Overview: LiLAC Group (LILA/LILAB/LILAK) *(Pre-Cable&Wireless Acquisition)

LiLAC Group (LILA/LILAB/LILAK)

Betting on industry’s best operators rolling up the highly fragmented Latin American cable assets

January 6, 2016

***Cable & Wireless (CWC) + consolidated "NewCo" valuation in progress....will provide updates***

About LiLAC:

LiLAC is a “tracking stock” created June 24, 2015 to provide investors a more pure-play capability on the Liberty Latin America and Caribbean cable assets, which were historically consolidated under the Liberty Global company. As the Latin American and Caribbean assets were such a small component of overall Liberty Global, as well as investors were generally less familiar with these assets, they received little focus and attention from investors. Management at Liberty believed the creation of a tracking stock was appropriate to ‘show’ investors that these assets were valuable as well as give investors a pure-play opportunity in the expected consolidation of Latin American and Caribbean cable and telecom assets in the next 5-10 years.

LiLAC is not a separate entity, and shareholders of LILA/LILAB/LILAK are ultimately shareholders of Liberty Global Plc.

There is an additional “forced selling” investment opportunity as the LiLAC tracking stock is given to current Liberty Global shareholders at a ratio of 1 LiLAC share for every 20 Liberty Global shares owned. For most investors, the LiLAC ownership would likely be too small in relation to their portfolio, and thus these shares would be discarded without much analysis or investment rationale.

As of current, LiLAC consists of 100% ownership of VTR (Chile cable operator) and 60% of Liberty Cablevision Puerto Rico (40% owned by Searchlight Capital).

What makes Latin America attractive:

·         Highly fragmented in Latin America and Caribbean landscape, ripe for consolidation

·         Liberty already has presence – Puerto Rico & Chile – thus not new to the region, understands the risks

·         Low broadband and Pay-TV penetration represents strong growth opportunity, almost similar to where Europe was 10-15 years ago

·         Improving soci-economic backdrop leads to strong underlying demand and growth

·         Foreign exchange headwinds and market volatility creates opportunity for strategic acquirer (similar to Liberty’s announcement of CWC)

·         Across certain markets, large market share by satellite companies (DISH and DirecTV), which provides opportunity to take market share as Liberty can offer broadband and comparable TV product (similar to cable companies in the United States in 2015 to current)

Mike Fries (Q3/2015): “..As we rolled out our Lat Am tracker, we did mention that in our opinion, this region is underpenetrated in broadband and pay-TV and is likely to experience above-average growth, just look at our own assets, and is ripe for consolidation, particularly by experienced and well-capitalized operators…”

Mergers & Acquisition strategy:

Liberty has stated multiple times they will not start from an asset-level viewpoint, but rather will look at the markets in Latin America and where they could potentially be the #1 or #2 cable operator. Otherwise, they will not enter the market, as they desire scale advantages (customer service, advertising, size, programming, capital expenditures).

In summarization:

1.       Start at country-by-country basis

2.       Can, through M&A, Liberty become the #1 or #2 cable operator

3.       If yes, look to enter market and start evaluating the assets in the market

4.       Be an advantageous acquirer

5.       Build scale through combination of customer growth, more RGUs, increase penetration, etc.

6.       Use parent-company Liberty Global as a mature corporation to obtain funding for the deals (can use LILA stock, LBTYA stock, add to LBTYA debt or company level debt)

7.       Use Liberty’s M&A experience to be opportunistic in entering markets and increasing scale

Mike Fries (Dec. 2015 UBS): (paraphrased) “We like the region of Latin America which is why we created the tracking stock  - “LILA, LILAK”. 2 great assets down there, which are growing high-single digit to low-double-digit EBITDA (VTR and Liberty Puerto Rico). These 2 current assets are “sub scale”. We are trying to find ways to build a platform that has scale. The CWC deal brings that scale needed. They are the #1 fixed/broadband provider in 7 out of 18 countries. They have a massive sub-sea cable business that feeds those markets as well as our markets. They are heavily invested in mobile. Together, the CWC business with Liberty (LILA/K) gives us the scale and opportunity for growth. Think it will be low double-digit EBITDA growth. We have audited synergies of $125m on top of $145m of one-off capital expenditure synergies. By the way, there are two levels of synergy we can’t talk about. We’d like to but, but that’s how the U.K. works. Think the total synergy story is really attractive.”

