jebmo’s posthaven

As a value investor, I generally stay away from large cap companies that are well covered because the chances of such a security being materially mispriced are lower, especially if it lacks a special situation angle (i.e. spin-off, dividend cut, index removal, etc.).

In this particular case, I think recent negative headlines and near-term uncertainty has created a compelling opportunity to buy DaVita (NYSE:DVA) at ~10x FCF - especially given DVA's market leading position operating in an oligopoly, predictable, and long runway for growth and a shareholder friendly management and board.

As a quick overview, DaVita is a healthcare company that is primarily a US kidney care provider. Specifically, it operates three main segments:

1. U.S. Kidney Care - DVA operates 2,382 dialysis facilities that treat ~36% of the US market (End Stage Renal Disease or ESRD patients). 2017E operating income at close to $1.6 billion
2. DaVita Medical Group - DVA operates medical groups and affiliated physician networks in various US states. Basically, DVA contracts with a payor (like a private insurer). In return for a payment, DVA will provide services a covered patient may need and earns a spread between the payment DVA receives and the cost of the services rendered. 2017E operating income $110 million
3. International - Basically, the international version of DVA's US kidney care. Experiencing rapid growth ~30% in new facilities in recent years. At only 154 dialysis facilities, segment is expected to breakeven by 2018. 2017E operating income -$20 million (loss).

Taken together, DVA is expected to generate $1.7 billion in operating income in 2017. DVA market cap is currently ~ $12.7 billion with ~$8 billion in net debt for a total enterprise value of ~ $21 billion.

Here is how I get to ~10x FCF:

• Operating Income (EBIT) guidance of ~ $1.7 billion
• Add back $720 million depreciation
• Subtract maintenance capex $350 million
• Subtract $400 million interest
• $1.7 billion profit before tax. ~ $1.2 billion after tax
• ~197 million shares outstanding ~ $6.1 FCF.

For those uncomfortable with my adjustments, you can use DVA's historical presentation of FCF as a guide:

Source: DVA 2017 Capital Markets Presentation

Instead of providing my analysis of DVA, I will invert the process and focus on what the short thesis and concerns are and why I think they are misguided - hence the opportunity.

I think the two main sources that contribute to the DVA short thesis are:

1) John Oliver's recent episode.

2) A famed short-seller's commentary on DVA (~12 minutes in)

Essentially, I think John Oliver's points were primarily:

• DVA doesn't treat its patients nicely
• DVA is a bad profit maximizing firm as dialysis treatments are expensive
• Kidney transplants are superior
• DVA CEO is unfit as a leader (his actual language used is much stronger) and does not care for patients

For the famed short-seller's commentary, I think the main points are:

• Dialysis is too expensive and a burden to the healthcare system
• DVA and other dialysis companies are gaming the system by shifting patients to private insurers who pay more
• Implicitly reimbursement rates should decline and profits will be gone for DVA and other dialysis treatment companies. A good precedent would be how the game where pharmaceutical companies gamed the system and put through huge price increases (i.e. Valeant Pharmaceuticals (NYSE:VRX))

Starting with John Oliver's episode on dialysis, I would start by agreeing that ESRD is a serious problem and dialysis treatments are a costly way to treat this condition. I also agree that it would be a very good thing if more ESRD patients can safely have kidney transplants done to achieve better outcomes. In fact, his plea for #WhenIDiePleaseTakeMyKidneys is quite honorable and one I would support.

However, a quick review of FACTS will reveal that there simply isn't any realistic alternative to dialysis treatment for the majority of the ESRD population. For instance, in 2014, only 17,107 kidney transplants took place in the US while there were 678,383 cases of ESRD at the end of 2014. In other words, kidney transplants were only sufficient to help ~ 2.5% of ESRD patients (for reasons beyond the scope of this article but mainly due to the difficulty for living donors to give up a kidney and for the deceased to be a donor and have a healthy kidney (i.e. those passing from old age may not necessarily have the healthiest transplant appropriate kidneys)). This means essentially 97.5% of ESRD patients require dialysis. In other words, it would be fantastic if there were a cure for kidney failure but until then, the reality is dialysis treatments are required - this is not a medical condition DVA created or condoned (source 1, source 2).

