Home Dialysis to Benefit These Undervalued Providers

We expect DaVita DVA and Fresenius Medical Care FMS/FME to benefit as higher-margin home dialysis treatments gain share, with growth of nearly 8% set to outpace in-center dialysis growth of roughly 2.6%, driven by increasing interest across the industry to lower treatment costs. Specifically, the U.S. Department of Health and Human Services has proposed potential changes to reimbursement policy that are likely to encourage home treatment for kidney failure. Home therapy has been making a slow but consistent resurgence over the past decade; in this piece, we examine the competitive implications for DaVita and Fresenius should a more meaningful mix shift be on the horizon. Ultimately, we think these companies’ established clinic networks, along with the sticky relationship among provider, physician, and patient, will prove too high a barrier for competitors. While the stocks of both companies look cheap following recent underperformance, we think DaVita’s nearly 30% discount to our fair value estimate presents a compelling investment opportunity.

Adoption of Home-Based Dialysis Therapy Has Been Slow The two primary modalities amenable to at-home treatment are hemodialysis and peritoneal dialysis. Home hemodialysis is similar to treatments done in the clinic--patients use a machine to remove blood from the body, pass it through an external filter, and return the cleaned blood to the body. These treatments are typically shorter but more frequent than in-center hemodialysis. Peritoneal dialysis requires a tube to be inserted into a patient's abdomen to use his or her own abdominal membrane (peritoneum) as the filter. The patient either inserts and removes dialysis solution manually throughout the day or uses a cycler machine to automate these exchanges at night.

Peritoneal treatment has long been the favored home therapy because of its simplicity and ability to provide patients with a high degree of independence. But despite similar outcomes, strong patient preference, and a lower cost compared with in-center treatments, adoption of peritoneal dialysis (and home therapy more broadly) remains low. In the United States, roughly 10% of the prevalent dialysis population is on peritoneal therapy, with approximately 2% receiving hemodialysis treatments in the home.

Historically, the financial incentives for dialysis service providers and nephrologists in the U.S. encouraged the expansion of in-center treatment options and probably contributed to the decline in peritoneal dialysis as a share of total treatments during the 1990s and 2000s. In 2011, however, the Centers for Medicare & Medicaid Services changed the way Medicare pays for dialysis. The industry moved from a true fee-for-service model to a bundled payment approach in which CMS pays facilities a single dollar amount per dialysis treatment, regardless of modality. Theoretically, this approach should encourage physicians to prescribe more home treatments, since they cost less and require much less capital investment, resulting in more attractive returns for service providers.

This is what has panned out since CMS instituted the bundled payment methodology. Peritoneal dialysis continues to gain share of newly diagnosed patients on maintenance therapy, reaching 10% in 2016 compared with trough levels of nearly 5% as recently as 2007.

The shift toward home treatment is apparent in both government-sponsored and commercially insured patient cohorts, supporting our view that the bundled payment structure has led to increased use of at-home therapy. A higher overall penetration rate in the commercial segment is probably attributable to patient characteristics that make it a more suitable therapeutic option, such as a younger average age and generally fewer comorbidities. Additionally, patients on peritoneal dialysis are less costly to treat than in-center peers, providing an incentive for private payers to encourage home therapy when it offers a clinically viable alternative for patients.

Recent studies and broader literature reviews show that patients overwhelmingly prefer to be treated at home, but the arduous task of performing the therapy, the strain on family members or at-home caregivers, and the underutilization of predialysis educational benefits have historically limited its uptake, both in the U.S and abroad.

Treatment Mix in U.S. Is Comparable to Global Peers The U.S. isn't an outlier in its heavy reliance on in-center hemodialysis. While there is some variance by country, the U.S. treatment mix is more or less consistent with global and developed-country averages. The more meaningful differences across geographies are in kidney transplant rates rather than maintenance dialysis modalities.

In fact, U.S. policy has helped the country buck a broader global trend away from home-based therapy. While the underlying drivers of these trends are somewhat speculative, the most likely culprits boil down to changes in local reimbursement policy, resource availability, and relative treatment cost among different regions. Growth in global clinic capacity has encouraged caregivers to more effectively use these resources, especially in international markets. While peritoneal therapy costs less than in-center treatment in many developed economies, the high transportation cost for peritoneal solution and the comparably lower cost of labor make the economics of in-center therapy more attractive in some developing areas.

As the global leader in dialysis, Fresenius is much more exposed to trends in treatment growth internationally than DaVita. However, this stems from its dialysis product business rather than its services operation. Fresenius derives only 20% of its dialysis services revenue from ex-U.S. geographies, while nearly 75% of its product revenue comes from international markets. The company probably benefits more from clinic growth than expansion of home therapies, as its peritoneal product business is a distant second to Baxter’s BAX number-one position.