Mike Fries (2012 commenting on OneLink acquisition): “Consistent with our strategy of consolidating markets within our footprint, this transaction will make us the leading provider of cable services in Puerto Rico, passing approximately 70 percent of the cable homes on the island and adding substantial scale to our existing operation.”

Eric Zinterhofer (co-founder of Searchlight, commenting on Choice acquisition in 2015): “Eric Zinterhofer, co-founder of Searchlight, said, “We are excited about the opportunity to bring next-generation video capability and enhanced broadband services to Choice’s customers. Furthermore, through the creation of an island-wide cable operator, there are significant opportunities to drive scale benefits and develop incremental residential and commercial business opportunities in Puerto Rico.”





Chile: "VTR"

Background:

Liberty Global owned 80% of VTR until March 2014 when they acquired the remaining 20% from “Corp Group” for approx. $422 million (using 10.1 million shares at $41.80 per share of LBTYK stock).

Overview of the Market:

VTR is the largest cable television provider based on subscribers with 1,026,200 video subscribers at the end of Q3 2015. At the end of 2014, there were 2.8 million total video subscribers in Chile. VTR had a 35.9% market share, Telefonica (Movistar) was at 21.1% market share, and Claro Chile (subsidiary of America Movil) and DirecTV were even at 16.4% market share.

Television:

The Pay-TV market in Chile has expanded at a 11.5% CAGR from 2008 to 2014, going from 1.46m subscribers to 2.81m subscribers, as well as increasing the penetration in the country from 34.7% in 2009 to 48.6% in 2014. Despite the robust market growth of 11.5%, VTR was essentially a non-participant, only growing 2.1% from 2008 to 2014.

VTR is only available to about 60-65% of the Chilean television market, and in that footprint they have a strong ~57% market share compared to the closest competitor, Movistar (Telefonica) having about 19% market share.  

In my conversations with Liberty, the likely reason for the divergence in growth of the Pay-TV market and VTR’s subscriber growth is that VTR caters to the higher end market and does not offer a low-cost option similar to Claro and DirecTV. With the exception of DirecTV, who owns some soccer programming rights in Latin America, there is no differentiation in TV offerings across the providers. Additionally, piracy was very high in Chile until about a couple of years, and it is logical that the people that pirated television would mostly migrate to a low-cost option where VTR does not have a viable product.

Broadband:

There are approx. 5 internet providers in Chile – Movistar, VTR, Grupo Calro, Grupo GTD, and Grupo ENTEL. However, the market is essentially a duopoly, with Movistar commanding a 39.0% market share at the end of 2014 and VTR having a 37.2% share; combined, these two companies control over ¾ of the internet subscribers in Chile. While they seem comparable from a market share standpoint, their broadband products are night and day. VTR offers 40 mbps for ~ $70/month versus Movistar offering only 15 mbps as a DSL provider.

The subscriber growth in broadband was 11.4% CAGR from 2006 to 2014 to about 2.5 million subscribers. VTR has attained a similar growth rate at 10.5% over that time period.

Opportunities:

• Newbuild: Currently VTR is expands homes passed by about 50,000 – 60,000 due to just market growth; however, VTR will likely expand homes passed at a pace faster than traditional. A decent rule of thumb for thinking about the capital needed to expand could be to start with Liberty in U.K. which costs about $600 - $620 per newbuild home. In Chile, it is much cheaper, maybe half of that. The HFC costs are the same but the labor costs are much lower and the infrastructure in Latin America is easier to access because it is above-ground (utility poles) whereas Europe is mostly underground.
• Continued market growth: broadband penetration is estimated to be 51% in 2015, up from 44% in 2014, and expected to be 59% in 2017. Pay-TV penetration is expected to be 79% by 2017, up from an estimated 69% in 2015 and 54% in 2013.
• Mobile opportunity: Currently VTR has only ~1% market share in Chile through their MVNO relationship. The top mobile operators are Claro, Movistar and Entel PCS and five that use the MVNO model.
• Next generation Set-top Box: Began rolling it out in late 2015, could get 10-15% bump in ARPU once fully deployed.
• Churn: offering a quad-play (TV + internet + telephony + mobile) should really lower churn, accelerate growth. In the UK churn was about 14%, with the introduction of the quad-play, churn is said to be about 5%. VTR has a MVNO relationship with Telefonica to offer the mobile service.
• Margin improvement: lower churn, improved mobile growth (higher margin, low capex due to MVNO relationship) and scale improvements

