ZACKS ESTIMATES - Zacks Investment Research

March 04, 2015

DaVita Healthcare Partners Inc.

(DVA-NYSE)

Current Recommendation Prior Recommendation Date of Last Change

Current Price (03/03/15) Target Price

NEUTRAL

Outperform 02/24/2013

$75.89 $80.00

SUMMARY

DaVita Healthcare s fourth-quarter earnings surpassed the Zacks Consensus Estimate but declined year over year. Although top line improved, the rise in expenses being more than that of revenues, led to margin contraction. Nevertheless, the company s incessant efforts to upgrade services, global expansion initiatives and active acquisitions remain impressive and are supported by the company s strong cash flow and financial position. The merger with HealthCare Partners bodes well for long-term growth, although Medicare Advantage (MA) rate cuts may hurt this segment in future. High debt levels, the adverse effect of healthcare reforms, and an increase in MA beneficiaries are other concerns.

SUMMARY DATA

52-Week High 52-Week Low One-Year Return (%) Beta Average Daily Volume (sh)

Shares Outstanding (mil) Market Capitalization ($mil) Short Interest Ratio (days) Institutional Ownership (%) Insider Ownership (%)

Annual Cash Dividend Dividend Yield (%)

5-Yr. Historical Growth Rates Sales (%) Earnings Per Share (%) Dividend (%)

P/E using TTM EPS

P/E using 2015 Estimate P/E using 2016 Estimate

Zacks Rank *: Short Term 1 3 months outlook

* Definition / Disclosure on last page

$78.07 $67.12

11.00 0.63

1,480,142

216 $16,392

3.47 84 3

$0.00 0.00

19.5 16.4 N/A

20.7 20.1 18.4

3 - Hold

? 2015 Zacks Investment Research, All Rights reserved.

Risk Level *

Type of Stock Industry Zacks Industry Rank *

Low,

Large-Blend Med-Outp/Hm Cre

17 out of 267

ZACKS ESTIMATES

Revenue

(In millions of $)

Q1

(Mar)

2013 2014 2015 2016

2,830 A 3,043 A 3,271 E

Q2 (Jun)

2,872 A 3,172 A 3,384 E

Q3 (Sep)

3,000 A 3,252 A 3,468 E

Q4 (Dec)

3,063 A 3,328 A 3,532 E

Earnings Per Share

(EPS is operating earnings before non-recurring items)

Q1

Q2

Q3

Q4

(Mar)

(Jun)

(Sep)

(Dec)

2013 2014 2015 2016

$0.92 A $0.85 A $0.85 E

$0.92 A $0.95 A $0.93 E

$0.98 A $0.90 A $0.97 E

$0.99 A $0.96 A $1.02 E

Projected EPS Growth - Next 5 Years %

Year (Dec)

11,764 A 12,795 A 13,655 E 14,781 E

Year (Dec)

$3.81 A $3.66 A $3.77 E $4.13 E

12



111 North Canal Street, Chicago IL 60606

OVERVIEW

Founded in 1994 and headquartered in Denver, CO, DaVita HealthCare Partners Inc. is a leading provider of dialysis services in the U.S. to patients suffering from chronic kidney failure, also known as end stage renal disease (ESRD). The company operates kidney dialysis centers and provides related medical services primarily in dialysis centers and in contracted hospitals across the U.S. Its services include outpatient dialysis services, hospital inpatient dialysis services and ancillary services such as ESRD laboratory services and disease management services.

In Nov 2012, the company changed its name to DaVita HealthCare Partners Inc. from DaVita Inc., following its merger with HealthCare Partners. However, HealthCare Partners operates as a subsidiary of the holding company.

During 2014, DaVita acquired 18 centers, opened 105 centers, sold and closed 1 center and merged 16 centers in the U.S.

DaVita s Dialysis and related lab services business (64% of consolidated net operating revenue in 2014) segment provides inpatient as well as outpatient dialysis services, routine laboratory testing for ESRD patients and management services to outpatient dialysis centers.

The HealthCare Partners (HCP) (27%) business was acquired in Nov 2012. The unit operates primarily in the Southern California, Central Florida and Southern Nevada regions and provides primary care and specialty physician services along with hospital and other healthcare services.

The company s other ancillary services and strategic initiatives (9%) segment includes its international dialysis services, pharmacy services, infusion therapy services, disease management services, vascular access services, ESRD clinical research programs and physician services.

