Watch DaVita From The Sidelines

About: DaVita Inc. (DVA)
by: Marcello Pinto

DaVita is a great business that provides quality clinical care which drives reductions in healthcare costs and provides significant savings to the U.S. healthcare system.

Operating expenses are increasing due to inflation and a tight labor market. The company has not been able to offset this with productivity improvements.

With falling Medicare reimbursements, margins will continue to contract. The company still operates in a monopolistic manner and has a strong balance sheet and excellent capital allocation.

The company repurchased nearly 7 percent of the shares outstanding and sold off its less profitable medical division, but the future looks tough.

DaVita (DVA) is a leading provider of kidney dialysis services in the U.S. for patients suffering from chronic kidney failure, also known as end stage renal disease. The company has everything an investor could look for, high returns on equity, a strong competitive position and excellent capital allocation. However, secular headwinds have gradually eroded the attractiveness of this business over time and the company looks like it is going to continue struggling.

DaVita has a whopping 37% share of the U.S. dialysis market based upon the number of patients they serve. They continue to grow the number of dialysis centers in the United States and increased their footprint by around 5% last year, adding 160 new centers. The company has been able to grow its share of U.S. dialysis patients, the quality of its care, reduced patient mortality rates and the reputation it has with referring physicians. Moreover, DaVita's business is stable and predictable as the total U.S. dialysis patient base is a relatively stable and growing factor. With an ageing population, there is a growing need for dialysis service, and statistics show that the industry has an annual growth rate of around 3.5%.

DaVita ticks all the boxes for an outstanding healthcare company. It provides a superior quality of care, saves the United States healthcare system money and earns very high returns on equity. That is probably why Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) Ted Weschler decided to invest in the company.

Over time, though, DaVita has seen its unit economics worsen. Rising cost pressures from a tight job market have meant that the company has seen its margins slip. Additionally, as a result of across-the-board spending cuts that took effect in 2012, Medicare payments were reduced by 2% which has been extended all the way through fiscal year 2027. These across-the-board spending cuts have affected and will continue to adversely affect the results of the business. Given that Medicare assigned revenue comprises 59% of the company's total income, these cuts have been punishing for DaVita.

Source: Annual Report

Continued uncertainty about future payment rates remains a material risk to the business, although an important provision in the law is an annual adjustment, or market basket inflation update, to the Medicare base rate. Absent action by Congress, the PPS base rate is automatically updated annually by a formulaic inflation adjustment. This protects DaVita from having its funding completely slashed. Nevertheless, the healthcare industry is subject to substantial regulation the scope and effect of which are difficult to predict. This makes it difficult to value the company accurately.

DaVita has projected that it expects to incur increases in their operating costs in 2018 that will outpace Medicare rate increases. They project an increase in labour and supply costs including increases in maintenance costs and capital expenditures to improve, renovate and maintain facilities, equipment and information technology. This is a massive headwind. Inflationary pressures are also a burden to the company as it has invested heavily in upgrades to systems and internal processes to improve operating performance and reduce regulatory compliance risks. It is no surprise that the company's net income has not increased much lately.

I find the healthcare sector particularly challenging as determining the potential revenue is subject to significant estimation risks regarding Medicare payments and revenue per client. Additionally, since not all patients are insured, the company is also continuing to experience higher amounts of accounts receivable write-offs due to uninsured and underinsured patients. The provision for uncollectible accounts receivable for their U.S. dialysis and related lab services business was 4.9% for 2017.

Pivot to the Future

One positive development is DaVita's ancillary services and strategic initiatives, which generated approximately $1.6 billion of net revenues in 2017. The company expects to add additional service offerings and pursue additional strategic initiatives in the future, which could drive net income upward. Moreover, DaVita decided to sell its medical care division in 2018 to the United Health Group Inc. I thought that this was the correct decision, as it allowed them to focus on their core Dialysis business. DaVita also received a very handsome $4.9B for this transaction.

DaVita has also been repurchasing shares and looking for potential acquisition. Though, it looks like for the time being it will have to deal with a more challenging environment for its core business. Even at the current price, with only a price to earnings ratio of 10, I still would not buy the stock - given the deteriorating future economics of the business.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.