Tuesday, December 29, 2015

Analysis: DaVita HealthCare Partners ("DVA") - (December 28, 2015)

DaVita Healthcare Partners (DVA)
Solid “core” holding with 10-15% long-term returns
December 28, 2015

Financial Information through Q3/2015

Many are familiar with DaVita as a dialysis provider, as they have likely seen one of their ~2,200 clinics across the United States used to treat individuals with End Stage Renal Disease (ESRD) and Chronic Kidney Disease (CKD) who need dialysis to remove the waste and excess water from the blood due to kidney failure. This is what dialysis is and does. DaVita is the #2 dialysis provider in the U.S. with about a 35% market share, close to Fresenius’ 36% market share. They have about 177,000 patients in the U.S. and 10,000 internationally.

Less people are familiar with HealthCare Partners, the doctor network that was acquired by DaVita for $4.42 billion in 2012. “HCP” is a very capital-light people-heavy business, where they contract mostly with primary care doctor groups, specialists, and hospitals to have access to their patient network (capitated lives) whereby they can manage patients in a more responsive, proactive, and affordable manner. They have 808,000 total capitated members and oversee $1.26 billion “care dollars under management”.

Despite the businesses – legacy DaVita (dialysis) and HealthCare Partners (capitated lives and PCP-focused) – have little overlap, they are part of what DaVita’s management views as the future of the healthcare system: population health management. 

(I will go over the basics of the business, the products, the alternatives. For more discussion on the financials, skip ahead)

What is dialysis?
Dialysis is the process for removing waste and excess water from the blood and is used primarily as an artificial replacement for a lost kidney function in people with kidney failure (Wikipedia.com) Typically, people who need dialysis have kidney failure that results from two most frequent causes: diabetes (Type 2, or adult onset diabetes) and high blood pressure. For many people with kidney failure, dialysis and a kidney transplant enables them to live life with the disease. Without dialysis or a kidney transplant, once a person reaches stage 5 (ESRD), an individual could die without a few weeks due to the toxins building up. Therefore, the options are: transplant, dialysis, or death.

An individual with CKD or ESRD sees a nephrologist (kidney doctor) who then refers the patient to a dialysis facility in which most/all of his/her patients go to so that the nephrologist can monitor progress. In the case of DaVita, if they have strong relationships with a nephrologist (or the facility is partially owned by the nephrologist at start-up) then the patient stickiness is essentially 100%, unless the patient moves somewhere else, where they would likely move to a location in the US near another DaVita center. At a DaVita dialysis center, which generates about $4 million in revenue and $800,000 in operating income, there are 75 patients (this has been stable), of which 90% are government and 10% are private/commercial. The center has a total of 17 teammates on-site, including 5 nurses, 8 techs, and 4 other/admin. At any given moment, all 18 machines could be in use if at maximum utilization.

Kidney Failure options: Transplant or Dialysis (or death)
Once the kidney damage is done and there is enough decreased function to create chronic kidney disease (CKD), an individual has two main options: kidney transplant or dialysis. These only options create the dilemma for a vast majority of people, as more than 10% of American adults have chronic kidney disease and greater than 690,000 has ESRD (as of Q4/2014), but despite the 100,000 on the kidney transplant waiting list only about 16,000 transplants are done each year. Unfortunately, ESRD is irreversible and permanent kidney failure, so unless an individual gets a kidney transplant, they must be on dialysis until they die.

Who typically is on dialysis?
The average age of a new dialysis patient in the United States is 64 years and the average life expectancy for those on dialysis ranges from 5-10 years. Unfortunately, the older the dialysis patient, the less amount of years they can expect to live while on dialysis. The importance, from an investors point of view, of the average age of dialysis patient is due to the common type of insurance that patient has determines the level and adequacy of reimbursement to the dialysis provider. At 64 years of age, the majority of dialysis patients are government paying, and currently the government reimburses dialysis providers an inadequate amount. This puts pressure on the commercial paying patients, whose rates are multiples of the Medicare PPS rate, and provide 110-115% of the profitability.

Secular Tailwind: American Demographic Shift
A long-term secular tailwind for DaVita is the prevalence of ESRD for the ethnic populations that will become a larger component of the American population over time. For example, the prevalence in the Hispanic community is 1.5 times greater than the non-Hispanic community. Given current immigration trends, the future composition of the American population will include a much higher percentage of Hispanics (see chart from Pew Research Center).

Hispanic prevalence is 1.5x higher than non-Hispanic prevalence of ESRD

Population expectations for America includes much higher minority percentage

How is dialysis paid for?
Government dialysis-related payment rates in the US are determined by federal Medicare and state Medicaid policy. For Medicare, all ESRD payments for dialysis treatments are made under a single bundled payment rate (2015 rate  = $239.43 per treatment). Originally, pre-2011, the payment was separated based on the actual treatment and a separate payment for the drugs and labs (the changes from un-bundled to a bundled PPS and the errors in calculating an appropriate “bundled rate” led to a reported overpayment to dialysis providers of $4.9 billion because of overestimates of usage of anti-anemia drugs; see: http://www.modernhealthcare.com/article/20130701/NEWS/307019947) For patients only paying with Medicare, they are responsible for a 20% coinsurance on out-patient care, including dialysis treatments (average in 2010 out of pocket was $6,918 for patients with ESRD).  Patients using commercial insurance are the only means for any dialysis provider to earn any profit, as those rates are typically multiples of the Medicare reimbursement rate. While it might seem that dialysis providers gauge commercial insurance companies, they are able to “get away with” contracting for much higher rates than the $240 Medicare bundled rate because: (a) the typical ESRD patient population is small relative to the overall size of patient network in each geography, (b) the services some dialysis providers provide improves the wellness of the patient by limiting excessive readmissions to hospitals, and (c) the commercial insurance company is only on the hook for the first 33 months, in which the patient moves off of commercial insurance to Medicare as the primary payer.

