Dissecting The DMG Deal Risk For Davita (Podcast Transcript)

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Includes: DVA
by: Behind The Idea
Summary

There's a lot to agree on for DaVita bulls and bears, but the looming DMG sale seems to be the big turning point.

This transcript shares Ethan Watkins' bear case and why he thinks the DMG sale has taken so long to close. (Hint: he doesn't think it's a coincidence).

He also shares what he sees as the flaw in DaVita's business model, and the dialysis industry as a whole.

Editors' Note: This is a transcript version of our podcast with Ethan Watkins about Davita Healthcare (DVA), published earlier today. We hope you find it useful. You can check out our full Behind the Idea coverage of DaVita (three podcasts and two other transcripts) here.

Introduction

Daniel Shvartsman: On this week’s Behind The Idea, we revisit the DaVita HealthCare story once more. This time, we are talking to Ethan Watkins, whose short thesis sparked our initial interest in the company. We asked him about the argument that last week’s guest Mike Knipp made about the Medicare put in dialysis and how that makes things work much better than the bears recon, and he responded with this.

Ethan Watkins: Insurers in a lot of these dialysis companies have been playing, I don’t know if this is really the right way to describe, but have been playing hot potato with these patients.

DS: Then we asked a big question facing shorts, how does it feel to bet against DaVita’s shareholder, Warren Buffett’s Berkshire Hathaway.

Mike Taylor: Question, you are on the other side of the trade from a very powerful, well-known and legendary investor in Berkshire Hathaway and Warren Buffet, does that matter to you, how much does it matter to you?

EW: It doesn’t. Simply put.

DS: DaVita provides vital service to customers and yet it leaves everyone feeling a little awkward. A major divestiture appears to be hinge for either bull thesis or the bear thesis depending on how it might play out. So, what’s going to happen? We discuss on this week’s Behind The Idea.

Podcast

MT: Welcome to Behind The Idea. I’m Mike Taylor.

DS: And I’m Daniel Shvartsman.

MT: Today, we’re continuing our coverage of DaVita HealthCare, ticker symbol DVA for an unglamorous business focused on kidney dialysis, DaVita is a low-key battle ground stock. Bulls point to customers need for this crucial health service, well bears criticize the regulatory set up that seems to fuel a lot of DaVita’s success. Today, SA author Ethan Watkins, one of DaVita’s critics joins us on the podcast. Before we get started, a couple of quick notes. Behind The Idea is the Seeking Alpha podcast about great investment analysis, Daniel is long Berkshire Hathaway B shares and Ethan Watkins is shorts DaVita. Nothing on this podcast is meant as investment advice of any sort. We are recording this conversation on Friday, February 22nd. Okay, Ethan welcome to Behind The Idea.

Ethan Watkins: Well, thank you for having me.

MT: So, let’s just jump right into this. You’ve been notably bearish on DaVita for a bit now, what drew you to the DaVita story?

EW: What initially drew me to this story was kind of a picture – I was watching an interview with Jim Chanos and Bethany McLean for Vanity Fair and Jim Chanos had recommended a book called The Seven Signs of an Ethical Collapse, and I thought, this seems kind of interesting. So, I went out and I picked up the book and I started reading it. Then after that, I saw the John Oliver bit and I thought well wait a minute, hold on I kind of seen this movie before, I think – looked around a little bit more and the more and more I kind of looked around, I started asking a lot more questions kind of the more upset I became at really the dialysis industry as a whole and the more and kind of the situation that I started figuring out, I thought was kind of more upsetting and at some point it just kind of turned into more of a session and it started turning into talking to everybody, to digging through all the 10-Q and all the SEC filings, it turned into something a lot more than kind of what I thought originally it would be.

And then I was at Army School for a few weeks or so, and me and some of the other guys there, we were all kind of sitting around and talking about HealthCare and how it’s gotten so expensive and what is going with the state of healthcare. And I started kind of explaining a lot of this stuff, especially with DaVita specifically and they are like well this is kind of interesting as anybody really done any writing on it. I don’t think anybody has done a whole lot of writing on it, and so I was more or less encouraged to kind of go out and put something together out on Seeking Alpha and that was kind of more or less how things got started, that’s how I got into the story.

