DVA

Business Context and Reporting Period

Company: DaVita Inc.
Filing Type: Form 10-Q (Unaudited)
Period Ended: September 30, 2008
Business Overview: DaVita operates principally as a dialysis and related lab services business, supplemented by ancillary services including infusion therapy, pharmacy, vascular access, and special needs plans. The company is a large accelerated filer with approximately 103.8 million shares of common stock outstanding as of October 31, 2008.

Key Financial Metrics

Margins (Nine Months 2008):
- Operating Margin: 14.5%
- Net Profit Margin: 6.6%

Material Changes vs. Prior Period

• Revenue Growth: Net operating revenues increased 9.8% for the three months and 7.4% for the nine months ended September 30, 2008, compared to the same periods in 2007. This was driven primarily by a 6.2% increase in the number of dialysis treatments and growth in ancillary services (pharmacy and VillageHealth special needs plans).
• Operating Income Decline: Consolidated operating income decreased 2.1% for the three months and 8.5% for the nine months compared to 2007. The 2007 period included a $55 million non-recurring valuation gain on a product supply agreement and a $7 million Hurricane Katrina insurance settlement. Excluding these items, adjusted operating income for the nine months increased by approximately $5 million.
• Expense Increases: Patient care costs per treatment increased due to higher labor rates, lower productivity, pharmaceutical cost increases, and the impact of Hurricanes Gustav and Ike. General and administrative expenses rose due to higher labor and benefit costs.
• Debt Expense: Debt expense decreased by $25.6 million for the nine months ended September 30, 2008, compared to 2007, primarily due to lower LIBOR-based variable interest rates and the absence of $4.4 million in deferred financing cost write-offs recorded in 2007.

Guidance, Outlook, and Risks

Management Guidance

• 2008 Operating Income: Expected to be near the middle of the previously provided range of $800 million to $840 million.
• 2008 Operating Cash Flow: Expected to generate approximately $480 million to $530 million.
• 2009 Operating Income: Guidance remains unchanged at a range of $820 million to $880 million.
• Capital Expenditures: Expected to spend $110 million to $120 million on routine maintenance/IT and $300 million to $350 million on new center development, relocations, and acquisitions in 2008.

Key Risks and Contingencies

• Government Investigations: The company is subject to multiple ongoing civil and criminal investigations by the U.S. Attorney's Offices (Missouri, New York, Georgia) and the Office of Inspector General regarding EPO utilization, billing practices, and relationships with physicians. Negative findings could result in substantial penalties or exclusion from Medicare/Medicaid.
• Regulatory Changes: The Medicare Improvements for Patients and Providers Act of 2008 introduces a bundled payment system for dialysis starting in 2011, which may reduce reimbursement rates. Additionally, downward pressure on commercial payor rates poses a risk to profitability.
• Supply Chain: A recall of heparin by Baxter Healthcare has left only one supplier for this critical drug, significantly increasing costs with no separate Medicare reimbursement.
• Legal Proceedings: Various class action lawsuits and arbitration demands exist regarding billing practices and labor code violations.

Investor Verification Checklist

• Revenue Quality: Verify the sustainability of the 6.2% treatment growth rate given the impact of hurricanes and potential commercial payor rate reductions.
• Regulatory Exposure: Assess the potential financial impact of ongoing government investigations into EPO billing and physician relationships, specifically the risk of exclusion from federal programs.
• Cost Pressures: Monitor the trajectory of heparin costs and labor expenses, which are rising faster than reimbursement rates in some segments.
• Debt Servicing: Confirm the company's ability to service approximately $3.7 billion in debt, particularly given the variable rate exposure on roughly $1.1 billion of that debt.
• Guidance Adherence: Track quarterly results against the $800-$840 million operating income guidance for 2008 to ensure the "middle of the range" target is achievable.