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. 


  1. Interesting and comprehensive write-up. but what is Intrinsic value for DVA. What type of discount are we buying it to IV?

    1. "Intrinsic value" can be super subjective; I have a preference for thinking of it, as long as the company is viewed as a going-concern and nothing material has changed in the thesis, as a culmination of the current FCF yield (including actual capital expenditures - both maintenance & growth cap-ex) + the growth achieved through the reinvesting back in the business. If DVA only reinvested in software, up-keep of the clinics, and had no "growth expenditures", the current price-to-yield would provide investors >8%, but it would be non-growing, similar to a coupon on a bond. I would count limited growth in pricing, no additional clinics, no additional treatments per patient, still about 78 patients per clinic, and so on....Considering DVA can reinvest and earn relatively consistent ROIIC and the growth rate in demand is ~4%, it wouldn't be too out of the norm to have a 8-9% expected desire RoR. To me, rough math, "rough value" is about 20% higher from current levels, or $80-$85 per share would be a fair value, in my opinion.

  2. Thanks. Based on your analysis you have provided an expected "IRR" on DVA which is helpful, given the current fcf yield+growth, up to mid-teens IRR on the stock.

  3. Hey,
    Thank you for sharing such an amazing and informative post. Really enjoyed reading it . :)


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