Healthcare is a scary sector for many value investors. It sounds complicated – and often is. But DaVita HealthCare Partners is different. DaVita derives the majority of its revenues from its market-leading position in a market that has inelastic demand – kidney dialysis. It also recently acquired a more speculative business that has enormous growth potential. To top it all off, Warren Buffett (Trades, Portfolio)-anointed investment manager Ted Weschler has been buying a stake in DaVita for Berkshire. At the very least, this is a stock that every value investor should become familiar with.
1. Company History and Business Overview
DaVita HealthCare Partners has two primary business segments: DaVita Dialysis and HealthCare Partners. Dialysis contributes 66% of revenue and 75% of EBIT. HCP is 27% of revenue and 25% of EBIT. The rest of revenue comes from a small, unprofitable (and inconsequential) segment called ancillary services and strategic initiatives.
Back in 1999, Kent Thiry joined DaVita as CEO and transformed it from an overextended serial acquirer into a stable and profitable company by divesting essentially all but the domestic dialysis business. Since then, the company has grown primarily through prudent acquisitions of dialysis centers. EPS grew at 12% per year from 2004-2013 despite just 4% annual growth in the dialysis market and about 4.5% organic growth. The difference is due to market share gains and value-creating acquisitions (scale means a lot in this business, so when DaVita buys a smaller competitor, the acquisition instantly becomes more profitable).
In 2012, DaVita acquired what would become HealthCare Partners (HCP). HCP is a physician practice management business – completely unrelated to the dialysis business. More on this in section 1.2.
1.1 DaVita Dialysis (75% of profit)
DaVita Dialysis splits 70% of the fragmented U.S. dialysis market with Fresenius Medical Care. DaVita has over 2,000 dialysis centers across the U.S. No other dialysis provider in the U.S. comes close to matching either company’s scale.
The dialysis business provides kidney dialysis for patients suffering from end-stage renal disease (ESRD). ESRD involves total and permanent kidney failure. Once someone is diagnosed, they must get dialysis three times per week (to replace the work of the failed kidneys) for the rest of their life or get a kidney transplant.
Kidney transplants are one of the most common transplant operations in the U.S., but there is a long waiting line; as of May 2014, the National Kidney Foundation said 100,000 patients were awaiting kidney transplants and 2,500 were joining the list each month, but fewer than 15,000 transplants are performed each year. As a result, most people with ESRD opt for dialysis.
Once on dialysis, commercial insurance covers the treatments for 30 months, then Medicare takes over. 90% of patients use Medicare or Medicaid, which reimburses about $240 per treatment. DaVita makes all of its money on the portion covered by commercial insurance, where rates are higher than $1,000 per treatment.
Despite the strange profit model, the business is actually quite stable. Revenue per treatment and cost per treatment vary little from year-to-year.
These are average reimbursements/costs per treatment. Costs and reimbursements vary from center to center.
Both government and commercial insurance reimbursement rates are crucial top-line inputs. Commercial insurance companies are at a disadvantage because there are many insurers, but only two major dialysis providers. Since patients are treated 2-3 times per week, they want their treatment provider to be nearby. There’s a 70% chance that DaVita or Fresenius is the closest dialysis center, so the two companies have significant bargaining power in the arrangement. Proximity and routine also make customers loyal to one center. Therefore, commercial insurance reimbursement rates should only increase over time.
Medicare/Medicaid reimbursement rates are a bigger concern. Medicare reimbursements were slated for an immediate 9% cut in 2014 as a result of a law passed by Congress in early 2013. The cut would have forced many facilities in low-income areas to close; already, up to 10% of DaVita’s centers are unprofitable, but remain open to service Medicaid patients that might otherwise have to travel long distances to receive treatment. If 10% of the industry’s dialysis centers had to close due to unprofitability, it would lead to lower-quality care at best and multiple deaths from lack of access to treatment at worst.