MT: Got it. What specifically was upsetting to you and what kind of grabbed your buddies’ interest about this story, like what is it that sort of drives that?

EW: What I found more upsetting really about the industry as a whole is that, it’s a system that’s meant to be gained and so, I mean there are lawsuits that have come out where DaVita was taking a bunch of drug called Epogen and they were sticking into patients to help prop up their bottom line or there was a – I think this was the largest Medicare settlement ever was where DaVita was taking several vials of a drug called Venofer and they were pulling out parts of it and then giving the patient what it needed like say 100 milliliters and then more or less billing the government for three or four vials when they only needed one. Does that make sense?

MT: Yes, yes, that’s good. So that ties into kind of the next question, which is, what’s your perspective on this regulatory situation, you mentioned gaming, so how are the players involved in this market for dialysis and related services? How do they play against each other and what specifically do the – role do the regulators play?

EW: I think that lot of the regulatory situation that has kind of come up is a bit more of the symptom and not really the cause. And I think it also kind of shows that there is a lot of discourse between the union and management. And the fight that they are having with the union seems to be at a higher level than what a lot of other managements have had with the unions. I guess more specially to legislation that was happening out in California, to some extent, I think I kind of understand where the union is coming from, but I think that a lot of the legislation that they have proposed or have put up has been a little bit more misguided.

I think that there is kind of a dozen other things and I really wish that they would go out and tackle as opposed to simply trying to cut off profits. I wish the unions would go out and there was a legislation that was passed a year or so ago, where it allowed private approval of [dialysis clinics], so it used to be that a government inspector would come in and the dialysis clinic would get approved and get put up. Now, it’s much of a private deal. I wish the union would go and try and lobby for things like that, or it would lobby for more, cut fare wages or would lobby for other things other than just simply trying to cut of profits. But, as kind of more on the national level, DaVita has their own legislation that they’ve put up on Washington.

It’s called the Patient’s Act and to me it seems just to simply continue this current problem, and I think one of the biggest problems that is in this industry is that commercial payers pay exorbitantly more than the government payers, and that just seems to be really one of the torrents for just such terrible behavior, and at some point this Patient’s Act, I don’t think solves that issue, I think it just merely prolongs and continues to make the situation worse.

MT: Okay, this just illustrates the real complexity of the situation, so I want to just back up a second here and ask, for our listeners, the unions, who are they representing and what are the different sort of employer-employee dynamics at play here?

EW: So, the union is its own kind of separate entity, but they have been trying to unionize for some time now and they are representing kind of their own people, a lot of them have claimed that they are speaking out on behalf of patients and how patient care needs to be fixed. There is a hashtag out there going of fixed dialysis. To me a lot of what the union has advocated for hasn’t demonstrated more care for the patients, it’s merely just trying to cut of profitability, and I think that that is somewhat misguided.

MT: Got it. Okay. So, the union is trying to organize the dialysis workers and trying to maybe get a bigger cut from DaVita out of the process and they do it under kind of the guys of the patient advocacy, but really, it’s about something else, does that sound fair?

EW: Somewhat. I don’t think that they are looking for a bigger cut per se, but I think that if the union had a little bit more direction and was advocating for a couple of other deals, I think they would gain themselves a lot more traction and they would go further, but in specific to California, the bill that was shut down last year was vetoed by the Governor. There is a new Governor is California now. So, we will need to see, but it’s something that’s gone back and forth.

MT: Yes, that’s funny. We’re covering PG&E (PCG), the utility company with the wildfires, another California story. California is having a big month here on Behind The Idea. Gavin Newsom came up there and he assembled a strike force, I think it was called to kind and resolve the PG&E’s liabilities with the wildfires and I was a little bit surprised. It sounds like he is a little bit more pro-business than you might expect, so that will be interesting and I think he vetoed one of those California proposals to sort of remedy the situation in dialysis.

We tried to get a state senator on, but she has not returned our call. So, if you are sponsoring legislation out in California and you’re interested in appearing on Behind The Idea, please come. Is there a question here? Here’s the question, kind of, what’s your take on getting back to the investment side of things, what are sort of the risks and opportunities in this patient’s act and some the legislation that’s being considered?