Dialysis “business mix”:
A dialysis patient is not the same as another dialysis patient, at least in terms of profitability. Some basic costs, at least for DaVita, are “patient care costs” and “general and administrative”. These two, on a per treatment basis, are $220.92 and $25.78, respectively, for a total of $246.70. However, for FY2015 the Center for Medicare & Medicaid Services (“CMS”) finalized an ESRD prospective payment rate (bundled rate for one dialysis treatment) of $239.43. This amount was increased 0.0% based on the wage index-budget neutrality adjustment factor, but most importantly, it is woefully inadequate of the actual cost of service and provides a negative return on investment for each patient that has Medicare or Medicaid as the primary payer.

If the patient using Medicare or Medicaid as a primary payer provides for a negative rate of return per treatment, then how does DaVita make any profitability? The payment rates from contracted commercial payers are significantly higher than Medicare, Medicaid, and other government payment rates. Unfortunately, the rate of increase in patients using government reimbursement has slightly outpaced the growth of commercial patients, which is a trend that DaVita has experienced for the past few years or so. The reason is likely twofold: (1) lower mortality rates for DaVita patients means they are on dialysis longer, thus more treatments, and (2) a sluggish economy for employment, especially for older individuals who are more costly for employers due to health issues, compensation, and other benefits.

In order for DaVita, or any dialysis provider, to earn a rate of return on providing dialysis, is to have the rate from commercial paying patients be substantially higher than the Medicare bundled payment rate. For reasons I’ve mentioned earlier, this is still acceptable for commercial insurance companies, and is one of the reasons (in my opinion) DaVita and Fresenius are pushing into ancillary services (more holistic care) to control the patient cost beyond dialysis, as they become more of-value to commercial insurance companies if they can control unnecessary hospitalizations and illnesses and doctor’s visits.

FY 2015 CMS ruling for the bundled PPS rate of $239.43 for dialysis treatments

2/3 of dialysis revenues come from government-based programs, the remaining from commercial insurance

Investment highlights of DaVita Dialysis:

This slide from the 2015 Capital Markets presentation says it all (see slide). What I personally appreciate about the business is the consistent growth in ESRD prevalence, the duopoly industry structure (helps with scale over smaller providers with contract negotiations, supplies procurement, future reinvestment, access to capital), the decent (but not stellar) returns on invested capital at ~ 11%, and the long runway both domestically and internationally.

Currently, Fresenius is the top provider in the US with about 36% market share, and DaVita has a 35% market share. Combined, the top two providers have about 71% of the US dialysis market.
Investment highlights of DaVita the dialysis company

Kidney Care: consistent growth, shows stability and non-cyclicality of business model

Per treatment economics (my estimates, DVA filings and presentations)
As the need for dialysis is not cyclical or seasonal, there are limited alternatives (transplant or death) and the stickiness of the patients is exceptionally strong, the business is able to capitalize on the secular trends and reinvest and earn fairly consistent returns on capital employed.

2000 - 2012 CAGR for US dialysis patients: 3.9%
ESRD Prevalence per USRDS government data

Reasons to like DaVita:

The healthcare sector has been under some pressure recently, specifically hospitals (CYH, HCA, THC) and the health insurance plans (all being down >10% in the last 6 months: AET, ANTM, CI, CNC). Regardless of ones thoughts politically speaking on the effectiveness thus far of the Affordable Care Act (ACA), I think portfolio manager Ted Weschler has the right approach when thinking of healthcare companies. In May of 2014, right after the Berkshire Hathaway annual meeting, CNBC interviewed Warren Buffett along with his two newer portfolio managers – Todd Combs and Ted Weschler. Weschler, who used to manage outside capital at Peninsula Capital Advisors LLC, has owned DaVita (DVA) since the early 2000s and bought it for the Berkshire Hathaway (BRK-A/B) portfolio a number of times since his hiring in 2011. (link to interview: http://www.cnbc.com/2014/03/03/a-stock-pick-from-warren-buffetts-stock-picker.html) In the interview, Weschler, who says he has studied the dialysis industry for 30 years, provides a 3 part framework for healthcare companies:
  1. Does the company provide better quality of care than they could receive somewhere else?
  2. Does it deliver a net savings to the healthcare system, or is the total bill for healthcare improved because of this company?
  3. Are there high returns on capital and predictable growth and shareholder-friendly management?

