DVA DaVita Inc

We are downgrading our recommendation on DaVita Inc. (DVA) to Neutral based on an unfavorable shift in payor mix, headwinds from debt refinancing and ongoing concerns related tothe health care reform. However, the company’s strong cash flow and steady inorganic growth together limit the downside.

DaVita reported fourth-quarter operating earnings of $1.58 per share, which topped the Zacks Consensus Estimate of $1.48 and $1.13 in the prior-year quarter. Operating income amounted to $149.4 million, compared with $111.9 million in the fourth quarter of 2010.

DaVita has been generating strong operating cash flow, which increased at a 3-year CAGR (2008–2011) of 24%. The strong cash flows allow the company to meet its capital expenditure needs as well as repurchase shares and spend on acquisitions, which has been DaVita’s preferred business strategy over the years.

During 2011, the company increased its tally of outpatient dialysis centers by 208, which can be credited to acquisitions and opening of new centers. Apart from domestic acquisitions, the company is also looking for acquisition opportunities in all major European and Asian countries.

While DaVita’s Epogen purchase deal with Amgen Inc. (AMGN) has marginally increased the cost of Epogen in the near term, it is expected to significantly reduce the company’s future expenditure on the drug. It is likely that the company received substantial discounts and rebates under the agreement, which prompted it to sign a seven-year deal despite the fact that Epogen’s patent is set to expire in 2014 and low-cost competing products will be available in the market.

On the flip side, a significant portion of DaVita’s dialysis and related lab services revenues are generated from patients who have commercial payors as the primary payor. However, the mix of treatments reimbursed by non-government payors, as a percentage of total treatments, has been falling consistently over the years due to the wide disparity in the payment rates of commercial insurance and government schemes.

Moreover, the impact of the health care reform could adversely affect DaVita’s earnings. One provision requires the establishment of health insurance exchanges, which is expected to reduce the number of policyholders opting for commercial insurance.

Moreover, even those policyholders who choose to stay with commercial insurance are likely to opt for policies with limited benefits, carrying lower reimbursement rates. Consequently, the earnings of DaVita could be adversely affected by the establishment of the exchanges.

The Zacks Consensus Estimate for DaVita’s first-quarter earnings is currently pegged at $1.45 per share, up about 51% year over year. For 2012, earnings are expected to be about $6.24 per share, climbing about 21% year over year.

DaVita currently caries a Zacks #3 Rank, implying a short-term ‘Hold’ rating.

 
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