EW: So, with DaVita’s legislation in Washington, so it’s been introduced. I believe it’s been introduced in the House and I think it’s been introduced in Senate, but it hasn’t really gone anywhere and if it does, I expect a lot more of the insurance groups to be lobbing rather heavily against this, I think that was also acknowledged on one of the previously conference calls. It’s been a political football and it hasn’t gone anywhere for DaVita specifically, and with what is going on in Washington, honestly, I don’t think they are remotely thinking about it. They are worried more about Trump and his wall and kind of the day-to-day political footballs that have been going in Washington rather than actual issues.

MT: Lot of footballs. Daniel you want to chime in here?

DS: Yes, I wanted, Ethan. I spoke with a bull earlier this week about DaVita, and so I’m going to be sharing some sort of thoughts from that call, and one of the – just sort of first, again backing up a little bit, but there is a lot of different players here, I mean you’ve already mentioned, you brought up the union, which wasn’t something that we’ve discussed previously. We’re talking about specific political bills, we’re talking about the insurance companies, the sort of public-private split and I want to get into that specifically in a second, but first like how do you just think of the current, I don’t know if in your research what do you see, as far as the current climate around the dialysis industry and around the way that the U.S. treats dialysis as compared to what came before and just sort what would you, with healthcare its sort of difficult to imagine ever getting to a place where we’re just rewriting the rules, and kind of going from a white paper, but how does this compare to what was before and what do you think should be the situation for treatment in the dialysis treatment segment of the market I guess?

EW: That is a great question. So, really, I think there is a couple of small things that I really wish would happen. The first is, putting an end to this idea that the commercial payers pay three, four, or five times the rate that Medicare and Medicaid pay. I think that is an absolute point for terrible behavior and that is kind of the key thing that does need to be fixed. The second thing that if I could wave a wand and help fix this industry is the financial relationships between doctors and a lot of these dialysis clinics. And I think that that is also kind of a sticky point and I think that there is a great deal kind of more complex of interests.

We can talk about that a little bit further and when it also comes to treatment, I am going to get a little more blunt saying this, but I think that going forward I really do think that this does need to be part of the discussion is that a lot of the patients who are dialysis are older and there is a mortality rate of like 25% within the first year and then after five years there’s a 65% mortality rate. So, you being on dialysis it’s already kind difficult for somebody – your life expectancy really isn’t so long, and so it kind of makes me question what are we really paying for?

A lot of patients have described dialysis as kind of a very like life sucking and painful process and if we’re just taking somebody and prolonging their life like a year or maybe two or three years, what are we really paying for? And so, at some point, I think that that is kind of something that needs to get brought up into the discussion a little bit more, in part because this stuff is so expensive and for somebody just to really kind of sit there and be miserable, it leaves me kind of wonder.

MT: Yes. I think that’s the theme around healthcare in general and it kind of ties into where I want to go next, which is this question of, it’s clear from this conversation and from your writing that you have a real sort of moral perspective on this situation and also, you’ve considered a lot of sort of policy adjustments that might make for a better situation for all concerned. At Seeking Alpha, we tend to try and get people to sort of set their policy ideas or their moral advocacy outside of the investment thesis and really focus on the stock and the valuation, so how do you manage that interplay between this kind of policy ideas that you have and then your investment thesis on DaVita.

EW: It’s a good question. I think that when going back to a lot of my original research, I kind of started becoming more upset, but at the same time I also kind of realized that there was a fundamental thesis to this, and that fundamental thesis was that the insurance paying clients are going to get dropped for those patients have been using the American Kidney Fund or Charitable Assistance. It’s essentially the core of my bear thesis.

What I kind of feel more inspired to at least kind of about this because this has the potential to be a really serious issue and now that the individual mandate is gone and now that the tide is rolling back if you would, this seems to be one area that could very quickly and very easily become trouble]. And so, I think that’s kind of more of where I’m going with this, but at the same time I feel like this needs to be little bit more talked about what I think fundamentally there is a story here.

MT: Great, yes. It reminds me a little bit of Kyle Bass a billionaire investor who did some work around, basically he sought to undermine the intellectual property rates around pharmaceutical companies to reduce the cost of healthcare and so the basic fundamental thesis was that the pricing power in that industry is unsustainable and I’m going to actually agitate for lower prices and I’m also going to benefit on the investing side by being short companies that are exposed to this regulatory framework.