Risks:

• Chilean Peso (CLP) currency headwinds
• Chilean economy reliance on exporting commodities – copper specifically
• Lower than expected mobile growth
• Lower than expected future penetration rates, thus growth slowing combined with no pricing power
• lower multiple due to FX headwinds, some countries tied to commodities
• Declining population

Other notes:

•  Lack of pricing power: due to inflation of >4% in Chile, almost everyone in the market raises prices by the CPI, but not above it. Twice a year that take price increases, at CPI levels only.
• Programming costs mixed USD/CLP: About 45%-55% of VTR’s programming is US content and in USD, which behaves similarly to the U.S. Pay-TV headwinds in programming cost growth. The remaining 45-55% is local content and not very inflationary.
• VTR is thought as being the highest quality asset in Latin America by Liberty. There are no capacity issues, its true HFC cables, could easily get 120 mbps speeds right now. Once DOCSIS 3.1 gets introduced, VTR could get to over 1 gbps in speed for very little additional capital expenditure, roughly an additional $20 per home to upgrade from 3.0 to 3.1.
• Capital Expenditures – est. 2015 to be between 17-19%
• Some margin improvement in VTR from 2014 to 2015 was the reduction of more than 400 employees in November 2014 through January 2016

Puerto Rico: “Liberty Cablevision of Puerto Rico (LCPR)”

Background:

LiLAC became the largest cable operator in Puerto Rico mostly through mergers and acquisitions of the #1 and #3 operators (Liberty Cablevision “LCPR” was #2). What was originally Liberty Cablevision of Puerto Rico LLC, a cable operator and subsidiary of the Liberty Global company, they acquired “OneLink Communications” in 2012 with Searchlight Capital Partners LP and “Choice Cable TV” in the summer of 2015.

With the acquisition of “OneLink” in 2012, Liberty contributed their assets in Liberty Cablevision and Searchlight Capital put up the cash, resulting in a cable company that would be 60% owned by Liberty and 40% by Searchlight. The newly formed entity would be the largest cable operator in Puerto Rico with about 700,000 homes passed and RGUs approaching 500,000 (one source had it at 480,000 RGUs). While terms were not announced, Liberty Global had said the transaction values OneLink (before transaction costs) at about $585 million.

In December of 2014 Liberty announced the acquisition of “Choice Cable TV” in a deal valued at approximately $272.5 million, an estimate of 6.1 times Choice’s projected 2015 operating cash flow, after adjusting for synergies and integration. The acquisition was funded through incremental debt borrowings.

Overview of the financials:

Liberty Puerto Rico has generated revenues of ~$350m over the last year, with a most recent OIBDA margin of 44.4%, a large improvement from the pre-OneLink and pre-Choice days of high-20%. Prior to the Choice acquisition, there were about 2.1 RGU’s per customer relationship. Since Choice was mostly a broadband provider, the RGU per customer relationship is now 1.93 at the end of Q3/2015. ARPU as of the last quarter was $78.66, down from $85 in prior quarters, due to the acquisition of Choice and most Choice subscribers were broadband-only subs.

Despite the decline sequentially in ARPU, margins should improve due to scale and improved efficiency of the infrastructure (more bundled packages across all assets – Liberty, OneLink, and Choice)

Overview of the market:

Puerto Rico could be viewed as a much simpler competitive environment versus Liberty’s other assets. In Puerto Rico, there are only 2 cable operators on the island – Liberty and Claro – and Liberty is viewed as far superior as Claro’s footprint is 85% DSL-based infrastructure. Of the remaining 15% non-DSL, about half of that is actual fiber based (thus faster speeds). Due to the fact there are only 2 internet providers, Liberty has a strong market share of ~53% versus Claro’s ~47%.

