Can DaVita HealthCare Partners Inc's Run Last?

The two largest hemodialysis service providers, Fresenius Medical Care (NYSE: FMS  ) and DaVita HealthCare Partners (NYSE: DVA  ) , may have a lot in common, but the performance of their shares is not one of them. Over the past year, DaVita has a 10% lead on on Fresenius and that lead only increases at the two-year (roughly 60%), and five-year (nearly 120%) marks.

Though the operating margins have been similar, DaVita has significantly outgrown Fresenius over the past decade and generated more free cash flow as a percentage of revenue. Better still, DaVita's HealthCare Partners business looks like a "right place, right time, right idea" operation that can benefit from a growing focus on basing health care spending on outcomes, not procedures. Considering DaVita's growth potential, the shares may yet be as much as 20% undervalued today.

Number two in a vital, but tough, service business
DaVita is the second-largest provider of dialysis services in the U.S., with about one-third share of the market (some 5% behind Fresenius). DaVita provides its services at nearly 2,100 freestanding clinics, as well as providing acute services at about 1,000 hospitals. Unlike Fresenius, DaVita has focused the lion's share of its attention on the U.S. market.

That focus on the U.S. market is definitely a mixed blessing in some respects. While the number of people with end-stage renal disease is increasing, and these patients need dialysis to live, the peculiar structure of the U.S. market creates reimbursement challenges. U.S. law mandates that Medicare pay for dialysis treatments, but with those patients who have commercial health insurance being covered by those insurers for the first 30 months of treatment.

All manner of health care service providers have felt the sting of cuts in Medicare reimbursement and/or slow growth in payment amounts. As a result, private insurers reimburse for dialysis treatments at a rate three to four times higher than Medicare. The end result is that only around 10% of DaVita's dialysis patients are reimbursed through private insurance, but they account for about one-third of the segment's revenue.

It does not appear that the reimbursement environment is going to get any better. Basic dialysis reimbursement rates are unlikely to go up much (if at all) over the next few years and it seems plausible that there could be attempts to clawback some of the lower costs of drugs administered as part of the dialysis procedure. In such an environment, it will be critical for DaVita to carefully manage costs, including closing loss-making centers and possibly expanding the use of home dialysis.

HealthCare Partners may be the future
DaVita acquired HealthCare Partners in 2012, in part to diversify the business beyond dialysis. HealthCare Partners is a physician group manager that essentially coordinates care for the patients covered by commercial health plans or government-funded plans like Medicare. DaVita is paid a per-member fee (capitation) and the company coordinates and manages the care of those patients.

This is an appealing alternative for payers, as it allows them to control their costs and spread risk across the system. As costs become more and more of a focus in health care, HealthCare Partners may well be an example of an increasingly common model – a model that prioritizes paying for outcomes rather than procedures. The hope is that in paying for outcomes, there are fewer incentives to prescribe unnecessary procedures and tests (and/or procedures that don't really lead to improved outcomes), a greater focus on cost-benefit analysis, and an ability to focus on a "continuum of care" that prevents problems before they even arise.

Medicare Advantage is a key opportunity for the company. The whole idea of Medicare Advantage is to deliver better and more cost-effective outcomes by allowing patients to choose plans administered by private providers. Managed care companies like Humana (NYSE: HUM  ) and WellCare (particularly Humana) have made large commitments to the Medicare Advantage market, but a key to profiting from this business is in controlling costs.

HealthCare Partners is one of the largest physician group managers out there right now, and with its solid record of cost containment and outcomes improvement, it could be a key partner as Medicare Advantage expands. Humana, for instance, has talked of a target of 50% of its MA patients served by organizations like HealthCare Partners by 2017, and this could position DaVita as a key player in how payers manage health care costs in the future.

The bottom line
I expect DaVita to grow revenue at a long-term rate of around 6% as the company benefits from a growing number of dialysis patients and the expansion of the HealthCare Partners business. I am not expecting particularly large improvements in free cash flow generation, as I believe the reimbursement and cost environment will prove challenging. Even so, 5% FCF growth is more than enough to support a fair value target in the mid-$70's today.

Given DaVita's significant outperformance relative to Fresenius, I wouldn't be surprised if sell-side analysts start making calls to switch from DaVita to Fresenius on the basis that Fresenius shares somehow need to "catch up." I disagree, as I believe DaVita offers better FCF generation and its position in outcomes-based medicine gives it better growth prospects.

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