Dominance in Dialysis Digs DaVita a Moat

We take a favorable view of management’s recent sale of the DaVita Medical Group assets. Long a drag on profitability and returns on capital, the business had perennially underperformed following its acquisition in 2012. Absent any major structural changes to dialysis reimbursement policy, we anticipate DaVita’s returns on capital to improve as management focuses on scaling up its international presence without the distraction of DMG. While our assessment is that management’s capital-allocation prowess is somewhat tarnished by its experience with DMG, its planned use for the $4.9 billion in proceeds is largely debt reduction and stepped-up share repurchases, which we like as near immediate value-creating capital-deployment options.

Scale Brings Cost Advantages We believe DaVita and peer Fresenius Medical Care FMS benefit from scale-derived cost advantages thanks to their dominance in the global dialysis market. We estimate these two entities account for greater than 70% of the dialysis market in the United States when measured by either clinics operated or patients treated. This scale provides per-unit cost advantages for these companies along with material negotiating power when contracting against commercial insurers, which is crucial to sustainably earn excess returns in this industry.

DaVita treats just over 200,000 patients in the U.S. out of the 500,000 or so who currently require maintenance dialysis. The vast majority undergo in-center hemodialysis, although home-based treatments exist and have been gaining marginal share over time. In-center treatment is grueling, requiring three center visits per week for 3-4 hours each for the rest of a patient’s life or until a kidney transplant is received. As a result, the dialysis industry has been continuously expanding its overall facility count to build capacity to keep up with the pace of patient growth while also improving convenience. As of 2017, the number of facilities in the U.S. stood at roughly 7,000, up from approximately 4,500 in 2005--a 3.7% compound annual growth rate over the period. We estimate that this has been on par with the overall growth rate in prevalent end-stage renal disease cases since 2005.

As for many other healthcare providers we cover, government payers like Medicare and Medicaid represent the largest payers nationally. Unlike for other companies in our coverage, however, end-stage renal disease is the only disease state that automatically qualifies for Medicare coverage regardless of patient age or circumstance. A patient with traditional commercial insurance is allowed early enrollment into Medicare 33 months after initial diagnosis. This creates a unique reimbursement environment that makes negotiations with commercial payers vastly more important than for traditional healthcare providers and explains why dialysis services has become such a highly concentrated industry versus the fragmentation seen in other areas, such as acute care. In aggregate, government reimbursement is estimated to provide a negative to break-even margin, thus profitability at the industry level must be extracted from commercial insurers. DaVita earns roughly two thirds of its revenue from government-based payers with the other third from commercial-pay patients. We estimate its patient mix is even more lopsided, with roughly 10% of its patient base on commercial insurance. For 2018, the Medicare per treatment base payment rate was $232, and we estimate commercial reimbursement falls north of $1,000. DaVita’s ability to earn reimbursement rates that are 4-5 times what the government is willing to pay is indicative of substantial negotiating leverage, in our view.

On the cost side of the equation, the industry benefits from scale and high capacity utilization. According to MedPAC, the lowest-volume facilities operate with a Medicare cost per treatment north of $300, with the highest-volume operations benefiting from costs closer to $220. DaVita’s average facility provides 11,000-12,000 treatments annually, placing estimated average cost for a Medicare patient somewhere between $240 and $260 per treatment. This helps validate our profitability estimates by payer and confirm management’s commentary that suggests Medicare business is break-even at best for even the largest providers in the space. Both DaVita and Fresenius operate with best-in-class utilization levels that help improve their unit economics--these two largest providers operate at roughly 80% of companywide capacity, on average, versus the rest of the industry, which operates a little below 70% by our estimates.

In our view, DaVita’s advantages are two sided, as its scale allows it to earn best-in-class reimbursement from commercial insurers while also providing for procurement efficiencies, which support the company’s consistent midteens operating margin.

Government Exposure Is a Risk We give DaVita a medium uncertainty rating due to the critical nature of the services it provides to an expanding patient population. The company's concentrated exposure to government payers is in line with peers, and unilateral reimbursement pressure remains the key risk for the industry. However, we think the company's substantial scale ensures it is well positioned to mitigate headwinds that arise from potential reimbursement cuts or reduced patient coverage by commercial insurers. Over time, DaVita will face new risks and potential opportunities to expand its business and improve the lives of its patients. Broader adoption of comprehensive care initiatives, increased quality-linked payments and penalties, and changes to current reimbursements could meaningfully affect DaVita's business model and future payments.

While technological risk will probably generate headlines in the coming years, we think a wholesale transition away from in-center hemodialysis as the primary treatment modality is unlikely. Significant co-morbidities in a patient population that skews older makes widespread adoption of home-based therapy difficult, in our view. It’s likely to gain share on the margin as technology continues to advance and become more patient-friendly, but we don’t see this as a major risk to DaVita’s core operations.

Finally, while an appeals court struck down proposed rulemaking by the Centers for Medicare & Medicaid services related to limiting dialysis patients’ access to premium assistance programs, recently proposed legislation in California and other states threatened to enact similar barriers to patient access. While these specific initiatives failed to gain traction, we think it’s likely we’ll see future proposals targeting the dialysis industry, given its outsize per-patient cost structure. This will probably be an ongoing risk to DaVita’s profitability, but we believe its superior cost position will allow it to weather any upcoming storms.

We think the company operates with a responsible leverage profile given the high consistency of the business, with gross debt levels typically 3-4 times adjusted EBITDA. Following the divestiture of DMG, we expect management to allocate a sizable portion of the $4.9 billion in cash proceeds toward debt reduction, leaving our 2019 leverage estimate near 3 times. However, DaVita leases nearly all its dialysis clinics, creating an off-balance-sheet operating lease obligation totaling roughly $3.5 billion, by our estimate. Reimbursement pressures pose an acute risk to dialysis providers unseen elsewhere in the healthcare provider sector, given the industry’s reliance on a small segment of the overall end-stage renal disease patient population to maintain profitable operations. While this remains a key operational risk, we think DaVita’s superior cost position helps insulate it against adverse market conditions compared with smaller, more fragmented independent competitors.