Liberty’s primary competition for video services are DISH Network and DirecTV.

Broadband:

• Only 2 providers: Claro (~47% share) and Liberty (~53% share)
• Claro (Puerto Rico telecom) has 85% of footprint as DSL-infrastructure, a far inferior product to Liberty’s fiber deep hybrid-fiber-coaxial cables
•  Liberty’s base package offers 20 mbps vs. 5 mbps (English package)/ 3 mbps (Spanish package) for Claro

Subscriber Statistics:

As of the end of Q3/2015, Liberty provided a total of 769,300 RGUs across the cable footprint of 1,068,200 homes passed in Puerto Rico. The growth in RGU’s has largely come from acquisition; for example, the Choice acquisition in 2015 added an additional 355,300 homes passed (about 50% increase in footprint prior to deal) and 155,900 RGUs (from about 580,000 prior to acquisition).

“Choice” acquisition - 2015

The “Choice” acquisition was advantageous for Liberty as “Choice” had a sizable footprint in Puerto Rico but was predominantly a broadband provider (91,400 subs) over being a Pay-TV provider (48,600 subs). Since they were focused mostly on broadband, this acquisition gives Liberty the ability to offer bundles to legacy-Choice subscribers, which would increase ARPU, optimize the infrastructure, and decrease churn for that subscriber base. Additionally, they now have an island-wide footprint, which opens up B2B business opportunities. For example, if a business – a retailer, bank, etc. – has operations across the island and are looking at TV, internet, and telephone, Liberty can offer them that opportunity, whereas prior to the Choice acquisition they were unable to have this scale advantage. Lastly, as they are now island-wide, they can advertise and market across the island, whereas they couldn’t prior to the Choice acquisition.

Opportunities:

• Newbuild – but less so, as they already cover over 80% of the island. Given some demographics and the economics surrounding those demographics, a portion of the homes in Puerto Rico won’t be built to. Expect small scale newbuild over time.
• Bundle packages/Decrease Churn – with acquisition of Choice in 2015, should be able to offer more comprehensive bundles to the legacy Choice subscribers
• B2B opportunities – Liberty has island-wide footprint, giving them the ability to offer services to business that operate island-wide (Q3 2015 B2B business (including SOHO) grew over 20% on rebased basis Y/Y)
• Pricing power – in Q2/2015 raised prices in broadband by 8% and TV by 3% (pricing power in real terms different than Chile market/VTR)
• Increase market share & penetration – Liberty has one competitor in Puerto Rico (Claro) which is a DSL product. Liberty has internet speeds 4-7x faster than Claro, with the opportunity to go to 120 mbps.

Risks:

•  English package includes a lot of US programming, thus the cost is about 50% higher than the Spanish speaking package, may be unaffordable to people, they would stick to broadband only
• Geographical – hurricane or tropical storm damaging cable assets as most are above ground
•  Claro builds out the non-DSL footprint and increase fiber infrastructure. Would compete better versus Liberty as Claro already has monopoly on telephone, could be easier to cross-sell
• Country debt problems could cripple the consumer as potential increases in taxes decreases disposable income
• population decline

Searchlight Capital – the 40% owner of Puerto Rico assets

Searchlight is a private investment firm founded in 2010 by senior partners formerly with industry leading investment management firms. Searchlight Capital Partners currently manages over $860 million, invests in a wide range of industries in North America and Europe, and has offices in New York, London and Toronto. For more information, please visit www.searchlightcap.com.