I think there is some similarity here between that and what you are doing, which is you favor a specific policy outcome, you also think that the trend is going in the direction you favor and I guess we talked a lot about managing your psychology as an investor and that’s just because you want something to happen, doesn’t mean you shouldn’t also believe that it is, it shouldn’t affect necessarily one way or the other, how likely you think it is to happen. So, you should be like mindful of the fact that it’s something you desire, but at the same time that it doesn’t mean you shouldn’t bet on it. It’s kind of like betting on the home team maybe or something like that.

EW: Well yes, and that is something I have to kind of had to learn from more of the hip. I’m not a CFA, I’m not a CPA, I have a bachelor’s in business administration and I kind of learned everything more from the hip rather than having some huge formal schoolings. I kind of got to where I am just because I started asking a lot of questions, and I just kind of became more, I guess, curious and…

MT: So, let’s talk a little bit about the financial analysis side of the things. Is this really a balance sheet story or is this an earnings decline story or how do you sort of sum up the fundamental thesis here?

EW: I think it has the potential for both, simply put. I think that yes you are going to have the income decline with the commercial payers going to government payers and in effect the government payers lose money for treatment. They may call their money on these commercial payers. So, in effect, I do think that there is some, if you do have a bigger government payer population that the balance sheet in itself is also going to reflect a lot more of the income decline. That also being said, there is also all sorts of, I guess I call gremlins or other kinds of things that could very easily popup.

So, if you look in the SEC filings on Page 60 of the third quarter earnings, there is things where it talks about how DaVita manages a couple of facilities and is on financial hook or some of these clinics should they not become profitable, then they may have to provide more capital. So, in that sort of deal, there is more potential here that if the tide rolls back even slightly it could have much larger swing in a negative direction.

DS: Yes, totally. We appreciate the drilling down on this specific page number in the 10-Q, I think that’s always helpful.

MT: Behind the Idea first. You are a pioneer.

DS: I don’t know if that’s in the CFA curriculum. Mike has a CFA and mostly uses it to make fun of me, but that’s good analysis regardless. So, I wanted to ask about the payer dynamics a little bit more, you kind of hinted out there and you talked about it earlier or let me share with the bull case around that was basically look, the insurance companies pay more, but they have a specific put after 33 months, so that they can send those patients over to Medicare I think is what ends up paying for it and so Medicare pays at the lower rate, but there is like that the government has constructed this in a way to ensure, accentuate the bulls just calling it a triangle I think , you have the patients getting treatment, you have some insurance that they will get the treatment they need.

You have a way to make it attractive for the insurers to be involved and the insurers have been doing well for the last decade for example and then you have the dialysis companies who obviously, as you know 90% of their patients they make zero net margin on if not even a little bit less, the 10% that do pay the wages like that’s is sorted by design, I was curious what you – if that makes – I guess two things, I’m curious what you think about that and then also what you said that it creates abuses and I’m curious like what specifically I can see, it’s a weird system, so, it’s prone. I’m just curious of what if you could drill down a little bit more in that. I think that’s interesting again to back into the financial situation afterwards.

EW: It is a weird situation. And again, this is real crux, the one thing that I really wish would go away about this industry. The insurers in a lot of these dialysis companies have been playing, I don’t know, if this is really the right way to describe it, but have been playing hot potato with these patients in the sense that they’ve been kind of pushing it back and forth where you get the commercial payer of you get the charities to pay for the premium and then insurers push these patients back on to Medicare and Medicaid, and it’s been fighting back and forth. And this has been going on for a while. There was an article in the Washington Post that was dated in like 2016 about a family out in Idaho where they were more or less stuck in between these dialysis companies and the insurers.

