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Why Warren Buffett's Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 12, 2013 09:36PM

Warren Buffett asked Ted Weschler to be one of his two investment successors at Berkshire Hathaway (BRK.A)(BRK.B). At the time DaVita (DVA) was and continues to be even today, Weschler's second largest holding. Currently 34% of his portfolio at Berkshire (BRK.A, BRK.B) consists of DaVita. Buffett wouldn't have asked Weschler to be his successor if Buffett himself didn't think DaVita was a great idea.

This article hopes to explain why DaVita is such an attractive investment.

1. DaVita P/E

DaVita's P/E of 23 is misleading. First, DaVita took a large charge of $397 million for a legal settlement with the government this year. Second, DaVita has acquired hundreds of dialysis clinics over the years. As a result it has high amortization charges. At this point, I quote from Buffett's 1983 shareholder letter: "In analysis of operating results - that is, in evaluating the underlying economics of a business unit - amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. "

From this perspective, DaVita is extremely undervalued. It reported free cash flow of $1.24 billion over the last 12 months (i.e. operating cash flow of $1.49 billion — maintenance expenditure of $245 million).
Dialysis clinics require very little maintenance expenditure.

With 213 million shares outstanding, that is $5.84 free cash flow per share. Thus, DaVita's Price/Free Cash Flow is just 10.4 (60.63/5.84).

2. DaVita Return on Capital

DaVita has more than $11 billion of intangible assets ($8.9 billion of goodwill and $2.1 billion of amortizable intangibles). This works out to $52 per share. This is due to its acquisitions of other dialysis operators over the years. Again, we refer to Buffett's 1983 letter that says that return on tangible assets is what matters. If we back out the $52 per share of intangible assets, that leaves an enormous return on capital.

3. Medicare Reimbursement Risk

It has been an implicit understanding that private insurance pays several times more than Medicare per treatment while Medicare pays below cost of care. This is because private insurance needs to pay only for the first 30 months after which Medicare takes over irrespective of age. As a result all of DaVita's profits come from private insurance, though most of its revenue is Medicare.

Weschler has known the dialysis industry for nearly 30 years. He worked for Peter Grace who was the CEO at WR Grace. WR Grace acquired a dialysis company in the 1980s and sold it to Fresenius in the 1990s.

When the Center for Medicare Services (CMS) announced an intent to cut dialysis payments by 9.4% in July, the stock dropped. Weschler bought more DaVita then. Just before CMS was to announce its final decision on Nov. 22, Weschler bought 3.7 million shares of DaVita between Nov. 6 and Nov. 8. Weschler bought another 1.3 million shares last week.

The reason Weschler bought confidently is that he knew that CMS wouldn't be able to cut. Indeed, CMS announced on Nov. 22 that it would keep dialysis rates in 2014 and 2015 the same as 2013. Why? Because a lot of dialysis clinics with a higher concentration of Medicare patients would close down if it cut.

Without dialysis, patients die very fast. Dialysis is unique; it's the only treatment that Medicare covers irrespective of age because its indispensable.

DaVita is the lowest-cost operator which means that there are a lot of other operators who insulate DaVita from Medicare cuts.

205 Congressmen from both parties wrote a blunt letter to CMS asking it not to cut. That letter can be found at this link
[dropbox.norglobe.com]

4. DaVita Competitive Advantage

Some of DaVita's competitive advantages are:

a) It is the most efficient dialysis operator with per-treatment costs of just $217.

b) Its large scale (it is a duopoly together with Fresenius) gives it cheaper drugs, dialysis equipment and other supplies. Smaller dialysis operators would have to pay more to their suppliers.

c) Its large number of facilities all over the country give it negotiating leverage with insurance companies. Insurance companies cannot cut their payments to DaVita because without DaVita or Fresenius, patients may have to drive hundreds of miles for treatment. And most importantly, DaVita and Fresenius don't get into price wars with each other. As the DaVita CEO said, cutting prices is not "constructive for the community."

d) These advantages have allowed Davita and Fresenius to acquire hundreds of small dialysis clinics over the years. Thus, their advantages have only increased in a virtuous, self-feeding circle.

5. DaVita Growth Opportunities

DaVita acquired HealthCare Partners last year. The business model of HealthCare Partners is to provide "fee-for-value" as opposed to "fee-for-service." This provides better quality health care at lower cost. Currently, HealthCare Partners does business in five states. In the Capital Markets Day presentation on Dec. 9, Kent Thiry, the DaVita CEO, said that they plan to expand into two more states in 2014, three states in 2015 and a lot more in 2016. He called the growth opportunities "mouth-watering." Compared to dialysis whose growth opportunity he describes as solid, Kent Thiry says the growth opportunity for HealthCare Partners is huge.

Another growth avenue is VillageHealth. DaVita wants to take over all medical care for dialysis patients, not just dialysis. Medicare spends $88,000 per year per dialysis patient of which $33,000 goes to dialysis and the remaining $55,000 goes to other things. Because dialysis needs to be performed three times a week for up to four hours each time, DaVita can expand into other areas easily due to patient availability.