In breaking down these questions, I think the framework provided makes sense from an investor standpoint because (1) the healthcare system is fragile, almost ripe for disruption, due to the waste in the system and high cost of care and trends on the growth rates, (2) due to the high costs (17.1% of US GDP http://data.worldbank.org/indicator/SH.XPD.TOTL.ZS, which is the highest of any country globally except Tuvala), and (3) due to regulation and likely increased regulation over time as the government looks to reign in some of the healthcare spending, the company must be able to reinvest at adequate returns on capital, otherwise private capital would invest elsewhere.

Does DaVita provide a higher quality care than other dialysis providers, including Fresenius?

From the Capital Markets presentation, using multiple reference points, as well as data from Medicare’s new five-star ranking system, it is clear than DaVita provides the highest quality care of any dialysis provider, including Fresenius. With 5 stars being the best a dialysis provider could be ranked and 1 being the lowest, DaVita has 18% ranked in 5 stars (versus 6% for the industry less DVA), 33% in 4-star rankings (versus 14% for the industry) and 39% in 3 star (versus 41% of the industry). Only 10% of the clinics that are run by DaVita fall in to a 1 or 2 star ranking, compared to 38% for the industry.

Comparing to Fresenius (FMS) (#1 in US market share at ~36% versus DaVita’s 35%), DaVita is remarkably better than Fresenius. For example, DaVita has 805 clinics (of the ~2,200 in the U.S.) that are ranked 4 or 5 stars, but Fresenius only has 238 clinic. Alternatively, of the lowest ranked clinics being 1 or 2 stars, DaVita only had 180 clinics compared to Fresenius’ 787 clinics. Of the 5 star rankings, only 324 clinics receive top honors, with DaVita making up 57% of the clinics. Of the 1 star ranking, DaVita had 40, or 2% of the clinics ranked. (link: http://www.modernhealthcare.com/article/20150126/NEWS/301269852)

The dialysis industry gets hit with a “QIP” penalty based on some performance metrics. Only 1.5% of DaVita clinics were hit with a penalty, versus 6% for Fresenius and 7.4% for the industry-minus-DaVita.

Looking at mortality rates, DaVita’s has improved gross mortality from 19.0% in 2001 to 13.5% in 2014 (expect 2015 to be flat versus 2014). Using DaVita and Fresenius (combined they are called “LDOs” or large dialysis organizations) versus the remainder of the dialysis industry, the LDO’s have far superior standardized mortality rate of 0.972 versus 1.055 for the remainder of the industry.

Considering that 90% of the dialysis patients are “government-based” and that DaVita loses 10-15% on each of those patients, I would argue the combination of the quality of care and their ability to offset loses with commercial paying patients helps keep total healthcare system costs “in-check”, despite dialysis being an expensive treatment (patient needs treatment 3-4 times a week for about 5 years on average, at about $270 per treatment cost). Additionally, almost 10% of DaVita’s clinics (200) are operating at a loss but do so “in good faith” to prove value to the US Government and CMS about the delicacy of reimbursing dialysis providers an adequate rate, as DVA is a low cost provider and loses money on 10% of the clinics, a continued inadequate reimbursement rate would have larger effects on the other dialysis providers.

Does DaVita deliver predictable growth and high returns on invested capital?

I would argue that DaVita does deliver fairly predictable growth, starting with the almost linear growth in US dialysis patients of 3.9% CAGR since 2000. As dialysis is non-cyclical, not seasonal, the only alternative is a kidney transplant and there are only about 16,000 transplants per year, a patient on dialysis has 3-4 treatments a week without fail, and the stickiness of the dialysis center is exceptionally high (convenient, medical data, nephrologist connection, insurance). For these reasons, the growth for the dialysis industry has almost been like clockwork. For DaVita, they have accelerated growth through opening more facilities than industry growth (“de novos”) as well as have acquired smaller dialysis organizations over the last 15 years. The result is that since 2003 operating income growth for the dialysis segment has grown 13.7% CAGR, and this includes negative contribution of $50m in 2015 from international facilities.

Based on most recent numbers, DaVita is financed through a combination of shareholder’s equity ($5.2 billion), Debt ($9.2 billion), deferred taxes and payables to suppliers. Total invested capital is about $15.3 billion as of Q3/2015, of which only $4.0 billion is “tangible”. The difference of about $11.3 billion alludes to the acquisitions of dialysis companies over the years (as well as the goodwill and intangible assets from HCP). Based on actual capital expenditures of about $800m, DaVita earns a modest 13-14% on total shareholder’s equity (recall tangible equity is negative) and about 11% on total invested capital, post-tax. While these returns on investment aren’t stellar, they are consistent and are almost “regulated” to be adequate-enough to entice private investor capital. Considering the continued growth in ESRD and dialysis patients in the U.S., there will be a continued need for more facilities, in which one would expect a continued low double-digit return on INCREMENTALLY invested capital, which bodes well for building long-term earnings power. 

If you take into consideration a considerable amount of invested capital is non-tangible, and future reinvestment (unless DVA could acquire other smaller dialysis operators) is in M&A in the dialysis space, most of the future investment in the business will be in tangible assets (working capital, supplies, machines, building out of the dialysis center), in which the return on tangible capital is >40%. If DaVita is able to continue opening new clinics (as they have been to meet demand + accelerate growth above demand) then most of the future reinvestments should earn >40% and much less of operating cash flow is needed in order to grow the business 5-10%, which bodes well for the future cash flow generation of DaVita.