Sources:

12/10/2014 – Liberty Global buys “Choice Cable TV” http://www.bizjournals.com/denver/news/2014/12/10/liberty-global-buys-cable-tv-business-in-puerto.html

11/9/2012 – Liberty Global buys OneLink Communications http://www.bizjournals.com/denver/news/2012/11/09/liberty-global-partner-buy-puerto.html

Press Release - OneLink acquisition http://www.libertyglobal.com/pdf/press-release/11-09-press-release-final-puerto-rico.pdf

Press Release – Choice https://www.libertyglobal.com/pdf/press-release/12-10-Acquisition-of-Choice-FINAL.pdf

Liberty Puerto Rico – website https://www.libertypr.com/offers.aspx

Liberty LiLAC June 2015 presentation http://www.libertyglobal.com/pdf/presentations/LiLAC-Group-Presentation-June-2015-FINAL.pdf

Reviews on Puerto Rico - http://newtopuertorico.com/internet-service-providers-in-puerto-rico/

Liberty acquires 20% of VTR http://www.libertyglobal.com/pdf/press-release/03-14-VTR-FINAL.pdf

May 27, 2015 8-K http://www.sec.gov/Archives/edgar/data/1570585/000157058515000101/exhibit991-trackerxq42014r.htm

Additional Notes:

Programming costs for Chile = ~$80m annualized, with 48%- 53% denominated in US Dollars

Corporate Expenses shared by Liberty Global (LBTYA)

Choice Acquisition:


Disclosure:
I own shares of LiLAC through "LILA" shares

Cord-cutting: Myth or Reality? -- (Data through Q3/2015)

Through Q3/2015, based on the filings of 9 pay-TV companies (a total of 86.1 million video subscribers), as well as some estimates of the number of Sling TV subscribers in DISH Networks video numbers*, Q3/2015 had the largest year-over-year loss in subscribers ever, and the second worst sequential quarter ever (Q2/2015 was the worst). Is this a full on decline in all pay-TV provider video subscribers, or is this isolated to a few companies that are simply under-performing the industry?

Based on the numbers from these 9 company filings, the year-over-year decline in Pay-TV subscribers is largely attributed to declines at DISH Network (estimate 6 straight quarters of declines in residential video subscribers) and U-Verse (AT&T). After a large decline in video subscribers at DirecTV in Q2/2015 of 133,000 from the prior quarter, they actually added an estimated 5,000 net subs in Q3/2015.

U.S. Pay-TV video subscriber growth with the third consecutive quarter of declines

Q3/2015 - the worst quarterly decline every; Q2/2015 was the worst.

Cable companies actually had the best aggregate quarter since I began looking at data in 2007, with year-over-year declines of 0.9%.  Satellite companies - DISH and DirecTV - had the worst quarter with year-over-year losses of 1.3%. The telco's - AT&T U-Verse and Verizon FiOS - saw the slowest growth in video subscribers ever with only 2.5% year-over-year growth, to a total of 11.661 million subs.

Which companies did the best in Q3/2015:

1. Verizon FiOS (VZ)                                 +42,000
2. Charter Communications (CHTR)          +12,000
3. DirecTV (T)                                         +5,000

Which companies did the worst in Q3/2015:

1. DISH Networks (DISH)                          -178,000
2. AT&T U-Verse (T)                               -117,000
3. Comcast (CMCSA)                               -48,000

Cable companies with the best quarter in many years

Satellite companies with the worst Y/Y quarter ever

Thoughts:

I continue to believe that, while it is clear that the pay-TV industry in the U.S. is not a growth engine from a subscriber increase standpoint, it looks as if the infrastructure/structural advantages of the cable companies and telco's are taking video subscriber share from the satellite companies  - DISH and DirecTV. More specifically, it looks as if the cable companies are continuing to rebound and will soon completely stabilize video subscriber numbers and possibly have net additions. 

As DirecTV and DISH cannot provide some of the customer essentials - namely high speed internet -as well as cable companies investing heavily in both increasing their broadband speeds and video products (X1, Worldbox/Spectrum, TV Anywhere,Wi-Fi hotspots), cable is no longer in an inferior position to a majority of the U.S. population. Where satellite once had far superior video viewing -channels, HD,quality - the cable companies have finally caught up and will likely surpass them as they continue with improved customer service and video user interface. 

