DaVita's Outlook Is Improving Despite Obesity Drug Expansion

Senior Equity Analyst

Julie Utterback

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After selling the DaVita Medical Group in 2019, DaVita focuses almost exclusively on providing services to end-stage renal disease, or ESRD, patients primarily in the United States with an expanding international footprint. Over several decades, DaVita has built the largest network of dialysis clinics in the U.S., and although COVID-19-related mortality and labor pressures cut into DaVita's profits in recent years, we see brighter days ahead for DaVita, despite some challenges emerging on the obesity drug front.

Once COVID-19 concerns dissipate, we would expect DaVita to get back to more normalized growth trends driven primarily by ESRD trends. We think low to mid-single-digit revenue growth is likely for DaVita in the long run based on the continued expansion of the U.S. dialysis patient population, mild revenue per treatment growth, and ongoing international expansion. These expectations include ongoing expansion of at-home treatments, and we think DaVita can even benefit from extending the at-home treatment stage for patients, despite its clinic infrastructure. In general, we think DaVita stands to benefit from the continued growth in the ESRD population, however they are treated, and it is even pursuing integrated care models to gain a bigger piece of the treatment pie in the long run. 

Also, although the expansion of GLP-1 creates a threat to dialysis players like DaVita as kidney disease progression slows, these drugs may improve survival due to cardiac and other benefits for these chronic kidney disease patients over time, too. In fact, DaVita management has highlighted that it expects the expansion of these drugs should have a roughly neutral effect on its patient population for at least the next decade.

Business Strategy & Outlook

DaVita has dug a narrow moat in dialysis services, operating the most clinics in the United States. We believe the company’s competitive advantages in this business should help it generate returns on invested capital including goodwill in the low double digits on average throughout our explicit 10-year forecast period, or moderately above its capital costs. At DaVita, we see intangible assets and scale-related cost advantages as the firm's moat sources. 

In terms of intangible assets, DaVita has built the largest network of dialysis clinics in the U.S. over several decades, based in part on its brand and reputation for high-quality services, extensive physician relationships, and convenient locations, which all influence the lifeblood of its business—referrals from nephrologists. 

The firm’s reputation for quality remains especially important, and DaVita continues to deliver high-quality metrics in this essential niche of the healthcare service sector. Transparency around clinic quality appears strong with the Centers for Medicare and Medicaid Services rating clinics in the U.S. by care quality and patient survey results, which can be easily accessed by potential users. While one may argue that smaller clinics could deliver similar service quality, the data suggests that the other U.S. clinics are having a tough time replicating the service quality that DaVita and Fresenius regularly demonstrate. For example, the top two players in this niche score better on clinic quality than the other franchises on average when judging by a variety of factors, including hospitalizations, mortality rates, bloodstream infections, and waste removal. This consistent care quality influences doctor referrals, and DaVita recently estimated that it has referral relationships with about 70% of the practicing nephrologists in the U.S. These quality ratings also influence penalties that CMS imposes on underperforming facilities, and DaVita and Fresenius both avoid these penalties at a higher rate than other clinics based on the quality of their service offerings. 

We think aspects of DaVita’s relationships with referring nephrologists provide intangible assets, as well. For example, some referring physicians have ownership stakes in the clinics that DaVita operates. Specifically, about 28% of DaVita’s U.S. dialysis revenue in 2021 came from such joint venture arrangements. We believe these arrangements give partial owners incentive to refer patients to those specific clinics, which is a significant intangible asset, in our opinion. Also, each clinic employs a medical director, consisting of a nephrologist or nephrologist group, that can refer to dialysis clinics and receives compensation from DaVita for providing medical program guidance and other administrative functions. While DaVita denies that any referring physician is required to send patients to a specific clinic, we believe natural financial incentives, perceived quality based on influence at certain clinics, and other loyalties can influence a physician’s clinic recommendation when helping determine a patient’s care plan. 

Additionally, DaVita’s widespread clinic locations can offer patients convenience that is particularly important when considering where to regularly receive these typically time-intensive treatments. In-clinic dialysis patients receive treatment for three to four hours per day, three times per week for the rest of their lives or until they get a successful kidney transplant. Considering that grueling schedule for an already very sick patient, additional commute time to and from the treatment facility remains a major point of concern when physicians and patients determine individual treatment plans. Therefore, DaVita takes care to locate its clinics in convenient areas to serve ESRD patients efficiently. Also, we see a mild switching cost related to convenient locations because once a patient is slotted into a shift at a high-quality and convenient dialysis center, patients would have little incentive to leave that facility or care team, although we see this switching cost as only supportive of the moat rather than a moat source for the company.