Management has proven track record of creating shareholder-value

Estimating forward rates of returns:
Treatment growth:
DaVita provides a helpful framework for breaking down the “value drivers” of revenue and expenses. Starting with volume (number of treatments), DaVita’s management expects volume to be in 4.5% - 6.0% range. This is essentially a combination of the secular growth of US dialysis patients (~4%) adding in a factor for DaVita to open more facilities than the dialysis patient growth rate (0.5% - 2.0%). Looking over the last 7 years, the normalized “non-acquired growth” in treatments ranges from 4.1% to 5.1%, and on a quarterly basis only more recent quarters has it been below 4% twice (Q2/2015 at 3.7% and Q3/2015 at 3.5%). Thus, the 4.5% - 6.0% range is probable. The reasoning management has given as to why growth has slowed the last two quarters is due to a large number of facilities in California taking a little longer to get approved than normal, but once they are approved growth should accelerate back to the “normal” range.

DVA treatment growth - stable, consistent, within 4-6% target range 

Revenue per treatment:
The rate at which DaVita is reimbursed in dependent on a number of factors: patient mix of government-based versus commercial paying, mortality levels and the impact at which commercial paying patients provide higher rates for the first 30 months prior to moving to Medicare as the primary payer, inflation on labor and drug costs, among other factors. Of the ~25.8 million treatments in the last year by DaVita, 90% of those are on government based patients and 10% on commercial/private. However, DaVita loses 10-15% on the government-based patients, and thus the 10% commercial paying patients provide 110-115% of DaVita’s profits.

DaVita expects the reimbursement rate to be in the 0.0% - 1.5% range. The lower end reflects the headwinds from CMS on the rate, the higher end reflects some upside based on commercial contracting. Recent trends are at the upper end of this range, more so around 1.5% to 2.0%.

Costs per treatment:
The largest costs for a dialysis provider are the employee costs and pharmaceutical and supplies. Together, these make up about 60-70% of the total cost per treatment. The remaining costs, such as center-level costs and G&A, are more variable in nature, and will move in-line with treatment growth.

DVA provides a formula to show the drivers of the financial performance (2015 Capital Markets)

Operating Income growth:
Through looking at the treatment growth, revenue per treatment, and the expense drivers, DaVita estimates that the dialysis business will grow at 3% - 8% in terms of operating income. Based on historical financials, actual growth, and managements history of being conservative, I would expect operating income growth to be in the 5-10% range conservatively over time. From a cash flow standpoint, a lot of future growth will also come from international operations, which should lower the tax rate and further boost net income/FCF.

International Runway for Large Reinvestment

As of Q3/2015, DaVita had 10,000 patients and 104 international clinics. As of the end of 2014, according to Fresenius, there were 2.665 million dialysis patients globally, with North America only having 596,000. With DVA’s small international presence, there is a long and ample runway for international reinvestment and growth.

Furthermore, the international businesses provide an “upside call” option on the current financials as the 104 clinics have required a alot of start up costs and compliance and will be a $50m headwind in 2015, according to DVA. 

End of Q3/2015 has 104 clinics and 10,000 patients....ample runway for long-term reinvestment
International expansion still in "start up" phase for DaVita, expecting a $50m loss in 2015 due to start-up costs

  •  HealthCare Reform (ACA) creates narrowing of networks, more dialysis providers become out of network (and more expensive)
  •  HealthCare Reform (ACA) premium costs or health care costs are too high, causing the patient to “skip out” on some of the out-of-pocket expense to the dialysis provider (increases provision for doubtful accounts, a contra to the gross revenue line)
  • Commercial insurance as a primary payer shortens to less than the current 33 months before switching to Medicare as the primary payer and commercial as the secondary
  • Consolidation of commercial health care insurers providers for more negotiating power over DaVita and their “high” reimbursement rate
  • People get healthier, the prevalence for chronic kidney diseases (CKD) and End-Stage Renal Disease (ESRD) declines, which has been a decent secular growth driver for the industry
  • Advancements in dialysis whereby people need treatment less than 3-4 times per week (hemodialysis), which would impact profitability
  • Vast improvements in mortality rates negatively impacts DaVita because more patients move off of commercial insurance to the inadequate-rate-paying government plans.

HealthCare Partners (HCP)

HCP was acquired in 2012 for $4.4 billion. The premise of this deal was that the future of healthcare is less-so “fee for service” arrangement and will become more of what HCP does under a capitated model. Under the capitated model, the large group of doctors and the network of nurses and specialists receive a so-called flat fee per member per month to provide nearly all of the patient’s care. If the doctor group does an inadequate job of providing care, such that the member/patient goes to the hospital unnecessarily, or has illnesses that could have been prevented, and the cost of care exceeds the flat rate then the doctor group “eats the portion above the flat fee” as a loss of profit. In order for a group to become profitable under the capitated model, they must provide a high quality of care and be efficient with their costs in order to have total costs be less than the flat fee per member per month.