Comparing the growth in Netflix (NFLX) to the Pay-TV industry as a whole, the growth in Netflix far exceeds the subscriber declines in video subscribers. Many in the Pay-TV industry view Netflix (NFLX) as both friend and foe. Foe due to Netflix being a much lower cost alternative video subscription to traditional TV, but a friend because Netflix consumes a lot of home bandwidth data (37% of all North American traffic) and the cable companies benefit as they offer the infrastructure Netflix needs to provide their product to customers. Considering the low price points, as well as the improvement in cable video subscribers, it looks as if Netflix is a complimentary service to the current cable bundle subscription.

CHTR expects to have video net additions in 2015

While NFLX growth in US is slowing, it is still growing mid-teens year-over-year

Price points for Netflix (NFLX) - low enough to not fully cannibalize linear TV subscription,is more a complimentary subscription

Companies included:
Charter Communications (CHTR)
Comcast (CMCSA)
Cablevision (CVC)
Time Warner Cable (TWC)
DirecTV
AT&T (T)
Verizon (VZ)
Mediacom
DISH Networks (DISH)

Links:

http://recode.net/2015/11/09/sling-tvs-near-death-experience/

Liberty-company related notes: CEO Greg Maffei on SiriusXM (SIRI), Liberty Media (LMCA), Liberty Ventures (LVTNA) at Citi Conf. (01/06/2016)

Liberty-company related notes: SiriusXM (SIRI),  Liberty Media (LMCA), Liberty Ventures (LVTNA), Charter Communications (CHTR)

Citi Global Internet, Media and Telecommunication Conference

January 6, 2016

Liberty Media (LMCA)
Speaker: Greg Maffei (CEO)

Goals for 2016:

• Close CHTR merger with TWC/BHN
• Complete the transactions announced at Investor Day
• Narrow the discount at Liberty Media (LMCA)

 Businesses tied to economy?

• Most seemingly less tied to pure GDP growth
• High-yield markets impact somewhat because of financing
• Debt markets can create opportunities, look at CHTR low financings
• Most of big assets we have are U.S. – focused
• TripAdvisor, QVC has some big foreign currency risk elements
• Zulily and CHTR – currency less a factor
• Liberty businesses are mostly dominated by the microeconomic environment
• We spend a lot of time thinking about the impact of digital and mobile

 Charter (CHTR):

• When we originally invested we thought it was not as fully valued as we thought
• Thought cable was well-positioned, CHTR in particular
• Today, think radio has probably been discounted
• Problem is they all have screwed up capital structures and there’s no way to invest in some

 Linear video marketplace – market is bearish – is this rational?

• Most of the time these cash flows last longer than people think – been our experience, see DirecTV (DTV)
• Is there great growth prospects – less clear on this.

 Liberty Media (LMCA)

• 3 trackers – SiriusXM + Braves (and real estate) + remaining assets inside LMCA
• Trackers will trade probably in second quarter, early second Qtr

 Atlanta Braves:

• Thought the presence of the stadium create unique opportunity for real estate to generate attractive RoR
• Tenants have signed up, hotel, major office complex, number of retailers
• New field will cost $650 - $670m, we are paying about $220m
• Mixed-use facility - $550m in cost and paying 80% preleverage
• Hope to see revenues and CF for Braves
• Think investors will value the Braves in two ways – Braves team value + mixed-use real estate
• S-4 – team generates about $250m revenues and very little net income
• Revenues from Braves come from rights fees (TV is majority, less so radio), ticket sales and sponsorships
• Redid the TV deal 14-15 months ago, has a series of escalating rate, real kicker is in 2027
• In 2027 rates will likely be well below market, we inherited this contract when purchased Braves from Time Warner; in addition, we will own more of the parking and ancillary revenue streams, the SunTrust, etc.
• Been many transactions lately where teams sold at valuations as multiples of revenues – look at the CF for the Braves, add it big bump in 2027
• Teams have expanded dramatically in price -  look at the Dodgers (note: sold for $2.15 billion in 2012-- Link)
• If someone wanted to buy the Braves, for tax reasons, unlikely to sell for cash