She was getting treatment at Fresenius and then all of a sudden, her insurer told her, no, you are not going here, and she is like, where do I get my treatment. She is like, well there is DaVita down the street. So, she goes to DaVita for a little bit and then finds out that no, she can’t do that and this is all out of network and they have been going back and forth. And so, a lot of the patients have been getting caught in the middle on this, and one the big dynamics to this is that the patient is automatically eligible for Medicare regardless of age if you have end-stage renal disease. And so, the insurers are just merely trying to push as many people into Medicare as they can. And the dialysis companies are really trying to push as many into insurances they can, because that’s where they make all the money. And this is really the crux and this is really the torrent for such terrible behavior is that the patients are being caught in the middle on this structure and that the patients aren’t getting the treatment they should be getting and are being really disrupted in ways that I just don’t think be acceptable. And does that kind of answer what you are getting at.

DS: Yes, I think so. I think it sort of illustrates the – because one of the things I walked away with and when you sort of hit on it or you kind of got to it earlier, as well as I think what’s tough about healthcare, to me there are two things, here is what is tough about is the way it is and then as potentially the way it should be is the idea that ultimately healthcare is about lives, it’s about health, it’s about all these things that in theory, there’s a spectrum and some aspects of healthcare are more trivial than others, but it’s people lives on the line and so that’s kind of a weird dynamic which in the world does it is that potentially creates opportunities one way or the other as you try to sort through all that muck. It can be long, it can be short and without putting the socialist hat on or anything else like, you wonder if there is a way, I don’t know, I mean that’s what investing is, sometimes you feel icky about what you do, it’s a little bit odd, I was trying to get at with the bull, what should the margin be? What should margin be for a business like this that is in theory essential and who decides that and there’s just something challenging about anybody deciding.

EW: I agree and that makes investing and healthcare so difficult, because even when you hear a lot of these pharmaceutical companies they are making, going back to [indiscernible] they are making enormous profits off of this stuff and sure you might be doing well, but who is really suffering is the patients who are most in need and it’s kind of really sad, and it is hard to get somewhat of your emotions specifically to healthcare. If we were talking about a bank or we were talking about an energy company or something of that nature, it might not be as big of a deal, but when it’s healthcare, it’s people’s lives, it takes over, it’s a much harder think to deal with, and I think that, again, or I said it enough already, the structure of commercial payers and government payers needs to go away.

And ultimately what I think needs to happen is the government needs to pay more and that interest needs to be one flat rate and that is that. And that if the commercial payers want to do some sort of a supplemental plan, where patients need to get rights to clinics or you need to do some other smaller cheaper things, I think that commercial plans could offer something like that, but I think that if you have kidney failure or end-stage renal disease, you need to be on the government plan and the government needs to pay more, I think it’s the way that this needs to change.

MT: Okay. Daniel and I have a concept we call the socialist hat, which we put on our socialist hat every once in a while, to try and articulate some perspectives that some of our audience might not think or as investor friendly, so you are welcome to borrow that if you like. Otherwise, I wanted to get into just some of the rounding into the close here, some investment related questions. So, the first one is, where is the catalyst for a change here? This dynamic has been playing out for a long time. DaVita is sort of understood to have these warts on it and these vulnerabilities to some of these regulatory shifts we’re talking about. So, what’s your timeframe and what do you think is going to sort of prompt the change here that will make your short thesis play out?

EW: Ultimately, I guess what I think will happen is that, my timeframe, I own the Jan 2020 puts, so I really have this year, I’ve bought kind of at the money two year puts when I originally took on this position. The dynamics of this has changed a little bit since when I originally took the position, but as of right now, given the facts what I think is going to happen is that the DMP sale is going to break and that commercial payers get dropped and I think that what’s going to windup happening is Warren Buffett is going to have to step in and write a blank check to DaVita. I think it’s what’s going to happen. There is a potential energy if somebody like Warren Buffett doesn’t step in that this could be a really serious crisis. But ultimately, I do think that Buffett will step in.

MT: Okay, let’s just talk a little bit about the DMG sale, which is an important part of your thesis. It was announced at a lower but still substantial level after your last article came out, so what do you make of this sort of developments with the DMG sale?

EW: I make of it more of kind of showing that there is more gamesmanship, I don’t know. There are kind of things that are being tossed around and they’ve kind of played this, I don’t know if I want to use the word accounting game, but they have, there is a lot of things going on underneath this service, and I think that it’s kind of confirmatory towards that thought process. It’s really kind of what I think of the sale, but I did find it interesting that the sale price dropped because and they cited in the reasons in the 8-K was for taxes and so I thought that was kind of an interesting development that came out of that.