In other words, HCP’s model is based on survival of the best as the payment is not based on providing the actual service but based on a strong performance and high quality level of service in a cost-efficient manner. One would think this type of business model is very intriguing as insurance companies look to mitigate risks, manage costs, as well as the government looking to control healthcare spending for Medicare and MA.

Geographical presence of HCP; core markets are Los Angeles, Florida, Las Vegas

Since the 2012 acquisition:
The acquisition of 2012 has been nothing less than disappointing. From Medicare Advantage rate cuts to the newly expanded markets underperforming in quality of care (thus losing money) to the expected future M&A in the space to build scale has not yet come to fruition, despite about 3 years since the deal consummated. While total capitated members has increased from 724,000 in Q4/2012 to 808,300 as of Q3/2015 (was 826,500 at end of Q2/2015), and revenues have increased from about $2.4 billion to $3.8 billion, the level of profitability has declined to where the rolling 12-month EBITDA has gone from $547 million in Q4/2013 to a current level of $420 million.

Still, despite all of the disappointments, it seems as if things are showing signs of improvement. The team that has done the deals in the newer HCP markets (which are unsuccessful currently) have been fired, they have doubled down in the legacy markets (where they are strongest) and have added newer partnerships that bode well for the type of business model of HCP.

Regardless, as of the 2015 Capital Markets presentation, despite the headwinds, there was a tax step-up that is amortized at about $100m in cash benefit, implying a 7.6% cash-on-cash return in 2015.

Despite the headwinds and MA rate cuts, still a 7.6% cash-on-cash return for HCP acquisition

Examples of Quality:
Feel free to skip ahead of this section, if you prefer more financial analysis, less business related discussion. As the business prides itself on performance-based reimbursement, the best measurements of performance are how HCP compares to its biggest competition: the Medicare Fee-For-Service model.

HCP value proposition: lowers total healthcare costs by having lower hospitalizations and readmissions that Medicare Fee-For-Service

HCP acute admits per 1000 continuing to improve Y/Y in legacy markets

HCP legacy markets vs. "new markets"

Secular driver: Large and Growing Medicare Advantage (MA) membership

The Medicare Advantage (MA) membership is a secular tailwind for HCP’s business, as the reimbursement method is capitated, versus traditional Medicare as FFS.

Medicare Advantage plan growth a tailwind for membership for HCP businesses

As this business model thrives on those who can provide a high quality service in a cost-effective manner, CMS is reimbursing physician groups based on a “Star Rating”, whereby those who have higher performance get a financial bonus, those who are average or underperform get nothing. In 2015 plans that had 4 stars or greater (where the primary care physician was a HCP related PCP) received a 5% bonus, and plans less than 4 stars got a 0% bonus. For 2015, 84% of HCP’s Medicare Advantage patients were in 4+ star plans. This could be a nice tailwind, as they outperform and receive bonuses, and thus the insurance companies and government prefer them even more, and they get more capitated lives (faster growth) and maintain the level of quality and cost-effectiveness (continue to get bonuses), and so on.

An obvious risk is where a certain insurance company decides to contract with another physician group, not because that physician group is superior, but because that group will accept a very low level of profitability, one that provides for a very small margin of error if costs escalate. In this case, HCP could lose membership (this is what happened in the most recent quarter – Q3/2015, where HCP and a hospital/plan did not agree to the capitated rate).

How does HCP grow?
HCP is a non-capital intensive business; instead, it is all about obtaining the right level of PCPs, specialists, and nurses who are in agreement with this level of providing service to patients (capitated model) and thus HCP acquires or obtains more PCPs and their network of members. Another way is through partnerships with the insurance companies or certain health systems, who looks to HCP to manage their costs as they may not have been able to do an adequate job, in which HCP would take over the capitated lives in exchange for a percentage of profitability, in the case there is.

Based on the 2015 Capital Markets, there is the expectation for 0-3% baseline growth +/- legacy market competitive performance +/- new & future market growth. Since Kent Thiry fired the team involved in the deals that have been unsuccessful and he has been more focused on the deals himself, the level of profitability of the business has improved. Due to the success of the legacy markets, I expect most of them to receive the 5% bonus.

Capital Requirements – Maintenance & Growth
HCP requires no working capital, and the capital expenditures are largely in IT to build the software and capabilities to monitor the ~800,000 members and cross-reference illnesses, symptoms, causes, etc. in order to be more pro-active in providing care.  The actual level of capital expenditures for HCP is about 0.5%  - 1.0% of HCP revenues.

At ~ $70 per share, the current market capitalization is $15.2 billion and the Enterprise Value (excl. operating leases) is $23.3 billion. Trailing 12 months EBITDA (adj. for one-time legal expense) is about $2.34 billion (EV/EBITDA  = <10x), expected 2015 operating cash flow should be ~ $1.7 billion (EV/OCF = 13.7x), Free Cash Flow post-tax (FCFE + Interest expense) using actual all-in capital expenditures (growth & maintenance capex) is $1.13 billion (20.6x or 4.8% FCFF yield) and $723m FCFE using actual full capex (4.8% yield on market cap).

