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Dialysis Industry Overview
Initiating Coverage on the Dialysis Industry
We are initiating coverage of the dialysis providers DaVita (NYSE: DVA; $48.10;
Outperform, Above Average Risk; $58.00 price target) and Fresenius Medical Care (NYSE:
FMS; $45.71; Outperform, Above Average Risk; $59.00 price target). Our call on the dialysis
industry is three-pronged: 1) safe haven – we believe the industry is a safe haven due to
virtually no utilization risk and the stable recurring business and cash flows; 2) disease
management efforts could lead to enhanced, long-term opportunities; and 3) growth – while
the U.S. market is at a fairly steady state, we believe the providers are looking for new growth
opportunities either by increasing the overall service offering or in new markets.
Steady, Stable Demand Provides Comfort During A Challenging Time
We believe the dialysis industry could present a longer-term, safe investment opportunity due
to no utilization risk, stable reimbursement, and recurring cash flows. Industry fundamentals
are solid and demand continues to grow due to the increased incidence of diabetes and
hypertension in the U.S. The dialysis rate environment remains stable and future changes
should prove to be longer-term positives, in our opinion.
MSP Extension Would Be Good, But Difficult To Handicap
Although Medicare is the largest payor in the U.S. for dialysis services, reimbursement is a
very low margin business or a loss leader for providers. As the providers search for ways to
enhance their opportunities with the government, an extension to the Medicare Secondary
Payor (MSP) provision would lower costs to the government and increase the profitability of
the providers as commercial rates are approximately three times higher than Medicare. While
an MSP extension has been discussed in the past, it is difficult to predict.
Reimbursement Changes Should Be Long-Term Positive
While there might be some uncertainty regarding the Medicare reimbursement change to a
bundled payment for dialysis services, we believe dialysis providers will benefit from
mandatory annual inflationary rate increases starting in 2012. Furthermore, as the government
explores the use of quality incentive payments, we believe Fresenius and DaVita should
benefit as their patient outcomes typically exceed the benchmark thresholds.
Negotiations With Managed Care Remains Challenging
Consolidation in the managed care industry and among the dialysis providers continues to fuel
the negotiations battle for rate increases. Since healthcare is delivered in the local markets, we
believe the concentrated market share that Fresenius and DaVita command cannot be
overlooked since they care for approximately 65% of U.S. dialysis patients.
Looking For Additional Opportunities And Avenues Of Growth
We believe dialysis providers are searching for ways to enhance their revenue opportunity as
the U.S. market has reached somewhat of a steady state of growth. We believe providers are
looking at a few opportunities, including 1) international expansion, 2) providing more
comprehensive care, and 3) new treatment options. Based on the Medicare demonstration
programs, we believe the industry is shifting toward a comprehensive disease management
offering with more services provided to dialysis patients, which could help improve the quality
of care and reduce costs over time. Providers could also explore new and improved treatment
options, such as home hemodialysis, nocturnal dialysis, and portable dialysis, which would
help drive future growth and possibly lead to lower costs.
Table of Contents
Industry Outlook............................................................................................................................3
Industry Thesis.................................................................................................................................3
Why We Like The Dialysis Business ...............................................................................................3
Risks and Concerns..........................................................................................................................4
Dialysis Primer...............................................................................................................................4
Clinical Overview .............................................................................................................................4
ESRD Characteristics.......................................................................................................................5
ESRD Treatment..............................................................................................................................9
Kidney Transplant..........................................................................................................................14
Regulation......................................................................................................................................15
Dialysis Treatment Guidelines........................................................................................................16
Reimbursement Overview............................................................................................................17
Medicare ........................................................................................................................................17
The Competitive Landscape.........................................................................................................20
Key Dialysis Participants................................................................................................................22
Company Profiles.........................................................................................................................23
DaVita, Inc. – It Takes A Village To Care For Dialysis Patients ...................................................24
Fresenius Medical Care AG & Co. – Leading Global Provider of Dialysis Services .....................41
Required Disclosures ....................................................................................................................65
Additional Disclosures....................................................................................................................68
Industry Outlook
Industry Thesis
We have initiated coverage of the dialysis industry with an Outperform, Above Average risk
rating on DaVita (NYSE: DVA) and an Outperform, Above Average risk rating on Fresenius
Medical Care (NYSE: FMS). We believe that the dialysis industry represents an attractive nearterm
and long-term investment opportunity, due to its steady, predictable growth, limited
competition, and attractive returns on invested capital. While acquisition growth opportunities in
the U.S. are somewhat limited, we believe DaVita and Fresenius will continue to open de novo
centers relatively in-line with industry growth and also look for new and ancillary ways to enhance
their revenue opportunities.
Diabetes and obesity are the two leading comorbidities associated with CKD, which leads to endstage
renal disease (also know as established chronic kidney disease). The Centers for Disease
Control (CDC) estimates that there are currently 24 million people in the U.S. who have diabetes.
