DaVita (NYSE:TWO) increased by more than 40% after the crater on fears linked to Ozempic. Additional comments that GLP-1s could erode DaVita’s business have remained nonexistent since, proving once again that Mr. Market can be a pretty irrational man.
However, the future is very uncertain. Investors must be prepared for a wide variety of challenges and possible existential threats when investing for the long term. DaVita’s management team gave the best possible answer during its November 7 earnings call. Any impact of GLP-1 would go well beyond a reasonable time horizon:
This thesis relies on many uncertainties within a progressive disease, but the one area where we may have clarity is in timing. In this population, progression to end-stage renal disease typically lasts 15 to 20 years or more. Suffice it to say that this scenario goes beyond the horizon of our strategic plan. –DaVita Third Quarter Earnings Call
DaVita’s Chief Medical Officer reviewed its findings and hypotheses related to the impact of GLP-1. First, GLP-1s have been available since 2005, and across studies on GLP-1s and kidney disease, 40% showed no effect, 40% showed some improvement, and 20% were mixed. .
Currently, 5 to 8% of CKD patients take GLP-1, DaVita estimates that this rate could reach 30%, knowing that the discontinuation rate of GLP-1 is approximately 65%. Right off the bat, 30% of people with CKD are not eligible for GLP-1s, from there DaVita assumes 40% of eligible people will end up on GLP-1s. They then estimate that disease progression will slow by 25%, based on the 40% of studies that have shown effectiveness in delaying kidney disease.
DaVita CEO Javier Rodriguez translated what these results might look like in terms of impact on business results, and it’s tiny. DaVita estimates that approximately 700 commercial patients, those who would begin receiving dialysis between ages 62.5 and 65, would now delay progression to dialysis until after age 65, when Medicare coverage takes effect. Medicare revenue is not profitable for DaVita compared to commercial insurance.
As expected, the market reacted very quickly to the fact that dialysis is likely to stay. For shareholders lucky enough to benefit from the recent outperformance, it’s important to take stock. While winners usually prove to be sound advice, it’s good to view stocks with fresh eyes after valuation fluctuations.
Third quarter results
Once again, DaVita is a very simple company that has a substantial market share and provides a life-sustaining service. DaVita reported strong third-quarter results, achieving FCF of more than $1 billion for the full year, following a period of cost pressure.
DaVita’s FCF has historically been volatile. With a base cost of $10 billion, a few points of margin in one direction makes a significant difference in profitability. Although capital intensive, DaVita’s revenues are not cyclical, but profitability has been:
DaVita could reach an inflection towards a smoother FCF curve in the future, with cost inflation well behind. Management reduced costs by increasing the use of contract labor, switching to Mircera for anemia management, and consolidating its footprint.
It appears that DaVita is on track toward stronger profit growth thanks to cost reductions. Beyond the evidence that higher profits improve shareholder value, more consistent cash flows should inspire more confidence among investors who have witnessed a volatile stock price over the past decade. This is a risk though, given DaVita’s history, an unstable FCF can make optically cheap multiples seem more expensive very quickly.
Furthermore, management indicated that it would actually start repurchasing shares after reducing the leverage ratio and seizing the opportunity presented by Mr. Market during the sale of Ozempic:
As a result, and after reviewing our usual set of capital allocation principles, including our view of intrinsic value relative to the current market price of our shares, we intend to resume purchasing shares this trimester.
Great management teams know that buybacks are most profitable when done at prices below intrinsic value. The window of time that DaVita was trading lower quickly closed, but here’s hoping that management was able to trim the stock while the sun was shining.
The rally has increased DaVita’s FCF multiple from 7x to 9.5x, while the S&P 500 trades closer to 25x. DaVita increased the midpoint of its guidance by $75 million. The only true counterpart to DaVita is Fresenius Medical Care (OTCPK: FSNUY), which has a similar market share in the dialysis field. Fresenius trades at a similar multiple but is much less attractive for two main reasons: DaVita is listed in the United States, so domestic investors are not subject to exchange rate fluctuations, and Fresenius has not been a big repurchaser of actions.
The main concern with GLP-1 was that it would reduce the length of time that dialysis would remain a relevant treatment for chronic kidney disease. With management’s analysis evaluating the impact of GLP-1, it seems even more likely that dialysis will be the primary treatment option for years, if not decades, to come.
When a stock is dirt cheap and the underlying profits are consistent and sustainable, investors just need to own it and wait. Hopefully, DaVita will continue to deploy buybacks wisely while reducing its cost structure. The reason why multiple expansion has significantly reduced the FCF yield from around 14% to 10.5%. But it remains attractive compared to the rest of the market.