"It's a good habit to trumpet your failures and be quiet about your successes." -Charlie Munger (Trades, Portfolio)
"Experience is what you get when you didn't get what you wanted. And experience is often the most valuable thing you have to offer.” - Randy Pausch, "The Last Lecture"
In my last article, I shared the misjudgment I made with Colfax (CFX, Financial). While it was somewhat uncomfortable to trumpet a very humbling and, to some extent, humiliating experience, I do think doing so makes me vigilant. To practice my chutzpa, I have decided to write on another humbling and humiliating experience. As embarrassing as this might be, I hope we can all learn something from this painful memory. The company is called DaVita Inc. (DVA, Financial).
How DaVita got my attention
I first heard of DaVita in March of 2014 from a CNBC interview of Ted Weschler.
Weschler said he had followed the dialysis business for more than 30 years and offered three broad filters he used in general in health care investing. DaVita checks all three boxes.
Then I searched DaVita's jockey, Kent Thiry, on YouTube and watched a few videos about him. I was very impressed by him.
When I started researching DaVita later in 2014, I was immediately attracted to the consistency of the dialysis business. The loss of kidney function is normally irreversible. Kidney failure is typically caused by Type I and Type II diabetes, high blood pressure, polycystic kidney disease, long-term autoimmune attack on the kidney and prolonged urinary tract obstruction. ESRD is the stage of advanced kidney impairment that requires continued dialysis treatments or a kidney transplant to sustain life. Dialysis is the removal of toxins, fluids and salt from the blood of patients by artificial means. Patients suffering from ESRD generally require dialysis at least three times a week for the rest of their lives.
The underlying ESRD dialysis patient population had grown at an approximate compound rate of 4.0% from 2000 to 2013.
DaVita’s dialysis business has been incredibly consistent over the 15 years prior to 2014, with organic growth mirroring the ESRD dialysis patient growth rate at 4% to 5% a year and acquired growth at 4% to 5%. DaVita and Fresenius (FMS, Financial) together account for nearly two-thirds of the dialysis market in the U.S. The rest of the market is operated by smaller private clinics.
Like Colfax, DaVita made a transformational acquisition in 2012. In a multi-billion dollar deal, DaVita acquired HealthCare Partners, a leading integrated health care provider. Back in 2014, I was aware of the health care tectonic shift from volume to value. HCP is one of the best assets in health care in terms of providing better quality care with less cost and has a great track record. I thought the HCP business was going to take off soon even though it looked like the transition had some hiccups.
Why I thought DaVita was cheap
Average investors hate uncertainties. Understandably, this is a manifestation of human nature. Even for DaVita Kidney Care, a business that has a track record of stable and consistent growth, uncertainties still exist persistently and will exist for the foreseeable future. These uncertainties include change in the commercial rates the payers pay DaVita, the change in payer mix, changes in Medicare ESRD program, etc.
The acquisition of HCP adds another level of uncertainty to DaVita’s future as it mixes a historically stable and consistent growth business with another business with a less stable and less consistent business model. There is a fair amount of headwind challenges faced by HCP, the most prominent one being Medicare Advantage rate cuts. Furthermore, the impact of changes brought on by U.S. health care reform legislation is still far from certain, especially in the near term. Finally, the integration of HCP has been very bumpy with one problem after another.
My blind spot
I thought the Dialysis business was so consistent both from the revenue perspective and the operating income perspective.
My day of reckoning came earlier this year when United Healthcare (UNH, Financial) sued American Renal Associates (ARA, Financial), alleging the company was indirectly providing money through a charity (American Kidney Fund) to patients in Florida. Those patients qualified for coverage in government programs but used third-party payments to buy coverage from the insurer.
Right after the lawsuit, on Aug. 18, CMS issued a Request for Information with regard to possible inappropriate efforts by providers to steer patients eligible for Medicare and Medicaid into marketplace insurance plans paid for by third parties.
Not long after, on Oct. 24, an article published by a St.Louis website claimed DaVita encouraged some low-income patients to enroll in commercial plans.