MT: And just to backup, it’s important because the sale is kind of, I mean like most of these types of asset sales, it’s both to sort of repair the balance sheet somewhat, but it comes out with a sort of trade off about how future earnings are going to be impacted, so maybe can you just walk us through your sort of thought process and all that?

EW: I guess, even to take one more quick step back. DMG is a physician practice management. Originally it was a company called HealthCare Partners and the way that physician practice managements work is that you sign up the doctor for certain period of time for reduced salary and you pay them upfront bonus. So, if I said, you own your own doctors’ practice, and let’s say you doctors practice fair value is $150,000, I’m making up numbers, but say it’s worth $150,000 and you pay yourself $100,000 every year and your business breaks even right. So, as Mr. Businessman, I’m going to come in, I’m going to buy your $150,000 business at fair value and then I’m going to give you another $150,000 or a 50% pay cut for three years.

So, in other words I’m paying you upfront your salary, right. So, now what happens is, you take this deal, because I got $30,000, I can turn around and pay off my student loans or I can go do whatever with it, and after three years the problem is that you wanted to be paid more. So, I have to either re-up the contract and give you more or find some other way of being able to keep you enticed in order to keep in the business. So, it’s the inherent problem with lot of the PTMs, but Healthcare Partners was originally bought for right about where the sale price is now. So, it hasn’t really moved in value and it’s been really kind of nothing, but a money pit and so the sale right now is to Optum, or to United Health and this sale has kind of taken, really, it’s now 14 months or so, from the time of this recording, really one of those months wasn’t DaVita’s fault. The government shutdown, closed the FTC, and they were unable to close really throughout the month of January. It’s not really their fault, it was just kind of the way their cookie crumbles per se.

But the problem is, I don’t think that this sale will go through and I don’t think it will go through for really a few reasons and there has kind of been some signs around this sale not closing and to really kind of highlight one of them is when their sale is originally announced, the board of directors approved a share buyback and they went out and borrowed a bunch of money to start buying back their shares, while the deal was closing. Then in end of March or so, they get a second take from the FTC where they got to provided more information, and since then we haven’t really heard anything more publicly about this. And so, it’s been nearly a year since the second look.

So, it kind of already strikes me as, if something is wrong and there was really, I kind of pointed this out in my article, there was really two PPM’s that had sold recently that had closed really in a relatively short period of time. That was Envision Healthcare to KKR and Team Health to Blackstone, both closed 3 to 5 months or so and did so kind of without really any issues, but what makes the DMG deal different that Envision and Team Health is by and large DaVita’s kidney dialysis portion or their other branch of their business. And I kind of looked around and seeing if maybe there wasn’t some bigger relationship here, and I noticed that there is a large portion of DMG doctors who look for high blood pressure and diabetes, and those were kind of key stages to end-stage renal disease or ultimately to kidney failure.

And then on the last conference call, the CEO, Kent Thiry had acknowledged really that there was a mutual learning highway was he described of this business that had gone back and forth. And so now really kind of comes the question of, can doctors really have an interest in a lot of these dialysis clinics and I think the answer is, yes. And there is some regulatory discussion or kind of areas, but by and large the answer is yes, the doctors can have equity stakes in dialysis clinics. We are talking individual clinics, not necessarily the company as a whole and there is what’s called The Corporate Practice of Medicine and The Corporate Practice of Medicine very simply point is that the doctor has to make medical decisions independent of business. So, you can’t diagnose somebody with end-stage renal disease when they don’t really have it or you have to make the medical judgment based off of good medical judgment right. And so, The Corporate Practice of Medicine does have some restrictions as to who can have equity stakes over who and what have you, but the big thing is that you can’t have a nonmedical, or a non-licensed physician over a specific doctor with one or two notable exceptions, be it hospital or you could contract out a doctor, but by and large you can’t just, I as a non-physician can go out and hire a physician and say this is what you’re gonna do, that breaks the corporate.

MT: Right.

