FMCQF - Moon Capital - DaVita: A Recession-Resistant Cash Generating Machine

Summary

• During the fourth quarter, we purchased shares in DaVita.
• DaVita and Fresenius control a combined 80% of the $25 billion U.S. dialysis market.
• DaVita runs its business at relatively healthy low-teens operating margins.
• Assuming no revenue growth, we estimate DVA’s fair value is close to $100 a share, 50% above our purchase price and near where the company was trading as recently as 7 months ago.

The following segment was excerpted from this fund letter .

DaVita Inc. ( DVA )

During the fourth quarter, we purchased shares in DaVita, a dialysis center operator. For those unfamiliar, kidney dialysis involves the critical removal of toxins, fluids, and salts from the blood by artificial means. Roughly 500,000 patients receive kidney dialysis in the U.S., which requires a 3.5-hour treatment three times a week. The only alternatives to the treatments are a kidney transplant or potential fatality. Given the critical nature of its services, demand has little correlation with the overall economy, resulting in a highly recession-resistant business.

The U.S. dialysis industry is highly concentrated, with two companies (DaVita and its competitor Fresenius, FMS ) controlling a combined 80% of the $25 billion market. The dominance of this duopoly provides massive scale advantages, making it incredibly difficult for new entrants to gain profitable market share.

In the past, DaVita’s valuation has been penalized (we view unfairly) because the company generates a significant portion of its operating income from a small percentage of its patients. Of DaVita’s 200,000 patients, approximately 90% qualify for Medicare (or Medicaid), with the remaining 10% covered by a commercial insurance provider. While commercial insurers pay an average of $1,000 per treatment, the federal government’s pay rate for Medicare and Medicaid is only $275 – which is actually less than what it costs DVA to provide the treatment.

While this disparity in treatment costs could ostensibly be viewed as a form of price gouging on the commercial customer base, we tend to view the pricing structure as more of a symbiotic relationship between commercial insurers and the U.S. government. For its part, the federal government provides universal coverage for dialysis, regardless of age or financial circumstances. Patients with commercial insurance are covered by their providers for 30 months, after which Medicare becomes the coverage entity. That is, while commercial outfits may initially overpay, after 2.5 years they are no longer responsible for the cost of their clients’ treatment. Importantly, while DaVita runs its business at relatively healthy low-teens operating margins, the independent providers in the industry operate on incredibly thin margins, meaning the higher commercial pay rates provide the critical support necessary for independents to remain in business.

We purchased our stake in DaVita at roughly $72 per share, after the price had dropped from $130 following a reduction in the company’s 2023 earnings guidance. The company’s current EBITDA expectation for 2023 is $2.2 billion, a figure we believe will generate free cash flow of more than $1 billion. At our purchase price, we paid less than 7 times annualized free cash flow, which represents a multiple less than half of DaVita’s historical average.

If we assume no revenue growth, we estimate DVA’s fair value is close to $100 a share, 50% above our purchase price and near where the company was trading as recently as 7 months ago. As a recession-resistant cash generating machine with a free cash flow yield to equity of 14%, we suspect that this valuation may eventually prove conservative.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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