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Morningstar | DaVita Reports Mixed End to 2018, but Valuation Remains Compelling; Stock Remains a Best Idea

Narrow-moat DaVita reported mixed overall results for its fiscal fourth quarter and full year, although on balance net performance was more or less in line with our expectations. The firm's U.S. dialysis business again met our revenue forecast while falling slightly short of our outlook for profitability. As we account for adjustments in our model, we'll likely make only modest changes, if any, to our $81 per share fair value estimate, which implies 18 times and 8.5 times our lowered adjusted earnings and EBITDA forecasts for 2019--the current market price suggests multiples nearer 12.5 and 6.8, respectively. Given this striking valuation disconnect DaVita remains a top pick in our healthcare coverage, boasting a 5-star rating and over 45% upside to fair value.

Management provided guidance that calls for operating income between $1.54 billion and $1.64 billion, implying mid-single-digit growth at the midpoint. We anticipated a better number given many of the one-offs that occurred in 2018 and expect this range to prove conservative--our estimates remain at the high end. That said, organic treatment growth reported in the fourth quarter was uncharacteristically weak and undeniably concerning. After three quarters of growth averaging 3.4%, the fourth quarter came in at 2.6%, which marks the lowest quarterly organic rate over the last decade. While management maintained its 2.5%-3.5% expectation for 2019, we'd be disappointed in a full-year number below 3% as our projections call for a compound annual rate of 3.5% through 2023. Continued below-trend treatment growth and the potential for higher patient advocacy costs are likely the two main risks to our projections for the year ahead.

As an offset, lower capital spending needs should buoy free cash flow over time. The combination of increasing home therapy penetration and potentially lower volume growth requires fewer clinic openings and improves the firm's capital efficiency.

Unfortunately, it appears the dialysis industry will again be pitted against the California Legislature this year, which may result in higher advocacy spending needs than the incremental $30 million embedded in management's outlook. Last month, the California Assembly introduced AB 290, which is more or less a rehash of AB 1156 that was passed and subsequently vetoed last year. In short, the bill would effectively cap reimbursement rates for a small number of commercially insured patients receiving third-party financial assistance at prevailing Medicare payment rates. Former Gov. Jerry Brown vetoed similar legislation due to concerns around patient access. DaVita management quantified the potential impact of this proposal as a $25 million to $40 million hit to operating income. This is more favorable than our prior estimates of a $45 million to $100 million reduction in profitability, likely attributable to cost-saving measures and potential facility closures. Please see our report "Dialysis Remains Moatworthy Despite Regulatory Concerns" for additional background on California's dialysis-related policy proposals from last year.

Despite these concerns, we think the structure of the dialysis industry is set to improve over the coming five years. Medicare payment rate updates have turned positive after five years of rate rebasing left net per-treatment reimbursement flat over the period and patients will be allowed to enroll in Medicare Advantage plans beginning in 2021, both of which should help pricing to providers. Given the long-term stability in dialysis patient growth rates, we're keen to assume that recent weakness in treatment growth is more likely than not an anomaly, but industry data isn't up to date enough to know for sure. Either way, we don't think our model prices in overly optimistic expectations. We forecast 1% net price improvement, 3.5% treatment growth, and 20 basis points of margin expansion in the firm's U.S. dialysis franchise annually over the next five years. In addition, we think the international business can finally contribute to firmwide profitability, sporting a mid-single-digit EBITDA margin by 2023.

We contrast this outlook against market-implied expectations that seem to embed no pricing improvements, only 3% treatment growth, annual margin declines for the U.S. business, and no profit contribution from international operations between now and 2023. To us, these assumptions appear too pessimistic, and we believe investors are being more than fairly compensated for the policy and regulatory risks that will always be present when it comes to dialysis.