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
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.
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.
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.