REASONS TO BUY

Acquiring dialysis centers and businesses that own and operate dialysis centers as well as other ancillary services and strategic initiatives have been DaVita s preferred business strategy over several years in the past. In 2014, DaVita acquired 18 dialysis centers, sold one center, merged 16 centers and closed one center in the U.S. Outside of the U.S., the company acquired 7 dialysis centers and other medical businesses, opened 11 new dialysis and hospital operated centers and closed two dialysis centers. Per Congress requirements, all oral end-stage renal disease medications are to be incorporated in the bundled payment model by 2016. Once this service is implemented, it will add to the company s growth opportunities and revenues. In Jan 2013, the company entered into a service agreement with Fresenius Medical Care (FMC) and started offering certain pharmacy services to the latter s patients in the U.S. from the second half of 2013. This contract has been extended till 2015 and is expected to generate more clients for DaVita. Earlier, the company had added 120 outpatient dialysis centers in 2013 and 145 in 2012. This was led by higher acquisitions and establishment of new centers, partly offset by center closures and divestitures. In Sep 2011, it acquired rival company DSI Renal Inc., took over ModernMed in Jan 2012, and collaborated with HealthCare Partners in Nov 2012. While the acquisitions bolstered DaVita s client base, the merger augmented the company s primary care and specialty physician services as well as hospital and other healthcare services. More acquisitions and alliances are expected in the future since the uncertainties related to the bundling rule and the capital markets have eased.

DaVita is steadily expanding in the international markets. In the past few years, the company strengthened its position in the emerging and developing markets like Columbia, Portugal, Malaysia, Taiwan, Saudi Arabia, China, India and Germany, through strategic alliances as well as acquisition of

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dialysis centers. These are expected to help DaVita deliver more efficient patient care. To strengthen its existing operations in Arizona, HealthCare Partners LLC, a subsidiary of DaVita HealthCare merged with Arizona Integrated Physicians (AIP) in Sep 2013, contributing positively to increased patient volume and market growth. Moreover, the alliance with Aethlon Medical in Feb 2014 has enhanced client base, thereby aiding revenues. In Dec 2014 the company merged two of its business units DaVita Clinical Research (DCR) and HealthCare Partners Clinical Research to expand its extensive clinical research and data analytics services. In Nov 2014, the company developed a pilot program with Medtronic to identify cardiac arrhythmias in patients on dialysis with the help of Medtronic's Reveal LINQ Insertable Cardiac Monitoring system. Going forward, DaVita is seeking acquisition and partnership opportunities across major European and Asian countries. Alongside, the company is pursuing collaborations with local hospitals to improve patient care. We expect DaVita to benefit from such efforts and boost its competitive advantage and operating leverage.

The company has been generating strong operating cash flow stemming from improved earnings, robust cash collections and the timing of payments for working capital expenditures. Operating cash flow increased at a five-year CAGR (2009 2014) of about 17%. Management s operating cash flow guidance in the range of $1.5 $1.7 billion for 2015, in line or higher than 2014, also appears favorable. The strong cash flow enables the company to meet its capital expenditure needs and spend on acquisitions. Moreover, DaVita tries to generate cost efficiencies through various deals and alliances. While the company s seven-year Epogen purchase deal with Amgen Inc., entered in Nov 2011, has marginally increased the cost of Epogen in the near term, it will receive various discounts and rebates over the tenure of the agreement. Moreover, the agreement limits Amgen s ability to increase Epogen s price without the consent of DaVita. Thus, the deal is expected to significantly reduce the company s future expenditure on the drug.

REASONS TO SELL

A significant portion of DaVita s dialysis and related lab services revenues are generated from patients who have commercial payors as the primary payor. Almost 33% of the company s revenues from dialysis and related lab services came from such patients in 2014. The payments received from commercial payors are the primary generators of profit. However, a rise in unemployment may result in people shifting from commercial insurance schemes to government schemes due to wide disparity in payment rates. In fact, the mix of treatments reimbursed by non-government payors, as a percentage of total treatments, has been falling consistently over the years. Furthermore, almost 79% of DaVita s patients already use Medicare or Medicaid programs. With the overall increase in Medicare Advantage beneficiaries in the U.S., this percentage is likely to increase further, leading to additional pressure on the company s profitability, as inadequacy of government reimbursements could force it to close a number of centers. Moreover, owing to the new screening procedures designed by the Centers for Medicare and Medicaid Services (CMS), the Medicare contractor approval was delayed, thereby causing a delay in reimbursement. This may adversely affect revenues. Again, per its proposed 2014 ESRD PPS rule published in Jul 2013, effective 2016, CMS would adopt certain new clinical and reporting measures and revise some old ones. 2014 will be the performance period for these measures. A failure to comply with these quality measures might adversely affect DaVita s revenues, earnings and cash flows.

The company s debt refinancing continues to keep DaVita s financial leverage at high levels. The company depends upon future borrowings to service its indebtedness and fund other liquidity needs. DaVita raised about $4.25 billion in 2012 to finance the acquisition of HealthCare Partners. DaVita also entered into three interest rate swap and cap agreements in Mar 2013, which led to an increase in interest expenses in 2013. Although debt expense declined slightly in 2014, the continued elevated debt position is expected to increase borrowing costs going forward. Overall interest expenses (included within debt expenses) increased from $228 million in 2011 to $273 million in 2012 and $405

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million in 2013 due to the issuance of term loans. The company also incurred debt refinancing charges worth $97.5 million in 2014 against nil expenses in the year-ago period. Moreover, the issuance of the 5.125% senior notes worth $1.75 billion and the proposed $4.5 billion of term loans in Jun 2014 are likely to increase interest expenses further. The company s expenses are significantly high and rising levels of interest expenses are likely to aggravate it. Due to high indebtedness, DaVita may face difficulties in expanding its business, taking advantage of business opportunities, responding to competitive pressures or refinancing maturing debt, if additional debt refinancing was unavailable on acceptable terms. In fact, DaVita has not repurchased any shares since Jul 2011, in order to conserve cash for acquisitions amid the volatile debt market. As of Dec 31, 2014, stock worth approximately $358.2 million remained available for repurchase. Any increase in interest obligations may further increase the company s interest expenses and adversely affect the earnings and cash flow and the ability to service its debt. This is also evident from a deteriorated operating cash flow position that plunged 17.7% in 2014, raising caution for future as well.