Penetration Rate of At-Home Dialysis Likely to Increase While adoption has been slow, there are many reasons to believe that the penetration rate of at-home treatment in the U.S. will continue its upward trajectory. Proposed policy changes from CMS, attractive unit economics of home hemodialysis or peritoneal therapy, and the lower overall cost compared with in-center treatments will likely spur growth for years to come.

On July 10, President Donald Trump signed an executive order targeted at overhauling the way kidney disease is treated in the United States. It put forward three primary goals: a greater emphasis on prevention, detection, and treatment of chronic kidney disease to delay the progression toward end-stage renal disease, or ESRD; an expansion of home dialysis treatment for those with kidney failure; and an increased availability of organs for transplant. Shortly thereafter, CMS released a handful of policy proposals aimed at creating financial incentives for clinics and physicians to improve the utilization rates of home therapy and organ transplants over time.

These policy shifts come on the heels of a March 4 speech by HHS Secretary Alex Azar at the annual Kidney Patient Summit, where he emphasized the need to modify industrywide incentives to encourage use of peritoneal dialysis in particular, while boosting investment in next-generation technologies to improve the lives of patients living with ESRD. Azar said CMS may be underpaying for home-based therapies relative to in-center alternatives, and his overall commentary seemed to suggest working collaboratively with the provider industry toward a workable solution rather than putting forward radical, disruptive changes.

Because home-based treatment options carry meaningfully better Medicare margins than in-center hemodialysis, we think industrywide treatment is likely to continue to shift toward those able to be administered in the home. This won’t happen overnight, however, as the fixed costs embedded in the existing clinic network make filling marginal capacity a rather attractive alternative; according to the Medicare Payment Advisory Commission, Medicare payment rates exceed the marginal cost to treat by roughly 17%. While our profitability estimates are limited to treatments reimbursed through Medicare, we think understanding the relative economics of each modality helps identify the underlying drivers of provider decision-making.

The bundled payment approach leveled the playing field between at-home and in-center options and reoriented service providers around managing the cost to treat rather than revenue per treatment. With equivalent reimbursement structures, it’s clear that at-home therapies cost less, which provides better aggregate per-treatment profitability. Lower labor needs and lower facility overhead drive the bulk of the cost difference, partially offset by more-involved patient training and the incremental cost to place medical equipment in a patient’s home. The profit differential is particularly pronounced when looking at DaVita and Fresenius compared with the rest of the industry, illustrating that having negotiating leverage over suppliers still tends to matter when treating patients outside of the clinic. These numbers are consistent with recent commentary from DaVita management that suggests the rate of clinic capacity growth is likely to slow over the coming years.

In addition to better underlying per-treatment economics, improved payer mix likely enhances the overall profit profile of peritoneal and home hemodialysis programs. The proportion of commercial patients among those who receive home therapy is modestly higher than the broader population due to a relatively healthier and younger patient cohort, along with stronger incentives for insurers to encourage lower-cost treatment arrangements. While underlying outpatient expenditures for the Medicare program are roughly equivalent in either dialysis setting (reflecting the equivalent bundled payment rate), the overall cost associated with peritoneal dialysis has averaged roughly 20% lower than in-center hemodialysis over the last decade. Some of the benefit is probably attributable to patient selection, but lower drug usage, limited transportation needs, and fewer ancillary outpatient/inpatient visits or admissions also play a role.

Management teams at both DaVita and Fresenius, along with a handful of academic studies, seem to agree that home treatment could be clinically appropriate for 15%-25% of U.S. patients. Using recently published research on the long-term growth trajectory for overall ESRD prevalence, along with estimates of transplant rates and the potential adoption curve of home treatments, we’ve assessed a range of outcomes for patient growth in both the in-center and at-home cohorts. This analysis assumes the prevalent transplant population remains unchanged at roughly 30% of the overall ESRD population, a metric that has been remarkably consistent over the last few decades. The implied overall ESRD patient growth rate is consistent with our assumption of approximately 3% annually over the coming five years. However, modality mix has important ramifications for the rate of in-center hemodialysis versus other treatment forms.

Based on the higher profitability and lower capital requirements of home programs, we think this potential patient mix shift could prove favorable for DaVita’s and Fresenius’ returns on capital. However, with both companies sporting narrow economic moats supported by scale-derived cost advantages, does a shift away from in-center treatment weaken the competitive strengths inherent in the current industry structure? We don’t think it does, and we contend that these companies’ clinic networks will remain central to dialysis administration regardless of ultimate treatment modality.

Moats in Dialysis Intact Despite Shift to Home Therapy We have previously argued that the highly consolidated industry structure in the U.S. encouraged the formation of competitive moats for DaVita and Fresenius, given their dominant market positions. These companies' dialysis clinic networks are a central part of this argument, as excess returns on capital are achievable due to fixed-cost leverage and more convincing buyer power, while being protected by capital barriers to entry. If patients migrate out of the clinic and into the home, does this impair the advantageous position these companies have built over the past few decades? We don't think so. DaVita and Fresenius are already the clear leaders in facilitating at-home treatment, and we believe industry dynamics will make it as difficult for would-be competitors to compete for patients at home as it has been in the clinic.