Since I accounted for both maintenance and growth capital expenditures, these expenditures are necessary to maintain the business competitive position and to grow the business. In order for DaVita to grow, they must add new clinics (add patients, increase treatments), as there is very little room to increase pricing to earn an adequate RoR. Accounting for actual capital expenditures provides a truer measure of “Free Cash Flow” while adjusting for the fact that the capital expenditures will earn a decent 11-13% return on incremental capital and grow cash flow in the mid-to-high single digits. Assuming $800m in capital expenditures and 11% ROIIC gives us a 4.8% cash flow yield plus FCF growth over the next year of 7.8%, a total return of 12.7% for a business that is non-cyclical, non-seasonal, and very sticky.

DaVita estimates EPS growth over time to be in the 5-12% ball park. Knowing this growth comes from spending the necessary capital to obtain the returns, you could also estimate forward rates of return as 4.8% FCFE yield + 5-12% EPS growth, for a total return of 9.8% - 16.8% over time. Given the characteristics of the business, as well as higher valuations at the moment, I think DVA as a core holding to earn adequate rates of return over time is an attractive investment. 

DaVita's expected EPS growth over time (2015 Capital Markets)

DaVita dialysis links:

·         Renal & Urology News – November 2010 – Dialysis Providers Prepare for Bundled Payments : http://www.renalandurologynews.com/feature/dialysis-providers-prepare-for-bundled-payments/article/190929/
·         CMS proposes 9.4% cut for dialysis providers – July 2013: http://www.modernhealthcare.com/article/20130701/NEWS/307019947
·         Medicare beneficiaries with Kidney Failure have highest Out of Pocket Spending – July 2014 - https://www.kidney.org/blog/advocacy-action/medicare-beneficiaries-kidney-failure-have-highest-out-pocket-spending
·         Ethicare Advisors: “why dialysis is so expensive” http://ethicareadvisors.com/understanding-why-dialysis-treatments-are-so-expensive/
·         USRDS statistics on prevalence by ethnicity - http://www.usrds.org/2012/view/v2_01.aspx
·         Future composition of American population – Pew Research - http://www.pewresearch.org/fact-tank/2013/05/10/politics-and-race-looking-ahead-to-2060/
·         US healthcare % of GDP http://data.worldbank.org/indicator/SH.XPD.TOTL.ZS
·         DaVita has top honors in 5 star ranking, Fresenius the lowest http://www.modernhealthcare.com/article/20150126/NEWS/301269852

HealthCare Partners (HCP) links:

·         WSJ: Dialysis Firm Bets on Branching Out – May 2012 http://www.wsj.com/articles/SB10001424052702304019404577418083585806556

I own shares of DVA. 

Tuesday, December 22, 2015

Liberty Media (LMCA/QVCA/LBRDA) comments (CEO Greg Maffei) from 43rd UBS Conf. (12/08/2015)

43rd Annual Global Media and Communications Conference
Liberty Media Corp. (LMCA)
Speaker: CEO & President Greg Maffei
Tuesday: 12/08/2015

  • Consumption trends, a lot of change taking place, from high level what are greatest opportunities to take advantage of consumer behavior? Doesn’t stay in a vacuum. Most things not that inexpensive. Netflix gaining a lot of scale in OTT world but that doesn’t mean we should go buy Netflix stock, have to weigh what you are already in and what you are seeing and relative value. Very excited about a bunch of things, very excited about Charter (CHTR), excited about TripAdvisor, both of those have good growth prospects. Sirius has good success, having hell of a year, raising net adds.
  • Look at Netflix (NFLX), but other opportunities to compete with Netflix? Other things in video space? What I look at is short form video is exploding. YouTube, Snapchat, a lot of that is millennials, not only short form, not sure which device consumes their focus – small screen or the big screen. Millennials want to create stories and the like, it is a huge trend. Like this area a lot.
  • Reality is that this trend is participatory over time
  • Traditional video assets you have, does this view about millennials and short form, does it make you concerned about the value of traditional video assets? You know, these things tend to take a lot longer than people think. The models go a long time. But have to be aware of this trend.

Liberty Interactive (QVCA)
  • Transformation in e-commerce business last 12-18 months. QVC has been acquisition, CommerceHub, etc. What are you seeing in marketplace? If you look at moves we made, originally got in these businesses because they were niche, had some moats. Have done well on a number of them. If you look at bodybuilding.com, our entry price versus current value, we have made a lot. Scale is attractive. ProFlowers merging with FTD. We have been moving and shifting trying to get scale.
  • Small mid-cap internet name like Zulily, is that reverse, is that saying QVC already has scale? I think it does a lot of positive. Scale advantages that QVC has to bring to Zulily, such as: shipping and handling, many elements of the supply chain, around some procurement, also some things on the revenue side – cross selling, bringing the youthful audience of Zulily up to the QVC universe. Actually tested last night – Zulily was on QVC plus, already done a lot of things, where promote things on Zulily. Entering new markets, having Zulily’s experience, being asset light to enter market where they aren’t as strong.
  • CommerceHub – where is this as an asset inside Liberty to stand on its own? Very low tax basis, came up inside QVC, moved it out and became bigger company. Smaller than we would like to be a public company, but there are advantages it has being a public company in being an acquirer or to be acquired. Much more flexibility being a public company.