The impact of the health care reform legislation could adversely affect DaVita s earnings. While some provisions of the legislation became effective in 2010 and 2011, many provisions are yet to be implemented. Moreover, the establishment of health insurance exchanges is a cause of concern for DaVita. The exchanges are reducing 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. Thus, the establishment of the exchanges could have an unfavorable effect on DaVita s earnings and cash flow. Further, beginning 2014, CMS payments to Medicare Advantage (MA) plans are likely to decrease as this government entity will have to increase coding intensity adjustments for MA plans. Subsequently, payment to DaVita is expected to reduce in future. Moreover, the company s revenues, earnings and cash flows are likely to decline due to the government s budget for fiscal 2014 that increased the coding intensity adjustments effective Jan 2015. Revenues will also likely be adversely affected by the government s proposed cut in Medicare reimbursements in 2015. Although a reversal in estimated rates was announced by CMS in its final 2014 call letter, published in Apr 2013, it was based on the assumption that the government action would prospectively fix the Medicare physician fee schedule s Sustainable Growth Rate (SGR) formula. The delay in the SGR implementation (in Mar 2014) for the next 12 months is likely to reduce Medicare payments to physicians and thereby lower the company s earnings. Moreover, the secretary of the U.S. Department of Health and Human Services (HHS) has been given the authority to deny Medicare Advantage plan bids if these are liable to increase cost sharing or reduce benefits. At present, if bids offered by plans contracted by HCP are denied, the company s revenues, earnings and cash flows might face a significant blow.

RECENT NEWS

DaVita Beats on Q4 Earnings, Down Y/Y; Retains 2015 View Feb 12, 2015

DaVita HealthCare Partners reported fourth-quarter 2014 adjusted operating earnings of $1.09 per share that surpassed the Zacks Consensus Estimate of $0.88. However, earnings declined slightly from the year-ago quarter figure of $1.10 per share owing to a rise in expenses.

Including extraordinary items, the company s net income came in at $0.96 per share, down from $0.99 in the year-ago quarter.

Operational Update

Total net revenue increased 8.6% to approximately $3.3 billion. The top line met the Zacks Consensus Estimate. The year-over-year increase was mainly attributable to rise in patient service revenues, capitated revenues and other revenues.

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Total operating expenses and charges of DaVita Healthcare were $2.9 billion in the reported quarter, up 11.5% year over year. This was primarily due to rise in patient care costs and other costs, general and administrative charges, provision for uncollectible accounts as well as depreciation and amortization expenses.

Total U.S. dialysis treatments in the reported quarter came in at approximately 6.5 million or 81,434 treatments per day. This represents a per day increase of 6.2% year over year. Growth of non-acquired treatment in the reported quarter was 5.2% while normalized non-acquired treatment growth was 4.6%.

In fourth-quarter 2014, DaVita Healthcare opened 30 dialysis centers in the U.S. The company also took over 2 dialysis centers and closed 5 dialysis centers in the U.S. Moreover, DaVita Healthcare bought 3 dialysis centers and opened 1 dialysis center outside the U.S.

Segment Update

Revenues from the Dialysis and Related Lab Services segment amounted to approximately $2.2 billion, up 7.2% year over year. Operating income at the segment also increased 8.9% year over year to $443 million in the reported quarter.

HealthCare Partners (HCP) generated revenues of $882 million in the quarter, up 6.4% year over year. However, operating income in the segment decreased to $33 million from $98 million a year ago.

Ancillary services and strategic initiatives recorded revenues of $309 million, higher than $242 million in the fourth quarter of 2013. Operating loss during the reported quarter was $19 million, wider than a loss of $9 million in the comparable quarter a year ago.

Full-Year Highlights

DaVita reported 2014 adjusted operating earnings of $4.13 per share that declined from $4.26 per share earned in 2013.

Including extra-ordinary items, DaVita Healthcare s net income came in at $3.64 per share, down from $3.81 in 2013.

Financial Update

Total cash and cash equivalents of DaVita Healthcare increased to $965.2 million as of Dec 31, 2014, from $946.2 million at the end of 2013.

Net cash flow from operating activities in 2014 came in at $1.5 billion, down 17.7% year over year. Cash flows were also below the company guided level of $1.7 $1.8 billion.

DaVita Healthcare s long-term debt as of Dec 31, 2014 was $8.4 billion, up from $8.1 billion as of Dec 31, 2013.

Guidance for 2015

DaVita reiterated its 2015 outlook.

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