“Internal emails from DaVita HealthCare Partners Inc. show the Denver-based company targeted some patients in a campaign to get them to buy insurance they didn’t necessarily need, saying their monthly premiums would be paid by a nonprofit foundation.
DaVita, one of the nation’s largest dialysis providers, with a major presence in St. Louis, had a financial incentive to get certain Medicaid-eligible dialysis patients to enroll in private insurance. Medicaid, the government-run health insurance program for low-income Americans, pays significantly less than traditional commercial insurance for dialysis treatment.”
DaVita’s shares plunged both times.
Back in 2014, in my research, I was blind to DaVita’s connection to American Kidney Fund and how this could lead to the potential dialysis rate headwind: Low income dialysis patients who do not qualify for Medicare were either uninsured or covered by Medicaid. Medicaid has the worst coverage and many providers do not accept Medicaid patients. Before President Obama's Affordable Care Act, those Medicaid or uninsured ESRD patients had no options because they would not be able to find low-cost plans due to their pre-existing conditions. The Affordable Care Act changed that so they have the option of the Affordable Care plan, which has much better coverage than Medicaid. But to many of them, even the premium is expensive. Major dialysis providers all contribute to the American Kidney Fund to provide financial assistance to ESRD patients who need help paying for insurance premiums. This is a great thing for those patients covered by Medicaid because now they can switch to the Affordable Care plans. The problem is, Managed Care Organizations (MCO) such as United Healthcare suddenly have to suffer huge losses from those dialysis patients because the premiums are far below the cost and these patients could no longer be rejected due to pre-existing conditions.
It became more and more clear to me that compared to Fresenius, DaVita had a disproportionate exposure to the American Kidney Fund and would have to temporarily suspend support for Medicaid patients who also obtain coverage from the Affordable Care Act. While this only affects 3,000 patients, given the rate differential between the Affordable Care Act, which is commercial, and Medicaid, as well as the number of treatments per year needed by each patient, the financial impact was substantial as the top line decreases trickle down to bottom line dollar for dollar. DaVita announced a $140 million impact on operating income and a potential additional $90 million impact.
What else went worse than expected?
The HCP business has considerably underperformed since the 2012 acquisition and it looks like it will take much longer than I expected for DaVita to reap the benefits. Management had revised HCP operating income guidance a few times since the acquisition. HCP experienced a massive reimbursement cut, which led to $200 million of operating income cut. HCP also experienced almost 100% turnover in leadership. Moreover, DaVita’s management admitted that the infrastructure at HCP has suffered from years of underinvestment as management was dressing the business up for sale in the years leading up to 2012. This means DaVita would have to invest a lot of capital to play catch-up. Even Thiry admitted he made some mistake in calculating the purchase price of HCP during DaVita’s Capital Market Day:
“I did a poor job of handicapping government reimbursement for which it'd be appropriate to criticize, and it was a poor performance on my part. Period. And there should have been parts of the deal that were contingent on some aspects of government reimbursement. And now it's just a miss on my part. Period. So it's out of control, but not in that sense. And I apologize.”
Checklist items added:
- In situations where a business makes the majority of profit from a disproportionate small amount of customers, has anything changed that would impact the revenue per customer in that specific customer group? In other words, do I understand the most important factors affecting the revenue mix?
- In what ways would new regulation impact the food chain in the ecosystem and who will be the winners and losers? How would the losers react and how would the losers’ reaction affect others? In this case, I should have followed closely to the Managed Care Organizations' exchange losses and tied that to the dialysis patients.
- Did the management team make a transformational acquisition using debt? (This one applies to both Colfax and DaVita). If so, does the acquired company have a different business model? Is it subject to different business cycles and different regulatory pressures?
Summary lesson
My biggest mistake was paying too little attention to DaVita’s dialysis business’ revenue mix and the factors that impact the revenue mix (in this case the American Kidney Fund exposure). It was disclosed by DaVita but I did not think too much of it. I also failed to ask the "so what, then what" question when all the major Managed Care Organizations announced huge losses on the Affordable Care plans. Finally, I was too optimistic about the timing of acquisition benefits when disconfirming evidences presented themselves at the time of my initial analysis.
Disclosure: Long DaVita.
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