As for the accusations DVA is maximizing profits without regards for patients, I would first point out that the US healthcare system is a hybrid one where half of healthcare spending comes from private funds and half comes from federal, state and local governments - where private healthcare providers (including DVA) are allowed. Second, in 1972, the US made dialysis treatments covered by Medicare given the cost and severity of ESRD. In other words, DVA didn't do anything illegal or unethical to be in the position to be a private company driven to deliver profits from providing a critical service to ESRD patients. Through this lens, one might appreciate the competing objectives it must achieve: 1) treat ESRD patients, 2) keep costs low and 3) generate a return for shareholders. So, while it may seem inappropriate to have quick turnover in terms of treatment sessions, it is important to recognize quick turnover and keeping costs low is critical in serving DVA's dialysis patients (i.e. doing it too slow means some patients requiring this critical treatment may not have a time slot to do so).

The above discussion always helps me point out another inconvenient truth - US dialysis companies are critical in serving the needs of ESRD patients (unless the US government expropriates them) because of the growing ESRD population that is unfortunately both fairly predictable and has a lot of factors that will likely increase the ESRD population for years to come.

According to the USRDS report, the ESRD population (i.e. existing ESRD population + incidences - mortality) has grown in the 3.5-4.5% per annum in recent years. Because of three key trends, the growth rate could be sustained (or be higher) for many years to come: 1) rising diabetes and obesity rates are contributing to ESRD cases (new cases are called "incidences" in the USRDS report), 2) improving treatment regimes are improving mortality rates from almost 17% in 2008 to just over 14% in 2014 (meaning ESRD patients on dialysis tend to live for seven years instead of under six, growing the total population of ESRD patients), and 3) the baby boomer demographic (where people more likely develop ESRD at an elderly age) which is self explanatory.

Source: USRDS

Source: USRDS

Therefore, DVA has an important role as a private provider to deliver quality dialysis care and keep costs low given the landscape of ESRD growth - which indirectly ties into John Oliver's criticism of DVA CEO Kent Thiry as being unfit as a leader. Given the seriousness of treating ESRD patients, the sensitivity around reimbursement rates and the need to keep costs low, many DVA workers do not get wages that are significantly above minimum wage. Instead, Thiry has created a culture where DVA employees belong to a community to engage them via various non-monetary ways (community, recognition and praise, employee funded safety net program that helps each other out, etc.). If that means Thiry has to do some unconventional things as a leader (i.e. with a musketeer outfit, all for one and one for all) to get employees engaged and motivated and have a sense a belonging, it seems it's a cost Thiry is willing to bear for the benefit of DVA and its patients.

Given the famed short-seller's strong track record and reputation, I will spend a bit more time analyzing the points raised regarding DVA.

First, I again concur that kidney dialysis is expensive and represents a significant burden on the US healthcare system. However, as discussed previously, with the current state of ESRD and likely trajectory in terms of patient growth, there really is no alternative. Perhaps a reasonable "fix" would be two pronged: 1) significant investment in the healthcare system to screen and offer preventative lifestyle changes that would address ESRD risk (in terms of diet and exercise habits etc.) and 2) significant investment in finding cost effective cures for renal diseases.

Second, the short thesis seems to be predicated on DVA embarking on egregious "rent-seeking" behavior or, in other words, price gouging. Again, it is important to look at the facts and realize this is not a VRX (more on this later). In fact, DVA's revenue per dialysis treatment was $352 in 2016, $348 in 2015, and $342 in 2014. Going back 10 years to 2006, the revenue per dialysis treatment DVA realized was $330 per treatment (FYI this is also before Obamacare). Looking at the operating expenses in DVA's US kidney segment for 2016, you can see with some basic arithmetic that DVA's operating expenses were $271 per treatment. This, to me, certainly does not seem to be some sort of price gouging unethical behavior. We can debate whether margins should be higher or lower, but charging $352 for something that costs $271 does not seem to be terribly unreasonable and definitely not price gouging. DVA is not a charity after all.