SiriusXM (SIRI):
  • SiriusXM (SIRI/LMCA) – from here, to create value going forward, do you need to own connected car? There are a bunch of value drivers inside SiriusXM. We continue to have a good SAAR, which is a positive. Net sub adds are up enormously this year, both in the back of growth in new cars and improved penetration but also in used cars. Probably not a lot of further growth potential in the SAAR from here, not like we will see 25 million, or we aren’t counting on it getting to 25 million SAAR. Enormously long tail of growth in used car market that won’t peak for 10-15 years. Long train of growth in that. Way underpenetrated, continue to add new cars in because of the SAAR, at a much higher rate than the old cars are dropping off because they’ve aged out of this population. So that’s an opportunity (used car market). Another is the connected vehicle. Another opportunity is in the “zombies”, which are cars that are approaching 100 million within 3 years on the road that are not subscribers, will never be subscribers, that Sirius has radios in them that we can light up and provide a free service. If terrestrial radio is good but SiriusXM is “best” then this service we would offer would be in-between, more content that is ad-based. Another opportunity is we have a lot of spectrum capacity with S-XM 17 we can free up over time, either to create new services inside of SiriusXM or to find alternative uses for it outside of Sirius. Think there are a lot of ways that value grows over time for SiriusXM.
  • We’ve been hearing about the used car opportunity for a number of years, you’re starting to make some progress on that, are you gaining traction? We have 32% penetration in this market this year, maybe it’s the low hanging fruit, but it has been huge for us, over 2mm growth.
  • Content side, do you get involved with negotiations with Howard Stern? Yes, I do, and I’m confident we will have a deal with Howard Stern.
  • How do you think about the ownership stake of LMCA with SIRIUS? We are not splitting, instead creating 3 trackers, goal to reduce discount to NAV. Hasn’t reduced the discount to NAV yet, maybe moved a point or two, but we haven’t created the trackers yet. If there is a discount to NAV, would think they all would have an equal discount, but possible they don’t. If one tracker has a larger discount to NAV than the others, we can attack that one through a repurchase or something else. Other opportunities have opened up as well, been some speculation in the past, such as SiriusXM buying LMCA stock due to the discount in NAV and we are a significant portion of the value, to the point we have a pure SIRI tracker, where they can buy the LMCA-SIRI tracker stock.
  • Don’t see the need to close the gap in the near term unless there was some activity going to happen, such as merge them together…Why the timing now? We were just annoyed at the discount and wanted to do something about it. We conjure up stuff. This creates more flexibility for us. If we want to spin-off the Braves, we can. Just creates more flexibility for us, but no rush for this otherwise. Everyday SIRI buys back stock and LMCA doesn’t sell, we increase our ownership stake. Inevitably it points in that direction.
  • SIRI is a big one where a lot capital can be accessed. Not wrong or a bad thought. We think that the SIRI use of cash flow to repurchase stock is a good thing. Good thing for shareholders and for LMCA because our % increases ownership. If you look at options today, don’t think there are better options than that repurchase. Now, down the road, alternative market environment, maybe a strategic acquisition in SIRI, is there another market SIRI where we can buy and take it to the next level, maybe at some point in the future.
  • Spectrum? Spectrum valuation, hard thing to know. Some restrictions on its use, maybe that changes over time. It doesn’t get freed up until mid-next decade, but when it does it can create new opportunities for SIRI or for someone else. We are not trying to get rid of it but there are prices for spectrum that may be good.

Expedia (EXPE) and TripAdvisor (TRIP)
  • Expedia stake? Spinning off <20% stake in Expedia in new Holdco., with bodybuilding.com, creates more flexibility. Ultimately what happens over time it combines with Expedia but no certainty with that.
  • Proxy vote – Mr. Diller & Mr. Malone? TripAdvisor has no proxy, 22% of economic, and 56% is vote is Liberty-Trip. No proxy in that deal.
  • TripAdvisor (TRIP) , a lot of changes last 36 months. 7 of top 10 hotels, and largest OTA. Sits at top of funnel, especially for leisure travelers, for people who are investigation where to say, what to do, while on a trip. It is the largest travel site in the world by visit, has 375 million unique monthly visitors.  Challenge is to move from place where there was vertical search to where you can make transactions.  Have gone through 2 transitions for that. (1) One was to move from multiple screens to metasearch, which was required to improve the customer experience but was necessary to operate in a mobile world. (2) Other is where you move from cost per lead or per referral by the OTAs to where you can book with hotel, take credit cards. Enormous two transitions. All while business is still growing at very fast rate. Some trade-offs, such as where you are fully paid-out for the lead by the OTA, who monetizes better than we do in short term, for commission we get paid by the hotel. Challenge is working new way into business model, is attractive, may have some headwinds next 12-18 months. Also allowing closer relationship with customers. Long term opportunity is to have the lowest cost per customer acquisition, where we have hundreds of million reviews, which are free to us, are an enormous moat, to convert those to new customers or a higher percentage.
  • Travelers come to us, we want to improve their experience. How? One is to improve the number of properties,  add depth of information on those properties. Booking.com has helped. Another is confidence in the booking process.