 Liberty Media (LMCA) – tracker

• 34% stake in Live Nation (LYV) + 20% Braves asset + venture portfolio assets like Tastemade, etc.
• Put the 20% Braves assets to have a potential source of funding, to raise capital, can sell that stock on a tax-free basis
• We like writing big checks, and having more capital is good (look at CHTR)
• Not that many people that can write a $3b  - $5b check into a non-control situation. Warren Buffett can do it, but he doesn’t play much in TMT.
• Would want to inject a lot of capital if there’s another downturn, that’s the kind of deal we like to do

 Live Nation (LYV)

• 34.4% stake in LYV
• Very strong management team, built a true leadership position in the promotion business
• Opportunities to, on the biggest global tours, to fill their portfolio where we may own the global tour, but we still need to outsource portions of it
• Continue to  buy either new promoters or buy new companies – concert co’s to help us in different markets
• Bought a bunch of festivals last few years
• Opportunities to use that scale and grow over time and increase stake in secondary market
• Bunch of ancillary benefits that come from e-commerce and sponsorship
• Goals: consolidate global concerts and festivals, consolidate global ticketing, organic growth in secondary ticketing and sponsorship, emerging content offers like Vice, Yahoo
• Strength in global concert promotion is what enables us to have strength in ticketing
• Key to other components is that LYV has strength in concerts
• Don’t think the 2016 concert slate will be a disaster, but we have a long-term view
• Added to LYV at price we thought was attractive at the time
• Relationship with Vivendi is complicated; keep in mind we have a $1.1 billion judgment against them

 Other Notes:

• Continue to look to aim towards tax-efficiency I non-core assets like Viacom
• We don’t like to pay taxes
• If we saw an opportunity to utilize some cash in a better fashion, we might choke and generate cash and just pay the taxes
• Think there are synergies between LYV and SIRI, but the rate probably won’t make me happy
• Disruption of Expedia by Airbnb? Question is has Airbnb generated incremental demand – probably. But it’s some sort of substitution. Probably have some demand shifted to Airbnb, no doubt.
• Hearing on Vivendi litigation – March 2016
• We want to build some liquidity to write big checks
• Businesses that we like, probably won’t change: subscription, free cash flow oriented businesses, try to stay away from ad-based businesses due to comfort
• LYV is not a subscription business but there were other reasons we liked it

 SiriusXM:

• Tried to combine tracker and a company before and didn’t work, maybe will in the future
• Ultimately, longer-term perspective is that it’s likely Sirius ends up being 100% controlled by Liberty; we are at 61% or so now
• The connected car is actually a positive for SiriusXM, not a negative like the market thinks
• Advantage could be the use of satellite, but could get reduced when cars get connected
• Other advantages: content, exclusivity, differentiation, etc.
• Also could be a hedge where is cars are connected and we don’t need the spectrum, could monetize it – so it’s a hedge on value
• SIRI bought back about $2b in stock last year; had FCF for only about 60% of that, had to borrow remaining 40%
• Leverage at <4.0x, looking to move it up slowly

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

Risks:

•  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.

Valuation:

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:

·         http://www.usrds.org/qtr/default.aspx

·         https://www.cms.gov/Medicare/Provider-Enrollment-and-certification/guidanceforlawsandregulations/dialysis.html

·         https://www.cms.gov/Center/Special-Topic/End-Stage-Renal-Disease-ESRD-Center.html

·         https://en.wikipedia.org/wiki/Dialysis

·         http://www.davita.com/kidney-disease/dialysis/treatment/what-happens-if-someone-stops-dialysis?/e/1521

·         http://newoldage.blogs.nytimes.com/2013/12/04/dialysis-raises-hard-questions-for-older-patients/?_r=0

·         http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3862087/

·         http://www.nephrologynews.com/cms-retains-12-cut-in-drug-payments-for-esrd-care-approves-new-qip-measures/

·         https://www.cms.gov/Outreach-and-Education/Medicare-Learning-Network-MLN/MLNProducts/downloads/End-Stage_Renal_Disease_Prospective_Payment_System_ICN905143.pdf

·         https://www.cms.gov/Outreach-and-Education/Training/CMSNationalTrainingProgram/Downloads/2013-Medicare-for-People-with-End-Stage-Renal-Disease-Workbook.pdf

·         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

Disclosure:
I own shares of DVA.