEO leading a company convention in a Three Musketeers outfit complete with fencing sword and full swashbuckling regalia right out of Dumas' imagination.

How he dresses is his business of course, and all these lavish eccentricities wouldn't be so bad if DaVita didn't get 64% of all its revenues from government programs, AKA taxpayers. 79% (page 4) of its patients are covered by either Medicare or Medicaid. The rest must be non-US citizens, as everyone else is covered under the ESRD Program.

Blitzer's report goes into a lawsuit that was filed back in 2007 against DaVita for wanton waste in order to overbill Medicare, and it could turn out to be the largest case of Medicare fraud in US history (see CNN link). The latest lawsuit against it was filed in 2010 for kickbacks. DaVita has already set aside $397M in the event of a settlement for the latter. As for the big one, DaVita is being accused of purposeful waste of medical supplies for the purpose of overbilling Medicare and Medicaid. One example given is that medical practitioners were being told to dose patients with 100mg of iron using four 25mg infusions of four 100mg vials, throwing out the remaining 75mg in each vial and billing all four to Medicare. This case still has a while to go before being resolved, but the problems with investing in DaVita, especially now, are many.

The biggest problem is, don't bite the hand that feeds you. When you start messing with the government, it can fight back and give business to your competitors. This hasn't happened yet, but could at any time. Another: investing in any company with 64% of its revenues from one customer (the government) who happens to be over $17T in debt with rising interest rates is a big risk.

Bottom line, DaVita has not moved much since that CNN report came out, moving about 10% since then, well below the S&P rate of return since November 2012, and if it loses this Medicare fraud lawsuit, it will be in trouble, or at least quite infamous. Investing in it is a game of roulette.

Are Smaller Dialysis Companies The Answer?

For someone who wants to get involved in this space, the options are few and far between, as Medicare has such a tight grip on the dialysis market share through DaVita that any serious disturbance of the hierarchy will affect the smaller fish in the pond. Take Rockwell (NASDAQ:RMTI), for instance. This stock has been going absolutely parabolic since July, rising 322% on negative earnings from $3.42 to $14.45 in only 5 months in a move that would make Bitcoin investors turn their heads. But besides that, every year, DaVita has accounted for a higher and higher percentage (page 14) of Rockwell's total sales, rising from 42%, to 48%, and now 49% as of 2012. Clearly, Rockwell is second in line for taxpayer money with the same top-heavy customer base as DaVita. With DaVita possibly in hot water and Rockwell bleeding cash and going parabolic, now is not a great time for a RMTI market order. Long dated put options look quite expensive on this one, but near the money puts on May 2014 seem reasonably priced and could spike any minute considering recent parabolic price action.

Then there's NxStage (NASDAQ:NXTM). At least this company has shrinking losses and climbing revenues to speak of. But once again, direct sales to DaVita have accounted for 31% (page 8) of total sales in 2012. Not as bad as Rockwell and the stock has plunged 30% since October 18th, so it is not in a parabolic mania right now and there could very well be some major short term upside, but only play it for the bounce.

Fresenius Is The Only Long-Term Hold In The Sector

For someone looking to take a stake in dialysis, there is one good long-term option, and that is Fresenius (NYSE:FMS). There are both fundamental as well as technical reasons to pick Fresenius over DaVita. Fundamentally, Fresenius pays a dividend. DaVita does not. Fresenius is even larger than DaVita, and though it is involved in its own share of lawsuits, most are counterpartied by other companies in minor squabbles over patent violations rather than defrauding the Federal government in potentially the biggest Medicare fraud in history. Perhaps most importantly, at least most pertinent to the point trying to be made in this article, is that Medicare and Medicaid account for only 22% of Fresenius' net trade accounts (page 187 at the PDF), and US commercial providers 19%, fairly well balanced. This compared with DaVita's lopsided top-heavy 64%.

The only reason Fresenius can achieve this balance is that it is a German company. There is no way that an American company can operate in the dialysis field without having most of its revenues come from the ESRD program, unless it is a niche company treating conscientious objectors to government subsidies who need dialysis (there aren't many of those) or non US citizens.

From a technical standpoint, Fresenius also has major advantages over DaVita. DaVita reached an all-time high of $65.60 only 7 months ago in May. It is only 11% below that high now. Fresenius, on the other hand, reached its all-time high of $39.28 two and a half years ago in April 2011 and has shown strong, consistent support comfortably above the $30 mark ever since.

Overall, FMS has the least amount of risk and strongest upside, with the Fed supporting stocks indefinitely as it has been doing, with no signs of stopping the printing presses. And if DaVita ever does get in real trouble with the Federal government, it is Fresenius that will pick up its market share. DaVita may just keep going up anyway, but Fresenius makes more sense from a risk/reward standpoint overall.

Acute Kidney Injury Prevention Is The Wild Card

A dialysis piece would not be complete without mentioning the interesting sideline developments in the kidney world. A recent study published just last month by the University of Cincinnati found that patients who have suffered from acute kidney injury [AKI] prior to dialysis were 1.5x more likely to die within the first year of dialysis than patients who have not suffered from AKI. AKI is an abrupt, total, but temporary failure of the kidneys, like turning off a light switch rather than the gradual failure of ESRD akin to slowly dimming a bulb. AKI can happen for various reasons including dehydration or sepsis from an infection, but by far the most preventable and common is major surgery involving contrast dyes.

Contrast dyes are radioactive dyes pumped into a patient to enhance x-rays, and these dyes must be filtered out eventually by the kidneys. A study commissioned by the NIH found that an amazing 11% of patients pumped with a contrast agent develop AKI, and the procedure is very common for all kinds of different surgeries. 11% is a highly significant number, and it means that a way to prevent it could dramatically increase the average length of time affected people can undergo dialysis without dying, as eventually a donor must be found. A way to prevent AKI from contrast dyes could mean lives saved while ESRD patients wait for an organ donor, on top of increased revenues for dialysis companies.

The only public company currently selling a contrast-induced AKI prevention system is PLC Systems (OTCPK:PLCSF), a tiny company struggling to survive through FDA approval of its RenalGuard device. What RenalGuard does is monitor the urine production rate in real time while adding water to blood at the same rate so the kidneys are guarded against a sudden flood of radioactive dye, protecting them against AKI during surgery. There are three ongoing open clinical trials being conducted with RenalGuard right now, one in phase 3 and another in phase 4. Two of them are scheduled for completion in December 2015.

PLCSF is less interesting as a hold or trade, it being a speculative penny stock as it is, but more interesting as to the impact RenalGuard may have on the dialysis sector if and when approved. Of course, if it is approved and either Fresenius or DaVita take notice and understand the implications of how it could increase their revenues without resorting to Medicare fraud, it'll be fun to see what will happen to PLC and/or whichever company acquires RenalGuard.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.