EW: So, the SEC Filings on Page 72 also kind of by and large acknowledge, I’ll read it to you, it says, accordingly neither DMG nor DMG subsidiaries directly own any equity interests in any physician groups in California, Colorado, Nevada, and Washington. So, the key word here is that they don’t have any equity interests in physician groups. A dialysis clinic is not a physician group, it’s a center where you go and receive treatments for this. And so that’s kind of really where this gray area is, and there was an article in New England Journal of Medicine and it was published just before Thanksgiving last year, and it is titled dialysis facility joint venture ownership in complex of interests.

It’s a really good article. It’s like two pages long or so, but it basically brings down and talks about how doctors having equity interests in individual clinics has certain complex of interest and has certain complex of interest. And part of, at least going over to kidney care, mind you that really the 25% of the population passes away while you are on dialysis. DaVita has, they disclose somewhere like 227,000 patients. So, if you have 25% of your population is going away, I mean, you need to replace somewhere between 55,000 to 60,000 patients every year and the only way to really keep this machine moving is to have these referrals from doctors and this is kind of really the area and this is how they’ve enticed a lot out of these doctors is through these equity interests in individual clinics.

And so, this is kind of where more of these put provisions have popped up, is that if the doctor wants to get out of the clinic, the companies or DaVita says we will buy you out, but keeping you vested in your interest, you can effectively make money and get paid more for having an interest here in clinic. And so, it’s kind of a very interesting situation. And there was a lawsuit that came out in 2014, it was a DOJ lawsuit and in it described that doctors had non-compete causes for their dialysis clinics. So, you couldn’t refer somebody to Fresenius or to some other dialysis clinic and that’s by and large what the DOJ nailed it for, but what came out also in that is that a lot of these DaVita what they were doing was that they were manipulating the numbers or the appraised values of these clinics lower, so that doctors could come in buy a bigger stake. And that was in part of how, I think this is still going on, but I don’t have confirmations, but I do think it’s still going on, is that the doctors could take a much larger stake in these clinics and this is kind of been little bit more of the sticky point.

Now, given that there is a large number of these DMG doctors who treat high blood pressure and diabetes, which are the leading causes for end-stage renal disease, it’s impossible to actually know this and this is what kind of came out in the New England Journal of Medicine, but is what really strikes me as what’s holding up this DMG sale is that DMG doctors who have equity stakes in these individual dialysis clinics, and I think that because there are so many of these that it now causes this problem of being able to divest, and the other kind of things that are pointing more to this is that in the third quarter 10-K it did acknowledge that it was going to be more expensive and that their share buyback, they didn’t buyback everything that they were authorized, it kind of stopped up short.

So, it leads me to believe that there is some problem here with and it is something big and expensive. And if it was so big and expensive, they could just go out and borrow a little bit against the equity of this. This purchase contract, fill it and then close the deal. I think that it is in the fact exceeding the size of this deal and that’s more of that’s what’s keeping this deal closing and that’s what I think is and how this deal closes. Now, it could be wrong and I don’t think I am, but I think that is more or less what’s going on and that’s what holding up this deal from actually closing and if this deal doesn’t close, they don’t have the assets to pay their liabilities on June 30 and then with the Laws of Charitable Assistance, I don’t think they will have the ability to refinance that and I think that’s really kind of where Buffet has to step in.

MT: Awesome. Okay. There’s a lot of moving parts to that, but I think that’s really valuable to kind of walk through. And you’ve given good basis for kind of your expectation around the deals sort of long and total history, so that’s great.

EW: I think that this is what’s going to wind up happening, but we shall see, but I’m confident in my assessment.

MT: That leads to kind of the next question. You are on the other side of the trade from a very powerful, well-known, and legendary investor in Berkshire Hathaway and Warren Buffet, does that matter you and how much does it matter to you?

EW: It doesn’t. Simply put. And the reason the advise that Chanos had was that you look from the inside of the onion and out, you look at all the things that these companies and organizations have to tell you and then you look out to everything that’s going on in the landscape and the picture looks substantially more different than if you take a look at the rumors and then look into the onion. Initial ly, when I had started doing a lot of my poking around in DaVita, I’ve been so focused on the fundamental of the story, I’ve been focused on working with this that it wasn’t until I was two or three weeks into really diving into this that I realized that Warren Buffet was the larger show.