Beyond those intangible assets, we think scale-related factors lead to cost advantages and negotiating power with key payers that help DaVita generate economic profits. 

On the most basic level, today’s dialysis service industry embodies how third-party payers reward using cheaper outpatient facilities (dialysis clinics) rather than an acute care setting (hospitals) to lower the cost of treating chronically ill patients. In healthcare, outpatient facilities typically enjoy much lower overhead costs than their hospital peers and can be reimbursed by payers at lower rates because of that fundamental cost advantage. For example, receiving an emergency dialysis treatment in an acute care hospital would cost many multiples of what a scheduled outpatient treatment would cost (around $359 on average per treatment at DaVita in 2021), and third-party payers have incentive to drive ESRD patients to that cheaper outpatient alternative for care on a regular basis. 

Additionally, we think both top-tier dialysis service providers enjoy scale-related advantages relative to their healthcare service and even dialysis clinic peers where DaVita and Fresenius operate at similar scales and cumulatively treat about 75% of outpatient dialysis patients in the U.S. This scale-related advantage contributes to pricing power against commercial insurers. While we do not think the negotiating position of DaVita is substantially different than Fresenius given their similar market positions, we think both players enjoy stronger negotiating positions than the average U.S. healthcare service provider versus commercial health insurers. This differential is especially important in dialysis services since nearly all of the industry’s profits are derived from commercial insurers, and the dialysis industry's concentration appears much stronger than other major healthcare systems in the U.S. For example, the top 10 hospitals claim only about 15% of the hospital market and the top independent reference labs (narrow-moat LabCorp and Quest) cumulatively claim less than 25% of the lab services market. This scale difference appears to give DaVita and Fresenius a much stronger negotiating position relative to commercial insurers than the average U.S. caregiver. For example on the average dialysis treatment, commercial insurers pay DaVita about 4 times what the government would pay for a dialysis treatment, and that differential is substantially higher than what the average healthcare service provider can garner from a commercial insurer versus Medicare, which is roughly 2 times. This scale-related pricing power directly affects DaVita’s ability to generate economic returns in our opinion, and from a commercial payer negotiation perspective, we view the dialysis industry as stronger than the narrow moat reference lab industry and much stronger than the hospital space, which we generally view as a no-moat industry with some exceptions, such as narrow-moat HCA. 

Relative to other dialysis clinics, we see scale-related cost advantages at DaVita and Fresenius, too. The Medicare Payment Advisory Commission, or MedPac, has identified higher volume dialysis facilities as having a cost-per-treatment advantage based on direct reports from individual clinics. Based on the treatments per facility, we think DaVita and Fresenius benefit from a mild cost advantage over their smaller dialysis clinic peers. We think these cost advantages are influenced by internal efficiencies probably related to the experience and standardization of its operations. For example, the average DaVita and Fresenius clinic in the U.S. operates with higher potential capacity, higher utilization, and fewer full-time employees than their smaller peers. Additionally, we believe DaVita and Fresenius have more negotiating leverage for major treatment inputs, including pharmaceuticals and supplies, than smaller clinics, and they can spread general and administrative costs over a larger base of clinics than smaller clinics, as well. All of these factors help reduce the overall cost per treatment at the top-tier players relative to smaller-scale peers, which helps the top-tier players generate economic profits.

Narrow

Economic Moat

DaVita

DaVita, Inc. engages in the provision of medical care services. It operates through the following two segments: US Dialysis and Related Lab Services, and Other-Ancillary Services and Strategic Initiatives. The US Dialysis and Related Lab Services segment offers kidney dialysis services in the United States for patients suffering from chronic kidney failure. The Other-Ancillary Services and Strategic Initiatives segment consist primarily of pharmacy services, disease management services, vascular access services, clinical research programs, physician services, direct primary care, end stage renal disease seamless care organizations, and comprehensive care. The company was founded in 1994 and is headquartered in Denver, CO.

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DaVita Inc.(NYSE: DVA) is a medical services company providing kidney dialysis services to patients in the United States as well as internationally.

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