Fortunately, lawmakers and regulators got their act together and decided to space out the reductions over the next 3-4 years. Reimbursement rates will remain flat in 2014 and 2015, and will decline by 9% over the course of the next two years. This gives DaVita time to reduce costs and hike private rates to level off profitability.
Regulators’ actions here are instructive. Congress clearly wanted cuts, but significant and immediate cuts could wipe out centers in remote areas. Given the absolute necessity of dialysis treatments, it’s unlikely that Congress will act in a manner that bankrupts the industry. Therefore, additional cuts to Medicare and Medicaid are unlikely to be as drastic as the already-announced cuts.
Costs are pretty straightforward. Labor is the biggest input, followed by pharmaceuticals and other supplies, other center-level costs, and G&A. All expenses except for pharmaceuticals tend to move in line with sales. Pharmaceuticals vary, but they tend to tie supplier contracts with reimbursement rates.
Number of treatments
The only remaining variable in DaVita’s profit formula is the total number of treatments. Unfortunately, there’s not much room here for center-level growth. The typical center has 78 patients and can’t grow that number by much. Center-level growth comes from higher profit per treatment and company-wide growth comes from acquiring and developing additional centers.
Despite deriving all of its profitability from just 10% of its customers, DaVita Dialysis has an enduring moat that allows it to earn outsized profits for the foreseeable future. In addition to economies of scale, DaVita’s moat is threefold:
(1)The fragmented nature of the private insurance industry gives DaVita bargaining power in reimbursement rate negotiations. This is crucial to its profitability.
(2) Medicare and Medicaid reimbursements are already straining the industry; reimbursements cannot go much lower without quality of care and access to centers being significantly impaired. Therefore, I judge it unlikely that Congress will move in favor of further cuts for dialysis treatments any time soon. This limits DaVita’s losses on government-funded treatments.
(3) Inelastic demand. Patients need dialysis or they will die.
1.2 HealthCare Partners
I won’t spend too much space talking about HCP since it’s a smaller and more speculative aspect of the company. HCP is a physician practice management company. It receives flat-rate payments from health insurers on a pool of patients under coverage. When a patient in that pool needs medical attention, HCP treats the patient in its own facility or arranges treatment in a network facility and pays for the cost of treatment. The difference between the flat-rate payment and the cost of care is HCP’s profit.
HCP’s profit structure provides incentives to keep costs low and reduce the number of unnecessary treatments. Patients under HCP’s care have significantly shorter hospital stays and lower death rates than patients under a fee-per-service model. The key takeaway is that this model makes the healthcare system more efficient, so it is unlikely to be the subject of restrictive regulation.
HCP has a huge growth opportunity. It derived about $385 million in operating income from just three major markets in 2013. It plans to expand to another 10 markets over the next three years. This expansion alone could add $1 billion in EBIT at maturity.
Unfortunately, HCP doesn’t have a clear competitive advantage. It’s a small player in a fragmented industry. There’s a significant growth opportunity to expand to new markets, but it is not clear how profitable that expansion will be. However, it’s a low-capital business so mistakes are not devastating.
2. Financial Strength
DaVita has strong and stable cash flows with a manageable amount of leverage. Debt-to-EBITDA is a rather high 3.9x, but its maturities are spaced out enough so that cash flow can easily cover it if the company cannot roll it over (for whatever reason).
Earning power is addressed in the section on valuation.
Kent Thiry has been CEO since 1999. After acquiring HCP, Thiry remained CEO of the dialysis business while HCP CEO Robert Margolis remained HCP’s CEO. However, sequester cuts have caused HCP to perform worse than expected, so Thiry has now jumped over to run HCP and one of his lieutenants will run dialysis. Thiry has a long history of prudently managing DaVita Dialysis’ growth, but HCP’s lack of an apparent moat may make it challenging to pull off a similar feat. In any case, a ham sandwich could run the dialysis business so the major profit-driver is in good hands.
