DVA

DaVita Inc. Q1 2006 10-Q Summary

Business Context and Reporting Period

This Form 10-Q covers the three-month period ended March 31, 2006. DaVita Inc. is a large accelerated filer providing dialysis services. The reporting period includes the full impact of the DVA Renal Healthcare acquisition (completed October 2005) and the first quarter of implementation for FAS 123(R) regarding stock-based compensation. The company divested three centers in January 2006 to satisfy FTC consent order requirements related to the DVA acquisition.

Key Financial Metrics

Margins: Operating margin was approximately 13.9% in Q1 2006 compared to 17.1% in Q1 2005. Patient care costs represented 70% of revenues in Q1 2006.

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 101% year-over-year, primarily driven by the inclusion of DVA Renal Healthcare. Organic treatment volume grew approximately 6.0%, and revenue per treatment increased due to Medicare rate adjustments effective January 1, 2006.
• Expense Increases: Patient care costs rose due to higher labor, benefit, and pharmaceutical costs. General and administrative expenses increased due to the DVA acquisition, integration costs, and the adoption of FAS 123(R), which added approximately $4.6 million in incremental stock-based compensation expense.
• Cash Flow Volatility: Operating cash flow turned negative ($23.6 million used) compared to a positive $111.4 million in Q1 2005. This was primarily due to an $85 million income tax payment related to divestitures and $116 million in cash interest payments.
• Debt Reduction: The company made principal prepayments of $90 million ($53 million on Term Loan A and $37 million on Term Loan B) during the quarter.

Guidance, Outlook, and Risks

Outlook: Management targets 2006 operating income in the range of $600 million to $680 million, reflecting the impact of FAS 123(R). The company projects operating cash flow for 2006 between $350 million and $420 million (excluding tax benefits from stock option exercises). Capital expenditure guidance is $125-$135 million for maintenance/IT and $130-$150 million for new center development and acquisitions.

Management Commentary: The company achieved a 0.25% reduction in interest rate margins on its credit facility due to improved financial ratios. The effective weighted average interest rate on the credit facility was 6.29% as of March 31, 2006.

Risks and Contingencies:

• Legal Proceedings: The company is cooperating with multiple U.S. Attorney investigations (Missouri, New York, Pennsylvania) regarding billing practices, physician relationships, and pharmaceutical administration. No proceedings have been initiated, but potential penalties could be substantial.
• Regulatory Risk: Changes in Medicare/Medicaid payment structures, specifically regarding EPO (Erythropoietin) coverage and the shift to average sale price plus 6% for pharmaceuticals, pose revenue risks.
• Integration Risk: Successful integration of DVA Renal Healthcare is critical; failure to realize cost synergies or manage turnover could adversely affect results.

Investor Verification Checklist

• Verify the status of ongoing U.S. Attorney investigations and potential financial exposure from subpoenas.
• Monitor the impact of the new CMS EPO payment coverage policy effective April 1, 2006, on pharmaceutical revenue margins.
• Assess the sustainability of operating cash flow given the significant tax payments and interest obligations in Q1.
• Review the progress of DVA Renal Healthcare integration and the realization of projected cost savings.
• Confirm the company's ability to maintain commercial payer rates, which represent approximately 35% of revenues and are subject to downward pressure.