During times of stock market angst, many investors find that they have not built or positioned their portfolios to allow them to rest comfortably at night and get caught up in the panic themselves. Having a portfolio too focused on one segment of the market or a certain strategy can cause serious heartburn, but investors should always remember that even when playing from behind, it is important to make decisive decisions when managing your worst-case scenario risks. Over the last 6-12 months, a lot of investors got caught holding far too much exposure to the high beta, high-growth names and have seen some serious losses as many of those stocks have retreated significantly. While cash is king right now, we recognize that sometimes you have to be allocated to equities and actually own something, and we do think that there are some names out there which could help portfolios outperform if markets head lower (keep in mind this means that the market simply has to decline more than the chosen equity). One of those names is DaVita Inc. (NYSE:DVA).
Why We Like DaVita
DaVita is one of those companies that provides a service/product which is not easily replaced, is regulated, and is required by those who need it. DaVita, along with Fresenius Medical Care (FMS), controls a large portion of the dialysis center market in the United States. The two companies have been on a consolidation spree, and now it appears that the M&A portion of the strategy has mostly played out with the current administration in the United States and more scrutiny now being applied to corporate M&A activity in the country.
The company has relatively stable and reliable revenues and profits even with headwinds that have arisen in recent years. The share buybacks that management has engaged in for almost a decade have provided a tailwind for EPS figures and helped move the shares higher. Yet, even though buybacks may face hurdles moving forward (whether due to Washington legislation or having to adjust buybacks due to the debt on the balance sheet), we still like the potential for the stock moving forward as the company should have stable CapEx moving forward, with most of it being spent on maintenance and no longer on development; which still affords management some maneuverability should the economy face another shock. While some of that development CapEx is spent internationally, the growth from those operations each year will not be enough to meaningfully move the needle for the entire company in the next few years but does open some potentially attractive markets for the company moving forward. In short, DaVita’s business is life and death, and in a market like the US, where insurance and government plans pay the majority of the cost of treatment, rather than the individual, most people choose life and ignore cost, making this a very reliable business.
Moving forward, management sees many of the issues that impacted results due to COVID receding as fewer variants and sub-variants make their way through the country. This should continue to help increase patient visits and continue to lower the mortality rate (due to COVID) among patient demographics which had spiked in 2020 and 2021.
When purchasing stability for a portfolio, we always like to look at ‘outs’ – basically understanding potential exit strategies. Our view is that this is a name that can hold up relatively well if the market continues to pull back, especially considering that roughly 40% of the shares are tied up by Berkshire Hathaway (BRK.B) and one of their portfolio managers (Ted Weschler). We recently wrote an article on who we thought Berkshire Hathaway should target next (located here), and although it focused on a different company, we did state that DaVita would naturally fit and have a higher probability due to the exposure that Berkshire already has. A potential buyout, with a strategic buyer who is already a shareholder, is always a nice tailwind to have during market turbulence.
One item we would point out to potential investors is the debt load that DaVita carries. The company has a favorable maturity schedule in our opinion, with just over $270 million coming due through 2023, but 2024 and 2026 will require some rather significant rolls – to put it kindly. With interest rates marching higher, we do wish that the company had issued more long-term bonds like those previously issued back in 2020, but we do think that the maturity schedule offers flexibility in debt refinancing by rolling to 3- and 5-year maturities in 2027 and 2029 when their first loan comes due in 2024. There is a little less flexibility on the 2026 loan when it matures, but the company could utilize a 2-year maturity (depending on where rates are and what credit raters may be asking for in terms of debt payoff and repayments) and a 10-year maturity to address that refinancing need.
It is also important to note that the company could utilize some of their free cash flow towards debt reduction which might have the added benefit of creating additional free cash flow in years ahead. We say this because the allocation for stock buybacks just eliminates shares outstanding, not a dividend outflow, so by eliminating debt, the company could potentially reduce interest expense (assuming rates do not go up considerably) and thus potentially increase cash available in future years.
We have already discussed some potential issues with the debt load, and while interest rates and refinancing are issues to watch, the immediate concerns for investors should focus around inflationary pressures that the company is currently facing. Labor is a major issue right now for almost every company, and DaVita’s management discussed staffing and labor expense on the most recent conference call (located here). With labor expenses rising 6%, this is the immediate worry as the Q&A session with analysts discussed how certain programs (Medicare, for instance) use input costs from as far back as two years ago and thus do not include the current input costs which are being driven higher by inflation. If inflation stays elevated for a period of time or continues higher, these costs would have to be floated by the company for a decent period of time before they would see relief from payers.
While we do not want to try and explain away the company missing on both the top and bottom lines for the most recently reported quarter, the conference call went into a lot of detail on some of the issues that the company ran into. First, there were fewer days in the quarter this year, which impacts patient visits/treatments as well as collections (while it appears that management was factoring this in, there did seem to be some confusion among the analysts). One can chalk that variance up to seasonality and assume that the company can realize that revenue in subsequent periods as the patients will still be getting treatments (as this was a timing issue really). The other big issue of patient mortality due to COVID, as well as canceled visits due to COVID, should abate as variants run their course and patients become more comfortable with the opened economy. We would point out that management did state that they do feel they will be able to meet the lower end of their guidance for the full year, even as they address these issues, which means Q2 through Q4, really the second half of the year, would be hitting the high-end of their previously announced targets (due to Q1 being weak).
Management also discussed implementing strategies to address rising costs, with their focus essentially on being more efficient. With the labor cost inflation, additional costs for training and outsourced/contract labor, the company does not expect to see these savings show up until 2023 with full benefits realized by 2025. While we admit that this does not sound particularly exciting for investors, the company’s CEO did say on the conference call that they believe all of this, “can keep us on a path to deliver on our long-term adjusted operating income growth of 3% to 7% and an adjusted earnings per share growth of 8% to 14%.” So, while this quarter initially looked pretty bad, the company’s continued belief in their ability to deliver on projections over the long term could very well explain the sharp bounce-back we saw after the initial selloff.
After the company’s quarterly results, two analysts lowered their price targets on DaVita, with Truist rating the stock a ‘Hold’ and lowering to $110/share from $125/share, and Cowen, which rates DaVita a ‘Market Perform’, also lowering their price target to $110/share from $120/share. Both cited higher labor costs for FY22 as reasons for lowering their targets.
We believe that DaVita is an attractive purchase to add stability to one’s portfolio within the $100/share to $110/share range. DaVita faces rising costs like many other companies out there, but the very nature of their business largely insulates investors from sharp moves lower in revenues and profits due to macroeconomic events, so their labor inflation risk is a reasonable risk to add to one’s portfolio. While the company does not pay a dividend, management has a longstanding commitment to repurchasing shares, which we believe may be a positive moving forward, as it gives them optionality with large debt maturities coming due. For as long as Berkshire Hathaway remains a shareholder, the stock should see some support from that link and there is the possibility that Mr. Buffett and Mr. Weschler decide to purchase the remaining ~60% of DaVita that they do not already own.
It is important to manage one’s expectations, so please keep in mind, we believe that DaVita is a stock that outperforms in a bear market but would lag if the market were to move strongly higher.