DVA

Business Context and Reporting Period

Company: DaVita Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2007
Business Overview: DaVita is a leading provider of dialysis services in the United States for patients with end-stage renal disease (ESRD). As of December 31, 2007, the company operated or provided administrative services to 1,359 outpatient dialysis centers in 43 states and the District of Columbia, serving approximately 107,000 patients. Dialysis and related services accounted for approximately 97% of total net revenues. The remaining 3% derived from ancillary services including infusion therapy, pharmacy, vascular access, and disease management.

Key Financial Metrics

Revenue Composition: 64% of dialysis revenue came from government-based programs (Medicare/Medicaid), while 36% came from commercial payors. Commercial payors generate nearly all of the company's profits, as Medicare rates are insufficient to cover the average cost of treatment.

Material Changes vs. Prior Period

• Revenue Growth: Net operating revenues increased 8% year-over-year, driven by a 5.7% increase in treatment volume and a 3% increase in average revenue per treatment.
• Profitability: Operating income increased 17% to $862 million. Operating margins expanded to 16.4% from 15.2%, aided by a $55 million valuation gain on the Alliance and Product Supply Agreement (due to the termination of purchase obligations for dialysis machines affected by an FDA import ban) and lower benefit costs.
• Debt Reduction: The company made principal prepayments of $450 million on its term loans in 2007, funded partly by the issuance of $400 million in new senior notes. Total long-term debt decreased slightly.
• Center Growth: The network grew by a net 59 centers (16 acquired, 64 developed, 6 closed/divested).

Guidance, Outlook, and Risks

2008 Guidance: Management projects 2008 operating income to be in the range of $790 million to $850 million, excluding the impact of potential Medicare legislation. Management noted that operating income is more likely to be in the lower end of this range due to "unusual earnings uncertainty."

Key Risks and Contingencies:

• Commercial Rate Pressure: In Q4 2007, commercial rate reductions exceeded increases. Continued downward pressure on commercial rates poses a significant risk to profitability.
• Government Scrutiny: The company is subject to multiple ongoing investigations by the U.S. Attorney's Offices (Missouri, New York, Texas) and the Office of Inspector General regarding EPO utilization, billing practices, and physician relationships. Negative findings could result in substantial penalties or exclusion from Medicare/Medicaid.
• EPO Reimbursement: Changes in CMS reimbursement methodologies for EPO (Epogen) and increased scrutiny of anemia management practices have reduced revenue per treatment and may continue to do so.
• Regulatory Compliance: The company operates under a Corporate Integrity Agreement (CIA) for centers acquired from Gambro Healthcare, requiring strict compliance and independent audits.

Investor Verification Checklist

• Commercial Payor Mix: Verify the trend of commercial vs. government patient mix, as commercial rates drive profitability while government rates are fixed and often below cost.
• EPO Utilization Trends: Monitor physician prescribing habits for EPO and the impact of new CMS monitoring policies on revenue per treatment.
• Legal Proceedings: Track the status of ongoing federal investigations (Missouri, New York, Texas) regarding billing and EPO administration for potential financial penalties.
• Debt Covenants: Review compliance with financial covenants in the Senior Secured Credit Facilities, specifically the leverage ratio and interest coverage ratio.
• Valuation Gains: Assess the sustainability of earnings given the one-time $55 million valuation gain recorded in 2007 related to the Gambro supply agreement.