Source: DVA 10-K

Third, the short-seller brings up a very good observation that it appears the existence of the American Kidney Fund (AKF) would expose DVA to significant conflicts of interest as DVA itself is a donor to that charity. Patients who are otherwise on Medicare can be privately insured if they qualify to have the AKF cover their premiums. In essence, the incentive would be for DVA to have patients covered by private insurers (instead of Medicare) since these private insurers pay substantially higher prices for DVA's dialysis treatments. In simple words, DVA would want to contribute to AKF, get patients on a private plan, get AKF to reimburse their premiums and DVA would receive higher revenues for dialysis treatments.

On the surface, this looks really bad for DVA as the conflict of interest is so obvious. The important question to ask is "why was DVA allowed to contribute to AKF in the first place?". The devil is in the details, and the answer to this question opens a whole can of worms that, in my view, explains it is NOT DVA who is doing the "gaming of the system".

It is important to note that two things: 1) it is obvious setting up the AKF this way creates tremendous potential conflicts of interest and 2) there is a criminal federal statute in the US that explicitly prevents the "exchange (or offer to exchange), of anything of value, in an effort to induce (or reward) the referral of federal health care program business."

So, DVA is not stupid, why does it participate in contributing to AKF? Well, a little further digging reveals the US Department of Health and Human Services' Office Inspector General actually provided an opinion this practice is **OK** subject to a bunch of conditions and observations.

So as we go down this rabbit hole, why in the world would the government essentially ok this behavior that would have the unintended consequence of dialysis companies incentivized to shift patients to private insurers?

Well, remember dialysis treatment is expensive and the US government agreed to cover it under Medicare since 1972. So, the US government itself would very much like to shift the cost burden onto private payors.

But are private payors stupid? No. They also know dialysis treatments are expensive, and they particularly dislike having to pay higher commercial treatment rates when compared to Medicare. So, what did they do? They lobbied the government hard to get out of this bind and finally got a deal where the private payor will only pay for the first 33 months only, after which, Medicare picks up the tab. Recall, ESRD patients are expected to live around seven years (84 months). So essentially the private payor is saying "fine we will pay 2x the cost at the commercial rate but we will only cover 40% of the duration of the treatment". So, it really is kind of "six of one, half a dozen of the other".

"Many people who need dialysis may be covered by an employer group health plan (EGHP) either through their own job or their spouse's... The Coordination of Benefits period is the 33 months (if you choose in-center hemodialysis) or 30 months (if you choose home hemodialysis or peritoneal dialysis) after you start dialysis..."

So, with all these twists and turns, I think we can safely conclude it is NOT DVA that is gaming the system, it is Medicare and private payors having this tremendous gamesmanship between one and other in determining who foots the bill - but the bill has to be paid.

So, with all these negative headlines, why doesn't DVA explain what I just explained above? Well, it is tough to lay out the facts the way I did because both Medicare and private payors are its customers (something about you don't bite the hand that feeds you). Ultimately, I think that is why this investment opportunity exists as it takes a lot of digging and understanding to really peel back the layers and understand what is going on.

Now, sometimes, the risk is perception becomes reality and extreme situations gather political attention as we have seen what happened to Valeant with its alleged unethical price hikes.

As mentioned previously, DVA charged $352 for a dialysis treatment that cost them $271 (like selling a can of pop for $1 that cost you $0.75). It is nowhere as egregious as what VRX has been alleged to have done - charging $1,000 for a toenail fungus treatment that a competitor charged $20. Also, again, the fact that dialysis treatments are critical is also another factor to keep in mind.

Summing it up, from a valuation perspective, I think DVA's (unlikely) downside is ~ $45 assuming a 15% cut to reimbursement rates (i.e. charging $290 per treatment that cost them $270) while the upside > $100 just based on status quo and a slightly higher FCF multiple. With that, an investor gets virtually free upside on the DMG segment contributing something and the international segment turning an operating income profit. As well, my valuation does not take into account DVA being very active in its share buyback program that should prove to be quite accretive (buying back shares at discount) - DVA noted in its capital markets day it is open to leveraging up to buy back shares if necessary - a very strong signal how management feels about DVA's current valuation. Of course, having Berkshire Hathaway Inc.'s stamp of approval isn't necessarily a bad thing either (BRK.A US owns ~20% of DVA).

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Disclosure: I am/we are long DVA, BRK.B.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.