Home dialysis doesn’t appear to have the same opportunity for fixed-cost leverage that in-center hemodialysis tends to show. We charted average cost per treatment and aggregate volume for each dialysis facility reported annually from 2011 to 2017. Despite finding a lack of direct cost advantage for the highest-volume facilities offering home therapy, we think the entrenched positions of DaVita and Fresenius give them advantages over peers.

The logistics of prescribing, administering, and monitoring a patient on either peritoneal dialysis or home hemodialysis is a difficult task, but a nationwide network of dialysis clinics makes it substantially easier. For instance:

• A patient needs to be prescribed home therapy by a nephrologist, who is typically contracted to work exclusively with one of the large dialysis chains or one of their smaller peers.
• The patient needs a series of training treatments in a clinic certified to provide this service to new patients. Approximately 30% of clinics nationwide are set up to provide home hemodialysis training.
• Medicare requires a monthly interaction between physician and patient to review lab work and assess the efficacy of the treatment.
• The provider needs to arrange for periodic shipment of dialysis supplies to the patient's home.

In our view, the relationships that DaVita and Fresenius have secured with prescribing nephrologists present the most meaningful barrier to market entrants. While the opportunity to develop a true cost advantage while treating patients at home is less convincing than in the clinic, the established and frequently exclusive relationships among existing dialysis providers, nephrologists, and patients have been a demonstrable factor in limiting the success of new or potential competitors. We expect this to remain the case and think DaVita and Fresenius will be the most likely entities to benefit from the higher returns on capital available in the home setting. Cost advantage remains the defining feature of the competitive moats protecting DaVita and Fresenius, but as patients move out of the clinic, we think the intangibles surrounding their physician relationships will become increasingly important.

DaVita Remains a Top Pick Our $79 fair value estimate for DaVita implies 40% upside from the current market price. At $56 per share, the company's current price implies less than 13 times our estimate of 2019 adjusted earnings--a meaningful discount to the valuation of the broader market, peer Fresenius, and DaVita's history.

Our model assumes the company maintains a marketlike revenue growth rate of 4%-5% in its U.S. dialysis services business, underpinned by roughly 3.5% growth in treatment volume and 1% blended price growth. We assume consolidated profitability remains consistent with historical averages and model adjusted EBITDA margins that average 19%-20% over the coming five years. Below, we highlight two of the most prominent risks to our thesis that could affect our fair value estimate but appear more than baked into market expectations.

Price regulation is again in the news and top of mind for investors. The California State Assembly passed AB 290 in March 2019 that would effectively cap dialysis reimbursement for commercially insured patients receiving third-party charitable premium assistance at Medicare rates. This bill is nearly identical to SB 1156, which was ultimately vetoed by former Gov. Jerry Brown in 2018, who cited the need for a more narrowly tailored approach that doesn’t allow insurers to pick and choose their membership base. With a new governor in office, the likelihood the legislation sees success isn’t zero, but last year’s veto and voters’ rejection of Proposition 8 suggests support for dialysis industry regulation in the state isn’t strong. Management has indicated the bill’s passage would likely be a $25 million-$40 million headwind in 2020, or approximately 1%-2% of segment EBITDA before contemplating potential cost offsets.

Same-facility treatment growth has uncharacteristically slowed in the past few quarters, sparking investor concern around the durability of the consistency in volume growth that has been such an attractive aspect of the industry for so long. Growth in the incidence rate of ESRD across the population had been decelerating throughout the mid-2000s. However, research by McCullough suggests the rate of incidence should pick up over the long run, growing nearly 1% annually through 2030. This is driven by both an aging demographic and shifts in the underlying racial distribution of the population. Declining ESRD mortality and a growing population lead to overall patient prevalence expanding at an approximate 3% annual clip, in line with our base-case projection. We assume same-facility treatments for both DaVita and Fresenius will continue to expand at this level, with acquisitions contributing a modest amount to total volume growth.

While we’ve been bullish on Fresenius as well, its stock has rallied about 20% year to date as it rebounded from valuation levels not seen in nearly a decade. As a result, this 4-star name is on the cusp of 3-star territory, leaving us less confident in its prospects for excess returns. DaVita, on the other hand, hasn’t participated in this rally. The stock remains deeply discounted, languishing near valuation levels that have marked troughs over the last decade.

We think the recent sale of the DaVita Medical Group assets to UnitedHealth will remove a substantial source of uncertainty and serve as an initial catalyst to get DaVita’s shares moving higher. Additionally, DaVita’s capital allocation has more or less been at a standstill since the end of the third quarter of 2018 as elevated leverage limited incremental share-repurchase activity in the fourth and first quarters. The opportunity for management to reduce the debt balance and resume buybacks at undervalued prices should be immediately accretive to equity and well received by the market.