This number is expected to reach 48 million by 2050 and has grown at a compounded annual
growth rate (CAGR) of 4.3% since 1980. Additionally, approximately 34% of American adults are
obese. The prospect for a growing end-stage renal disease (ESRD) patient population, sadly, looks
promising.
International opportunities abound with ESRD patients in many developing countries lacking the
necessary access to tools for diagnosis and treatment.
Approximately 70% of ESRD patients and 98% of new ESRD patients require dialysis. Barring
any major breakthrough in the treatment of ESRD, we believe the dialysis industry will continue
to reap the benefits of an over-weight and unhealthy population that continues to age.
Why We Like The Dialysis Business
• The dialysis market is large and still growing. The U.S. market for dialysis services is
approximately $18.5 billion. We believe it will grow approximately 4-5% over the next several
years due to the aging population and the increasing incidence of diabetes and hypertension,
two of the leading causes of kidney failure. According to the CDC, the incidence rate of
diabetes has grown at a 4.3% compounded annual growth rate (CAGR) since 1980.
• Defensive business with no utilization risk and limited alternative treatment options. Because
ESRD is a chronic, incurable condition and the number of suitable kidneys available for
transplant is limited, patients have no alternative but dialysis. Additionally, kidney transplant is
not a viable option for many patients because they are typically too old or too sick to withstand
surgery.
• The dialysis business is stable and predictable. Patients typically receive treatment at the same
center throughout their course of treatment and stay on a consistent, routine schedule. This
enables the providers to be highly efficient with center costs such as staffing and supply costs.
• While the U.S. market has been consolidated over the last few years through a few large
transactions, we believe there are still internal and external growth opportunities. Since
approximately 75% of dialysis patients receive treatment at centers owned by corporate chain
providers, we estimate roughly 50% of the remaining 25% could be potential acquisition
targets, which represents an acquisition opportunity of approximately 45,700 patients and $2.3
billion of annualized revenue.
• Competition is relatively stable. Since Medicare is the primary payor for dialysis services, there
is less competition based on price compared to other sub-segments in health care. Nationally,
the market is controlled by a few national providers and these providers also control the lion’s
hare in local markets. We believe Fresenius and DaVita have competitive advantages relative to
smaller providers, due to scale, access to capital, and quality outcomes.
• Changing the Medicare reimbursement system should be a longer-term positive. As Medicare
reimbursement for dialysis services transitions to a bundled payment in 2011, providers will
receive mandated annual inflationary rate increases beginning in 2012. In the past, providers
have sometimes received partial rate increases and in some years there were no rate increases.
Despite some uncertainty regarding the amount of the bundled payment in 2011, we view the
annual market basket increases starting in 2012 as a long-term positive that the industry has
fought hard for over the years.
• International markets provide opportunity for future expansion. Since the U.S. market is fairly
concentrated with steady, but limited growth opportunities, we believe the providers could be
targeting expansion in some developing countries where the incidence and prevalence of
diabetes and hypertension is relatively high.
Risks and Concerns
• Managed care consolidation. Commercial payor consolidation could create challenges in the
negotiation for rate increases.
• Rising unemployment could negatively impact the number of patients with commercial
insurance. Commercial reimbursement for dialysis services is typically three times higher than
Medicare rates. While higher unemployment and fewer patients with commercial insurance
could lead to margin pressure, COBRA benefits should be a decent backstop until Medicare
picks up coverage. If patients run out of employer-sponsored benefits before they are eligible
for Medicare, there are a number of renal charities set up to ensure patients have coverage.
While we think the economic environment is more challenging than past cycles, dialysis
providers historically have not experienced margin pressure from an adverse payor mix-shift.
• State budget deficits could pressure Medicaid rates. Roughly 4% of dialysis revenue is derived
from Medicaid reimbursement.
• Government investigations regarding dialysis pharmaceuticals and laboratory services. Over
the last several years, the federal government has investigated the dialysis providers regarding
the billing and utilization of renal pharmaceuticals, including Epogen. In late 2008, DaVita was
notified of a forthcoming civil inquiry from the Department of Justice and the U.S. Attorney’s
Office for the Northern District of Georgia regarding the administration of iron and vitamin D
pharmaceuticals. We believe these investigations a) increase the risk profile of the industry, b)
create a distraction for management, and c) lead to higher legal costs.
• Changes to the reimbursement landscape create some uncertainties. As Medicare shifts to a
bundled reimbursement system in 2011, we believe there is some uncertainty regarding what
will be included in the bundled payment and how much the payment will be.
• U.S. growth opportunities are relatively limited as approximately 65% of the industry is
controlled by Fresenius and DaVita. While there are limited acquisition opportunities in the
U.S., we believe increased market share will benefit FMS and DVA in negotiations with
commercial payors and have made both companies relevant entities in dealing with the
government.
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