Liberty Broadband (LBRDA/K) and Charter Communications (CHTR)
  • Liberty Broadband, a lot of changes taking place in Pay-TV ecosystem. Thesis still holding?… We are very excited about initial purchase that created our interest in Charter, it is about half of current price. Remain very interested. We have stepped up and put $3b of our capital and raised $2b of new capital from 3rd parties to buy more Charter stock upon the close of the 2 transactions at a price of about 6-7% less than the current price, maybe $11 per share less (note: $176.95 per share). Very bullish it will prove to be an  attractive entry point to put incremental capital in Charter, upon the close of that deal. How do we realize value? 2 ways…(1) someone could buy Liberty Broadband. (2) Other is Charter could merge with Liberty Broadband (LBRDA/K). Why would they want to do that? We have a bunch of governance rights, pre-emptive rights, have some things about governance that makes it attractive for them to eliminate. They could offer us a premium to market, which more closely reflects NAV.
  • What kind of premium? Those things get negotiated.
  • Tax issues for merging LBRDA with CHTR? LBRDA has been freely traded company for >1 yr, so anything tax-wise has likely already passed.
  • We have governance things that are beneficial for us with LBRDA and Charter.
  • Any leverage shifting back from content creators to distributors? Distributors have gained some relative hands than 6-12 months ago, are scaling faster than the content guys. Talk about sports costs, skinny bundles, helping distributors. Recognize third models (NFLX) that need to compete with.
  • First Charter Communications (CHTR) needs to complete the merger. Then execute on the plan that has been executed very well at Charter (CHTR) and do this at BHN and Time Warner Cable (TWC). Completing digital upgrade, simplifying pricing and packaging, approve minimal speeds for internet, improving TV experience, streamlining customer service, improving systems.
  • Part of thesis for Malone was that “TV Everywhere” was sub-par and that it really could change everything, and if he got that right it would be accelerated in timing? Think that’s right, but don’t think that’s the only way this works (deal being successful). The deal could work well even if “TV Everywhere” doesn’t take off. That’s just one option.
  • How big can the CHTR-TWC-BHN company be? Pretty big. $115-$120 billion in EV right out of the block.
  • How close are you following Yahoo situation with IRS? Guidelines are already in place by IRS. Everything we’ve announced at Investor Day is consistent with IRS guidelines.
  • QVCA – 38% of HSN, Zulily, 100% of QVC. Some where customers compete, some overlap.
  • Vivendi SA litigation proceeds, interested in swapping assets? Sure, depends on the price. Things we can help with Universal Music, such as things with SiriusXM and Live Nation. We have $1.1 billion judgment against them up on appeal. Goes to trial in March 2016. They’ve already lost once, so we will see. We are trying to get this under New York “contract law” and that the interest paid to us shouldn’t be treasury rates but instead 9% simple interest, that would be another $700 million for us. Think we have a good cause.

On Live Nation (“LYV”):
  • Live Nation Entertainment (LYV): up 37% for the year, massive amount of growth, More room to grow in secondary market. Largest purveyor of big tours. In other markets, like Latin America, we don’t own the tours and have to outsource in those markets. We’ve grown festivals as well, have 4 of the top 5. A lot to be done organically in M&A.
  • What to do with Live Nation (LYV)? We are used to this kind of stake from a percentage of total company ownership. We are up to 34.4% (some limitations with this).
  • Liquidity access, how to size this if something big came along? We would need more money. Believe bigger is better. The $5b for CHTR is unique. We brought in $3 billion, asked $2 billion from outside investors. Not a lot of investors play in our space, good to see Warren Buffett not involved much in TMT. This helps with less competition, so we build relationships with these investors. In future can have LBRDA add capital and have outside capital.
  • Why sell Viacom in Q1 2015? Sold at average price of $69, so that looks good.
  • Content model vs. distribution? Think the content model more challenged right now, am seeing ESPN have more pain. Distribution stream is around a void, high speed data, those needs. Would rather be in latter right now.

Atlanta Braves:
  • Atlanta Braves - $1.15 billion? Point is fair that assets are at increasing multiples, hope to add value with mixed real estate for valuation. The Forbes valuation was conservative in our view.
  • Sports Rights peaked in value? Don’t think so, depends on what team, look at EPL in France in which continues to get bid up. How this all plays out, think the RSNs (Dodgers, for example) are asking too much for what they are trying to achieve. Is it sustainable, probably not, but not to overall sports yet.
  • Liberty Ventures – top priorities? Complete spin of Expedia stake, spin of CommerceHub, close on $2.4b investments in LBRDA, new investments, potentially liquidate non-strategic investments.

John Malone:
  • John Malone said at Investor Day as what surprised him in 2014: – how much the market has overreacted to cord-cutting has been surprising. Some things are challenged, but cord-cutting won’t happen super quick. Advertising revenues won’t collapse in short time frame.

Consolidation in “Media” space:
  • Think there will be more consolidation in media space next 1-2 years….

Other notes:
Liberty Broadband (LBRDA) to add $5b to CHTR deal
Vivendi SA & Liberty Media articles from lawsuit
Liberty Media interested in Vivendi SA’s “Universal Music Group”