Davita Goes Shopping

By Will Ashworth | June 08, 2012 AAA

On May 21, Denver-based Davita Inc. (NYSE:DVA) announced it was buying HealthCare Partners (HCP) for $4.42 billion. The next day its stock dropped more than 5% on the news. Investors might not have liked what they heard, but I certainly did. I first came across Davita when I chronicled its exceptionally democratic workplace back in April 2010. Now that it's diversifying its revenue streams, the future looks brighter than ever. Trading within roughly 7% of its all-time high, you're not getting a bargain by any means. However, you are buying growth at a reasonable price.

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HealthCare Partners
Located in Torrance, California, HCP is the largest owner/operator of physician practices in the US. HCP makes money by providing health care at lower costs and better outcomes. It's the healthcare model of the future that has patients, payors and physicians all on the same page. Davita and HCP made this deal to speed the move to flat-fee primary care practices. Unfortunately, it took the parties 15 years to consummate a deal. I say this only half-joking. Apparently, Kent Thiry, CEO of Davita and Dr. Robert Margolis, CEO of HCP, originally met in 1997, but were unable to come to terms.

Thanks to the "medical loss ratio" requirement in Obamacare, which mandates health insurers spend at least 80% of the premiums collected for medical services or activities that benefit a patient's health; health insurers who don't, must rebate those misspent premiums to the consumer. HCP is already living within this system as it receives capitated payments per enrolled patient and must deliver medical care below those rates in order to profit from the relationship. By putting fewer restrictions on the medical care, including the number of visits, it's able to reduce the cost of care. Operating in California, Nevada and Florida, its relationship with hospitals, physicians and payors is top-notch.

SEE: Investing In The Healthcare Sector

Financial Implications
Davita paid $3.66 billion in cash and 9.38 million shares of stock. That's 8.4 times EBITDA. However, due to the legal structure of HCP, it actually costs just 7.2 times EBITDA. How's that possible? It was a limited liability company. As a result, Davita gets to step up the basis for a majority of what it paid and amortize for tax purposes most of that cost. As long as the combined entities achieve annual pretax profits of $100 million, it could save as much as $900 million on the deal.

The combined entities had 2011 revenues of $9.4 billion and EBITDA profits of $1.92 billion, so it's likely to achieve the entire savings. In the short-term, the only negative I see is that it's adding $3.8 billion in new debt, almost doubling its current amount. On the bright side, it was able to use its shares to pay for 17% of the deal. The transaction assigned a value of $81 a share, which is within 10% of its all-time high of $90.42. That's how you use share dilution. Now it can use its free cash to buy back shares should investors push it below $80.

Davita and Peers

Company

EV/EBITDA

Davita

7.78

Quest Diagnostics (NYSE:DGX)

7.61

Laboratory Corporation of America (NYSE:LH)

8.00

HCA Holdings (NYSE:HCA)

6.36

Intangibles

There are two that come to mind. The first involves the consistency of its stock. In the past decade, its annualized total return was 18.27%, considerably higher than either the S&P 500 or the medical care sector. More impressive still is the fact it only had two down years out of 10 with 2008 its worst at about a negative 12%. When you consider the index was off by 37% in 2008, you begin to appreciate how safe an investment it's been for long-term shareholders. The second intangible is Warren Buffett. Berkshire Hathaway (NYSE:BRK.B) owns six million shares or approximately 6.4% of its stock. In the first quarter Berkshire Hathaway picked up 3.3 million shares, more than doubling its stake in the company. I realize he's handed off most of the stock buying to Todd Combs and Ted Weschler, but his mere presence attracts additional investor attention. That can only be good for its stock.

SEE: Think Like Warren Buffett

Bottom Line

Don't be put off by the additional debt or the price of its stock. This is an excellent company that's about to get even better. Don't be shy.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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