American Renal and Healthcare Investing 101:
American Renal is a dialysis provider that recently went public. One of Ted Weschler’s career-making investments was in Davita, another dialysis provider. In this post, I wanted to discuss American Renal briefly, but then take a step back and think about health care investing in general.
From the company’s S-1, there is a good and brief description of what the company does:
We are the largest dialysis services provider in the United States focused exclusively on joint venture partnerships with physicians. We provide high-quality patient care and clinical outcomes to patients suffering from the most advanced stage of chronic kidney disease, known as end stage renal disease (“ESRD”). Our core values create a culture of clinical autonomy and operational accountability for our physician partners and staff members. We believe our joint venture (“JV”) model has helped us become one of the fastest-growing national dialysis services platforms, in terms of the growth rate of our non-acquired treatments since 2012.
We operate our clinics exclusively through a JV model, in which we partner primarily with local nephrologists to develop, own and operate dialysis clinics, while the providers of the majority of dialysis services in the United States operate through a combination of wholly owned subsidiaries and joint ventures. Each of our clinics is maintained as a separate joint venture in which generally we have the controlling interest and our nephrologist partners and other joint venture partners have a noncontrolling interest. We believe our JV model, combined with a high-quality operational infrastructure, provides our physician partners the independence to make improved clinical decisions so they can focus on maximizing patient care and grow their clinical practices.
As a starter, a few points about American Renal’s (“ARA”) flowery language. Their claim to be the largest dialysis service provider “focused exclusively on joint venture partnerships with physicians” reminds me of my philosophy classes where we discussed the meaning of the word “is”. Davita actually does a significant amount of JV business (approximately $2.2B in 2015) compared to ARA’s total revenue of approximately $650m in 2015, however, since Davita is not “focused exclusively” on JV partnerships, ARA’s statement is technically correct, but not something I would be particularly proud of as a part-owner, i.e. investor in the business. The other statement I would bicker with is the idea that ARA is the fastest growing “national dialysis services platform.” From 2014 to 2015, Davita grew its dialysis revenue over $500m, whereas ARA’s revenue grew approximately $90m. Given ARA’s relative size, the growth as a percentage is much greater, once again, making their statement technically correct.
ARA’s business is not too different from Davita’s. ARA’s treats people with End Stage Renal Disease (“ESRD”), which is basically failure of the kidneys. There are only two treatment options for these individuals, kidney transplant or life-long dialysis. Dialysis providers will build small offices in strip malls or around hospitals that cater to an “off-site” procedure where the patient comes for a approximately 3-4 hours per treatment for 2-3 times per week. Patients with ESRD are growing at a steady rate (3.6% annual growth), so the pie is getting bigger.
The main focus of any discussion of dialysis providers should focus on the reimbursement model. Since we are in the realm of healthcare, the reimbursement model makes almost no sense, so if what I am describing does not sound rational, you are probably reading it correctly.
Since dialysis patients are so expensive, and have little hope for a cure (kidney transplant), Medicare has allowed commercial insurance providers to offload these patients after approximately 30 months (sometimes there is a 3-month waiting period). Given this shifting of payments from commercial insurers to Medicare, commercial insurers are willing to subsidize the Medicare treatments for the rest of the patients lives. The commercial insurers do this by paying approximately 3-4x the amount Medicare pays per treatment. In other words, ARA loses money on each of the Medicare patients it treats, but makes a significant amount of money on the commercially insured patients. However, ARA loses these commercially insured patients after 30 months. For example, 84% of the patients it treats are covered by Medicare and the other 16% are covered by some sort of commercial insurance. I should note, Medicaid is also grouped within the Medicare bucket for percentage of patients because Medicaid also reimburses at a rate similar to Medicare. Davita also has a large skew towards Medicare, 89% of patients are covered by Medicare/Medicaid, and the other 11% by commercial insurance.
In discussing Moody’s business, Buffett had this to say about pricing power:
“…the single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business.”
This idea of pricing power is relevant to ARA and Davita. Despite reimbursing at rates lower than the cost of providing the service, Medicare has actually reduced its dialysis reimbursement rates 1% per year since 2012. Not only can ARA and Davita not raise their prices on the majority of its customers (greater than 84% and 89%), but the customers (payors) are actually demanding and receiving discounts.
The trade-off here is that dialysis providers are negotiating with commercial insurers who are generally expected to pick up the tab for the Medicare cutbacks in order to maintain the 30 month rule limit. However, this is not an iron-clad law or regulation, merely a way of doing business that allows the dialysis centers to stay in business while also shielding the insurance companies for significant long-tail dialysis exposure.
Healthcare Investing 101:
And this is where I would like to step back and think about health care investing in general. Given Buffett’s comments above, you would not be astonished to learn that Buffett has had few, if any that I can recall, healthcare investments in his career. This is another reason why Wechsler’s successful investment in Davita stands out and deserves some notice and study. The pricing power of the service providers, in this case the dialysis centers, is virtually non-existent. Given their inability to raise prices, they have two options. One: cut back on expenses, which inevitably leads to lower quality of care and eventually results in lawsuits. Second, game the system. There are a myriad of games that healthcare companies play in order to squeeze profits for the payor system. The current game ARA (and potentially Davita) is playing is to have a non profit agency, the American Kidney Foundation, pay the premiums of its patients in order to shift them from Medicaid (low reimbursement) to commercial insurance under the Affordable Care Act (high reimbursement). United Health is currently suing American Renal for just this game.
- Cut back on expenses = lower quality: Payors sue and demand higher quality
- Game the reimbursement system: Payors cut back on reimbursement
- Result of #1 is costs significant rise and result of #2 is revenues significantly decline. Some healthcare companies go bankrupt and there is a significant risk that the entire industry is at risk of insolvency.
Between 1995-2000, five of the largest skilled nursing providers went bankrupt, causing the Senate to hold hearings entitled: “Nursing Home Bankruptcies: What Caused Them?”.
In 2011, home health care service providers experienced a similar industry shake-up as a result of reimbursement gaming. Once again the Senate released a report and subsequent hearing focused on reimbursement gaming entitled: Staff Report on Home Health Care and The Medicare Therapy Threshold.
The best time to invest in healthcare is right during these periods of reimbursement uncertainty and legal risk, both of which lead to potential bankruptcy risk for healthcare companies. If you can find a company that is secure enough to survive the instability created by these factors, the value received will likely substantially exceed the price paid.
Turning back to American Renal, I do not think it is the appropriate time to invest. Some back of the envelope math:
- Shares outstanding after dilution: 34m shares
- Operating Cash Flow: $180m
- Maintenance Capex: $30m (this might be too low)
- Distributions to Joint Ventures: $90m (these are payments made to the joint owners of the dialysis centers)
- Interest Payments: 40m
- Total: Free cash flow to owners: approximately 100m.
- Current Debt: approximately $550m (inclusive of tax agreement)
- Equity ($20 share price x 34m fully diluted shares): $680m
- Total Enterprise Value: $1.23B
You are only paying around 12-13 FCF/EV value, there are or should be discounts to take into account the current reimbursement lawsuits and the ongoing pricing issues embedded in all healthcare business.
The storms are brewing for potential reimbursement lawsuits, the value of American Renal has not been significantly impacted. In other words, the value of the company could be cheap, but I would like it to be much cheaper given the risks in this business.
In a subsequent post, I will look back at Weschler’s investment in Davita and what factors contributed to this wildly successful investment.