THE HEDGEYE EDGE
We think trends in commercial patient volume, reimbursement, and margins are coming under pressure alongside regulatory problems. We see significant downside over the next 12-months for DaVita (DVA), which has little flexibility and apparently no plan except for repurchasing stock.
Since we presented our short thesis on DVA, things have gone from bad to worse. The 2019 guide included many of our assumptions about rising labor costs and their impact on patient care expense but surprised us to the downside with lower than expected organic patient volume of +0.5 percent. Meanwhile the federal government is looking to open up new channels of patient care and reduce its reliance on the duopoly of DVA and FMS.
It all makes us wonder, how bad can it get?
INTERMEDIATE TERM (TREND)
Key drivers of our thesis are declining to flat growth in commercially insured population on which DVA is disproportionately dependent. Meanwhile the Quad 4 environment of accelerating labor costs is putting pressure on total patient expense, while the pool of acquisition targets has largely been depleted.
The 2019 guide presented at the JP Morgan conference confirmed much of what we presented in December with organic treatment volume growth below our models at 0.5 percent. The guidance for operating income calls for a range of $1.54-$1.64B, which includes current consensus of $1.62B, but opens up the low end of the range considerably.
The components of the guide were all in line with our short thesis and included lower commercial patient mix (+/- 5 bps), commercial reimbursement pressure (-1.0% to +0.5%), wage inflation (+2.5%-3.0%), lower contribution from acquisitions and lower operating margins. We continue to expect the trend in commercial patient mix will deteriorate at a more rapid pace than the initial 2019 guidance and lead to additional reductions in guidance.
The company also suggested a number of headwinds other than the demographic headwinds we’ve cited since we went bearish. Management cited rising opioid deaths as a driver of available organ donors and subsequently a reduction in commercially insured patients who disproportionately receive available kidneys. This may be true, but we have not heard any anecdotes suggesting an uptick in transplants.
There was also a reduction in out of network and subsequently high reimbursement patients, something we have heard from facility operators, but assumed DVA was bringing more patients in network at lower rates. The company did not comment on the existing "physician puts" during their presentation or during the Q/A, which was surprising.
We are skeptical that when DVA closes its sale of DMG to UNH’s Optum unit, the plan for “significant stock repurchases” and debt repayment can overcome the secular headwinds. Assuming the buybacks and debt paydown associated with the sales of HCP to UnitedHealthcare, DVA trades at ~7X EV/EBITDA post-deal. We think the market will pay an even lower multiple for declining EBITDA.
DVA now faces new challenges to an already deteriorating policy environment. The California legislature will once again take up a bill that would, in effect, limit reimbursement to Medicare rates for patients accepting financial assistance from the National Kidney Fund. HHS Secretary Alex Azar has now made treatment of kidney disease a federal policy priority with an emphasis on improving transplantation, the growth of which DVA has cited as a headwind. What has not happened is also of interest.
From a healthcare policy perspective, AB 290 was introduced on Jan. 28, 2019 and is nearly identical to BS 1156 which was ultimately vetoed by Gov. Jerry Brown last year. If passed – which seems likely – the bill would reduce commercial reimbursement for which there is private, third party premium support to the Medicare rate of $235.27, before other adjustments.
Currently, there are approximately 2,000 commercially insured Californians who accept premium support from the American Kidney Fund. During their 4Q18 earnings call, DVA management stated passage would result in a $25 to $40 million headwind, although the specifics were not given as to the specific line item impacts to the P&L.
AB 290 has an easy path to the governor's signature. The exact same bill language was approved by both chambers of the California Legislature in 2018. Governor Brown’s veto was hardly a ringing condemnation of the approach. Instead, he suggested insurers and dialysis providers continue to work together to ensure patient access. California's new Governor, Gavin Newsome has staked his political future on health care policy, proposing seeping changes to the system like bulk purchases of prescription drugs and incremental steps toward a single payer. The idea of paying dialysis providers the Medicare rate would fit squarely into his framework.
More worrisome is the bill’s main advocate, the Service Employees International Union, has pledged to promote similar legislation in other states. Most states have bill filing deadlines in January and February. It will become apparent in the next few weeks if SEIU will make good on their threat.
BOTTOM LINE
Downside from commercial enrollment and reimbursement mix, high fixed costs, and few opportunities for margin expansion gives us high conviction with DVA as a Best Idea Short.
We expect the current EV/EBITDA multiple of 8.8X will violate the long run average of 8.3X, with downside from deteriorating fundamentals and policy environment.
ONE-YEAR TRAILING CHART