MT: Alright, it doesn’t matter. On Chanos, we are trying to get him on the podcast, so far, he is not responding, but so Jim Chanos, if you’re listening, we are looking for your perspective on this and you’ve been an influence on our guest here, Ethan Watkins. While we are at it, Warren Buffet come on, love to have you. Let’s just wrap with one final question. So, I’m interested lately in moats and the vulnerability of moats, and we’ve seen a couple of high profile, I don’t know if you saw Kraft Heinz news that came out over since yesterday, but their brand, they are another sort of Buffet friendly company, all American brand, they took a write-down on their brand, so that moat started to look vulnerable.

We mentioned PG&E on this podcast, it’s a utility and state regulated and that moat has been vulnerable. For DaVita, I think that the moat is sort of two-fold from the bull side. It’s the medical necessity of the treatments. You mentioned that it’s horrible and it doesn’t prolong lives that long and yet there is incredible demand for it. And then the second is, the relationships they have with the dialysis administrators that there is sort of difficulty for competitors to enter given that DaVita in some ways has these sort of exclusivity, so what do you think of DaVita’s moat? It’s sort of the flip side of the question about the catalyst, what do you think about these arguments with patient demand and the sort of provider relationships.

EW: I think it’s probably one of the best things that are going on for the bull cases that the patient essentially has to have it. There is kind of the weirder dynamic to it, and so mainly lies right around the government payers, and seeing how a lot of them breakeven or even lose money on a lot of these government payers. It kind of works against them. And so, you have to have it, so you have to show up and it’s not good if you don’t give them their treatment, but it could potentially spin in the large losses for DaVita.

So, it’s kind of a very weird crux is that it has to potential to turn into a real negative moat, I guess, if that makes sense, but the bulls are absolutely right. The people are going to show up and receive their dialysis no matter what because they know they are going to die that’s simple as that. It has the potential to turn negative through the government payers. So, yes, but you are going to do it at a loss, so that’s kind of a way that I look at.

MT: Yes. I feel like that’s a discovery of a kind of concept that may be relevant to our listeners who are trying to develop their investment process and I’m just sort of arriving at it now myself, but it’s that DaVita is kind of in equilibrium state right now with all the different players in the system and as long as that equilibrium remains stable, then it is a good business that’s really well protected. And I think part of your case is that if one sort of aspect of this stable equilibrium gets disrupted of removed, then the entire system can be sort of turned on its head. And what’s interesting about that to me is that in a way the bulls and bears are both correct.

There is this kind of high profitably business model, it’s very attractive from a shareholder perspective. The world kind of has to remain in its current state though for that to persist and so it seems like it is a strong equilibrium in one sense, but then any kind of disruption to any of the players like the providers or the regulators or the payers could up and the whole thing and suddenly it flips, it’s kind of like operating leverage but maybe it’s something you would call like strategic leverage or something where the whole business model is kind of that risk.

EW: It is and this is kind of the other amazing part of this story is that – real quick history, is that when Richard Nixon was in office, he signed a bill that said, anybody who needs kidney dialysis, the government will pay for it, right. That was kind of the real genesis of the dialysis industry. And so, when Nixon put this in, there was maybe 10,000 patients. Today, there is just south of half a million. This industry has grown and has grown rapidly over the course of 40 or 50 years, and it has turned into something that it was never really meant to be at least in my opinion. It wasn’t meant to be this level of gamesmanship, it wasn’t meant to be this huge deal, it was meant to be 10,000 maybe 20,000 people, kind of very smallish niche market. This is by and large the high price of the dollar menu. It’s kind of the way that I think about it, and so it is. This is a very, very sticky situation.

MT: Specific SEC filing page numbers, Richard Nixon reference. Ethan Watkins, it’s been a real pleasure having you on Behind The Idea. Thanks very much.

EW: Well thank you for having me. Thanks so much.

MT: Yes, let’s wrap there. Thanks again Ethan and take care.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Ethan Watkins, the guest on this podcast, is short DVA via puts. Daniel Shvartsman, one of the hosts, is long BRK.B. Mike Taylor, the other host, has no positions in any stocks discussed. Nothing on the podcast is meant as investment advice.