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Davita (Excerpt From Our Latest Letter)
This is an excerpt from Eagle Point Capital’s Fall 2023 letter to clients. Every six months, EPC writes to clients to explain what they own and why they own it. The portfolio-specific portion of each letter is for clients and prospective clients only. If you’d like to invest with EPC, please contact us. We offer separately managed accounts to retail investors, and 401(k) rollovers are often a good fit for our long-term approach.
Davita owns and operates the largest network of dialysis clinics in the US. The industry is an oligopoly dominated by Davita and Fresenius. The two have a combined 75% market share, split approximately equally. Davita’s large market share gives it strong bargaining power with commercial insurers and scale advantages. It is the industry’s lowest cost producer.
Davita’s patients have End Stage Renal Disease (ERSD), which makes them particularly susceptible to COVID-19. Many patients died or stayed home and missed dialysis treatments. Treatment volume was negative 2% in 2021 and 2022, down from mid-single digit growth in the years before the pandemic.
Business is now normalizing. Treatment volume has grown for two consecutive quarters. New patient admissions are back to their pre-pandemic pace but mortality and missed treatments remain elevated. Excess mortality and missed treatments are trending down and treatment volume growth is possible in 2024.
In June 2023, the Centers for Medicare & Medicaid Services (CMS) proposed to increase dialysis treatment payment rates 1.6% in 2024. This was a disappointing outcome. The increase falls short of forecasted inflation and fails to make up for prior shortfalls against actual inflation.
Medicare covers all dialysis patients, regardless of age, after commercial insurance pays for 33 months of treatment. Dialysis is one of the largest single line-items in the federal budget, running 6-7% of Medicare’s total costs and 1% of the entire federal budget. For every $100 you spend in taxes $1 goes towards someone's dialysis treatment.
CMS pays for 90% of Davita’s patients and has significant bargaining power. In the short-term CMS can set whatever rate they want. In the long term, insufficient rates will force high cost providers out of business. Davita is the industry’s low-cost producer and would be the last standing.
Davita breaks even on Medicare patients and makes all of its profit from the 10% of its patients using commercial insurance. Size gives Davita bargaining power over commercial insurers, who are more fragmented than the dialysis providers.
Davita has been squeezed by CMS before and knows how to control costs. Contract labor returned to its pre-pandemic level and Davita switched to a new, cheaper anemia medicine called Mircera. Base wages remain high and turnover is elevated, so there is more work to do.
Davita is also consolidating underutilized clinics. Year to date they closed 36 clinics and built 13 for a 1% net decline. Closures require upfront costs but should yield long-term savings. Davita is careful about closing clinics because proximity to customers is paramount. Over 90% of patients live within 10 miles of their clinic.
Davita expects to earn between $850-1,100 million this year. At the high end, that’s in-line with Davita’s three year pre-pandemic average free cash flow of $1,100 million.
Davita’s capital allocation priority is deleveraging. They paid down $560 million of debt in the most recent quarter. The company’s leverage ratio is 3.7 times and nearing their target of 3.5 times. Once leverage reaches 3.5 times, Davita will likely resume repurchasing stock.
Over the long run we expect Davita to return to its historical growth algorithm of low single digit sales growth, mid single digit earnings growth, and repurchases that drive mid-teens earnings per share growth. Davita’s repurchases have averaged 9% of shares per year, turning 5-7% earnings growth into 15% earnings per share growth.
Davita currently trades for ten times earnings and well below the company’s average historical valuation of 17 times. We think Davita’s valuation is more likely to increase than decrease. If it does, the stock will outperform the business. If it doesn’t Davita will repurchase more shares and produce faster earnings per share growth. Shareholders will benefit either way.
A long-term risk we are monitoring is the rise of GLP-1 and GLP-2 inhibitors. Commercially they’re known as Ozempic, Wegovy, and Mounjaro. They make your body feel full even when you’re not, causing weight loss. Wegovy is FDA-approved for chronic weight management and Mounjaro will be soon.
Obesity is a major cause of ESRD. If Americans suddenly become a lot skinnier, they won’t need as much dialysis. We’re a long way from that, but it bears watching.
Wegovy is prohibitively expensive for most Americans and especially Davita’s core customers. A month's supply costs $1,350 and insurance doesn’t cover it. However, GLP-1 prices are likely to fall considerably over time. Viagra debuted at $88.45 per pill in 1998 and today generics retail for less than a dollar. Prices declined 20% per year. GLP-1s could be within everyone’s reach within a few decades.
Neither Davita nor Fresenius are particularly worried about GLP-1s because their long-term side-effects, efficacy, and adherence are unknown. People begin gaining weight back as soon as they discontinue taking GLP-1s, so will the entire US population take GLP-1s forever? Unlikely. According to Fresenius, Wegovy’s 19% average weight loss would still classify most Americans as obese and maintain their risk of ESRD. Davita estimates that GLP1-s could impact around 6% of its potential patients over the long term.
We will watch how GLP-1s affect Davita, if at all, rather than make speculative long-term forecasts. Slow changes give businesses time to adapt, and GLP-1s will evolve slowly. In 63 AD Seneca wrote, 'There are more things likely to frighten us than to crush us. We suffer more often in imagination than in reality.” This is as true today as it was then.
We rarely discuss short-term stock price fluctuations, but Davita recently offered a good tutorial on investor psychology. Davita’s stock fell 20% in November after it disclosed the pandemic’s lingering effects on its patient population. These were almost certainly transitory, but the lack of short-term clarity caused investors to panic.
The stock sold down to $65 but has since rebounded to almost $100, 50% higher. Davita’s long-term prospects didn’t change over that period. Over-reactions to short-term blips in business are nothing new. These situations are excellent places to hunt for bargains. We suspect something similar is happening at Dollar General right now.
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