Valuation

DaVita is such a screaming bargain that we need not slice and dice it finely. Just consider the fact that dialysis patient growth has been 4% over the last decade. Add 1% for inflation, giving 5% guaranteed long-term growth. With a 10% discount rate, and using $5.84 FCF per share, the terminal value itself would be 5.84/(0.1 - 0.05) = $116.8. This is not even factoring in the greater expected growth at HealthCare Partners and other ventures such as VillageHealth and DaVita Rx.

Management

DaVita has an outstanding CEO. Kent Thiry took over as CEO of DaVita in October 1999 (then called Total Renal Care).

The stock at that time was trading at $6 per share with 81 million shares outstanding. Today the same company has 213 million shares outstanding at $61 per share. That is a compounded return of 26% per annum for 14 years.



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: Greg Speicher (IP Logged)
Date: December 12, 2013 01:33PM

Thanks for the nice write-up. Can you briefly walk through how you separated maintenance capex from growth capex?



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 12, 2013 08:44PM

Thanks for reading the article. I didn't separate them. If I had included only the capex required to handle 4% patient growth that I assumed in the article, it would look even more undervalued, but I didn't find that number. In the first 9 months of 2013, they have already added 8.5% more patients than they had at the end of 2012. At the end of 2012 they had 153,000 patients and at the end of Q3 2013 they reported 166,000 patients. They should end the year with at least 10% more patients than they started out with. I got the last 12-month cash flow numbers from the very last slide of their latest Capital Markets presentation: [phx.corporate-ir.net] For pure maintenance, I guess the numbers from slide 71 of their 2007 Capital Markets presentation are more accurate - they need less than 2% of revenue for maintenance. [library.corporate-ir.net]



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: rocco 78 (IP Logged)
Date: December 13, 2013 02:22AM

Davita has not amortization charges, in fact from 2012 financial report: During the year ended 2012, the Company did not record any goodwill impairment charges. As of December 31, 2012, none of the goodwill associated with the Company’s various reporting units was considered at risk of impairment. can you please clarify your statement?



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: batbeer2 (IP Logged)
Date: December 13, 2013 07:38AM

Thanks for an interesting article and your response to Greg's question. I have a couple:

>> a) It is the most efficient dialysis operator with per-treatment costs of just $217.

Where do you get that number and is there any way of breaking it down? If memory serves, Medicare reimbursements are now a lump sum per treatment which includes some related drugs (EPO).

Does the $217 include DVA's cost of EPO?

I would be surprised if it did.

>> b) Its large scale (it is a duopoly together with Fresenius) gives it cheaper drugs, dialysis equipment and other supplies. Smaller dialysis operators would have to pay more to their suppliers.

Fresenius is a major supplier of equipment and supplies within the space (Davita buys from Fresenius). So, one could argue that Fresenius has an advantage over Davita.

Thoughts?



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 13, 2013 10:49AM

Hi Rocco78 DaVita has amortizable intangibles too. These are described on Page 48 of the 2012 10-K. At the time Buffett wrote that letter in 1983, Goodwill used to be amortized over 40 years, but then they changed the accounting rule such that Goodwill need not be amortized. But we still need to remove Goodwill to calculate return on Capital.



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 13, 2013 10:51AM

Hi Batbeer Patient care costs do include EPO cost. The patient care cost has been drifting down ever since the bundled payment was introduced. In 2012 it was $213 in 2010 it was $232. This excerpt is from the 2011 10-K. "The dialysis and related lab services patient care costs on a per treatment basis were $217 and $232 for 2011 and 2010, respectively. The $15 decrease in the per treatment costs in 2011 as compared to 2010 was primarily attributable to a decline in the intensities of physician-prescribed pharmaceuticals, continued cost control initiatives, partially offset by higher labor and benefit costs, and higher EPO costs."



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 13, 2013 11:00AM

Hi Batbeer W.r.t your second question, this industry doesn't operate in the cut-throat mode. 1. For example, all dialysis operators unite in lobbying the government (this seems to be required almost every year). Reading the earnings calls for the last several years, they just don't talk about gaining on other dialysis providers - such cut-throat activity would be destructive long-term and these companies seem to be very aware of that. 2. It is indeed the case that Fresenius supplies a lot of stuff to DaVita. But there are transactions in the opposite direction too - Fresenius uses DaVitaRx. 3. DaVita sold its international assets to Fresenius in 1999. 4. In its latest earnings call, Fresenius said "Q2 to Q3, we saw a $2 increase in cost per treatment from $293 per treatment from $291." Of course, the "cost" here would be "revenue" somewhere else in Fresenius's financials. Therefore its not an apples-to-apples comparison with DaVita's cost. 5. DaVita has a unique company culture - you can search for "Kent Thiry" on Youtube.




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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: batbeer2 (IP Logged)
Date: December 13, 2013 11:34AM

I missed that in the 10-k, my bad.

Thanks!



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Re Why Warren Buffett s Successor Likes DaVita So Much
Posted by: noideahow (IP Logged)
Date: December 13, 2013 12:27PM

One more example of cooperation among these dialysis providers is lobbying the government for the ESCO program. They want to take over all medical care for dialysis patients (many of these patients are quite sick with comorbidities like heart disease and hypertension).



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