Two stocks on my watchlist (1/2)

This is not investment advice and is general in nature. Do your own research before taking any positions in the securities listed below

Over this series I will cover two very different companies - $DVA (US) and $NOL (AU) which are recent additions to my watchlist.

$DVA - Leveraged duopoly, with a history of buy-backs

Because this is a Ted Weschler/Berkshire Hathaway holding (and anything owned by them gets a lot of airtime on Substack & Twitter) I will keep this quite simple:

What $DVA do

• I covered $DVA fleetingly in another post, however, they provide kidney dialysis services in the US & Intl patients suffering from kidney failure or end-stage renal disease (ESRD) predominantly to Gov patients

• They are a pure-play business after selling their broader med biz to United Health

• In the US, $DVA & German rival Fresenius collectively cover 70-80% of the market

• Generally, $DVA is a low-growth business and opportunistically buy-back stock

What has happened recently

• In the Marietta vs. DaVita ruling by the Supreme Court (SCOTUS) in Jun'22 sided with the health plan, which allowed self-insured plans to exclude certain dialysis providers. Sellside broker BOA believes that should result in a 15% revenue cut, slashing $DVA forecast because they make a lot of their earnings from either Employer plans or Kidney Fund (more detail below)

• After a weak Q3'22 result, $DVA stock was down 23% to <$70. The explanation provided by management was:

  • Lower service volumes; which have persisted longer than expected (potentially due to the SCOTUS outcome above). Treatments were 7.34 million (92,859/day) compared with 7.47 million (94,509/day)

  • Contract labour costs and productivity levels are low. Revenue per treatment rose 2.0% to $360.54, while patient care costs per treatment increased 5.7% to $242.09.

Why this business is worth considering

• Numerically it is easy to understand

  • Revenue is split 70%/30% between Govt & Commercial patients but the GM is the reverse 10%/90% with commercial patients paying significantly more

Note - Major commercial insurers have signed long-term agreements (~5 years) with ‘stable’ pricing of dialysis reimbursement making the commercial revenue 'stickier'

• COGS is split out 80% Labour Costs/10% G&A (including contributions to Kidney Fund) and 10% D&A noting that there is fairly small amort charge for this business

• The client acquisition is known, in the US you get treated one of the following ways

  • Employer plan: >$1,000+ per treatment

  • Medicare: Subsidize the 20% coinsurance per treatment with secondary insurance (noting after 33mnths on Medicare you must switch to a separate plan)

  • Individual plan: Enroll in an individual health plan (via American Kidney Fund) presumably during open enrollment; pay limited out-of-pocket

• International operations have recently been a positive driver; first profitable in mid-2018 and now a small component of their earnings. No success of international dialysis seems to be priced in to $DVA valuation

• There is a risk of Kidney Fund closing down, however, I consider that highly unlikely

  • Without Kidney Fundup to 50% of clinics would be unprofitable

  • Patients would then be driven into the hospital at a 3-4x cost increase

  • States and Medicare are subsidized by private insurers today

  • There would be a risk of litigation

Valuing $DVA (high-level)

• As shown below; $DVA spins off a huge amount of cash, but don't get your hopes up about this growing materially - it will probably just spin off $1bn/pa net of capex of $0.5bn p.a.

• Share count has halved in the last 7yrs

• They have pretty good debt terms which is great given they are highly levered (3.9x)

Conclusion:

1. There is plenty of complexity around the regulatory environment of $DVA but I consider it unlikely that Medicare/Kidney Fund will stop being a material % of their client base and Employer plans a material % of their earnings.

2. Running a DCF requires a huge amount of accuracy because this is a low-growth levered business so I think the better approach is consider the following

   1. At 9x earnings they are an attractive option given their ability to repurchase shares and attractive debt funding

   2. It is unlikely that labour growth will long term outpace service costs because this won't benefit this duopoly long term

   3. There is an embedded lottery ticket with their international expansion which I ascribe limited value too but provides an appealing upside