DaVita trades at a rich 24 times earnings and 10 times EV/EBITDA, but neither metric does justice to the investment opportunity. Dialysis’ stable growth and HCP’s upside potential are not baked into the current stock price.
DaVita Dialysis’ pre-tax, pre-interest earning power is determined by the following equation:
Operating Earnings = Profit Per Treatment x Treatments Per Center x Number of Centers
This is what the equation looked like in 2013:
Operating Earnings = $51 x 11,737 x 2,014 = $1.205 billion
Since then, the company has added 189 centers. That makes its operating income come out to about $1.3 billion using the above numbers. Profit per treatment will decline in 2016 and 2017, but the number of treatments per center should rise as the current store base matures. Therefore, $1.3 billion is a realistic estimate of DaVita Dialysis’ pre-growth operating earnings at maturity based on 2013 numbers.
Long-term averages tell a slightly different story. Since 2006, DaVita averaged a $57 profit per treatment. If you plug that number into the formula, you get $1.5 billion in operating earnings. So DaVita Dialysis’ normal pre-growth operating earnings are probably between $1.2 billion and $1.5 billion.
HCP is harder to handicap. Its profit is the spread between its capitated revenue and costs of treatment. There is not enough historical data to make intelligent assumptions about average cost per head or even profit margin, so I’m just going to throw a lowball $200 million segment income contribution. It did $300mm in 2013 and is on track for about $270mm this year, but I’m not comfortable enough with the business to assign it much value.
In total, you have $1.5 billion to $1.8 billion in operating income based on the current productive potential of the assets already present in the business. In other words, this is pre-growth earning power. Take out $400 million in cash interest to get $1.1 billion to $1.4 billion in pre-tax income. At a 35% tax rate, that’s $715 million to $910 million in earnings.
DaVita has a $16 billion market capitalization. It trades at a 4.5% to 5.7% pre-growth earnings yield based on the above normalized net income. Earnings per share have shrunk only once in the last ten years and routinely increases by double digits. Assuming DaVita continues making only prudent acquisitions, you can stick on at least 5% of annual growth to get a 9.5% to 10.7% expected long-term annual return from buying DaVita at a $16 billion market capitalization (~$75 per share), plus a free option on HCP growth.
Paying for growth
DaVita is not a great investment unless it continues to profitably acquire new centers and at least maintains its current level profit per treatment. The dialysis industry is growing at 4% per year, so expecting 5% annual growth isn’t asking a whole lot out of the market co-leader.
Pressure on Medicare/Medicaid Reimbursements
This was discussed in section 1.1. I don’t believe there is much room to cut reimbursement rates further and expect quality and access to care to remain adequate.
Commercial reimbursements come down
DaVita has bargaining power in negotiations; I don’t see this as a huge concern
The mix between private and public reimbursements could change
Ten years ago, 70% of DaVita’s patients were covered by Medicare. Today, 90% of patients are Medicare/Medicaid. As far as I can tell, that jump is attributable to the expansion of Medicare rather than a shift in some other dynamic (the number was up to 87% by the end of 2006). This will be an important number to keep an eye on, however, as the 10% of patients with private insurance is crucial to DaVita’s profitability.
6. Guru Focus
If you’re still on the fence about DaVita, maybe these two gurus will help you make up your mind: Ted Weschler owned DaVita at his hedge fund, Peninsula Capital Advisors, and has built a $2.7 billion position in the stock for Berkshire.
“The dialysis business generates steady growth driven by the increased prevalence of diabetes and has additional growth opportunities from international expansion and integrated care. HCP contracts with health plans and is accountable for the healthcare of its patients in exchange for a fixed fee. In this way, HCP is incentivized to deliver high quality healthcare at low cost. We think DaVita has an opportunity to bring HCP's successful model into new markets and is well positioned to benefit from the shift from fee-for-service reimbursement to risk-sharing and coordinated care.”
A solid cash cow with a history of strong growth and a bright future that is touted by two investment gurus. What’s not to like about DaVita?