DVA

Business Context and Reporting Period

Company: DaVita Inc.
Filing Type: Form 10-K
Period Ended: December 31, 2004
Business Overview: DaVita is a leading provider of dialysis services for patients with end-stage renal disease (ESRD) in the United States. As of December 31, 2004, the company operated or provided administrative services to approximately 660 outpatient dialysis centers in 37 states and the District of Columbia, serving approximately 54,000 patients. The company also provides acute inpatient dialysis services in approximately 370 hospitals. Approximately 96% of revenues are derived from direct dialysis services.

Key Financial Metrics

Operational Metrics:

• Dialysis Treatments: 7,062,424 (10.8% increase from 2003).
• Average Revenue Per Treatment: $312 (up from $303 in 2003).
• Number of Centers: 658 at year-end (624 consolidated).

Material Changes Versus Prior Period

• Revenue Growth: Net operating revenues increased 14% to $2.30 billion, driven by a 10.8% increase in treatment volume and a 3% increase in average revenue per treatment. Approximately 40% of growth was attributed to new centers and 60% to increased treatments at existing centers.
• Profitability: Operating income increased 8% to $410 million. Net income increased 26% to $222 million, aided by a lower effective tax rate (38.6% vs. 39.0% in 2003) and reduced debt expense.
• Acquisitions: The company acquired 51 dialysis centers in 2004, including Physicians Dialysis, Inc. (PDI), for approximately $150 million. Total acquisition costs were $265 million (net of divestitures).
• Debt Structure: Long-term debt increased by approximately $205 million due to the addition of a $250 million Term Loan C to fund acquisitions and share repurchases, partially offset by debt repayments.
• Share Repurchases: The company repurchased 3.35 million shares for $96.5 million in 2004. The Board authorized an additional $200 million for repurchases in November 2004.

Guidance, Outlook, Risks, and Unusual Items

Outlook and Guidance

Management targets 2005 operating income to be between 2% and 6% higher than 2004 levels, excluding the effects of the pending Gambro Healthcare acquisition and the expensing of stock options under FASB No. 123R. The company expects the Gambro acquisition to be dilutive to earnings per share in the first year post-closing, neutral in the second year, and accretive thereafter.

Major Acquisition: Gambro Healthcare

On December 6, 2004, DaVita agreed to acquire Gambro Healthcare, Inc. for approximately $3.05 billion in cash. The transaction is expected to increase revenues by more than 80% based on 2004 levels. Completion is subject to antitrust review (Hart-Scott-Rodino Act); the FTC issued a "second request" for additional information on February 18, 2005, extending the waiting period. The company may be required to divest certain centers to obtain clearance.

Regulatory and Legal Risks

• Government Inquiries: The company is cooperating with two ongoing investigations by U.S. Attorney's Offices (Eastern District of New York and Eastern District of Pennsylvania) regarding billing practices, laboratory services, and financial relationships with physicians. No proceedings have been initiated, but penalties could be substantial if wrongdoing is found.
• Medicare Reimbursement: Effective January 1, 2005, changes to the Medicare ESRD program (MMA) resulted in a net reduction in reimbursement rates for pharmaceuticals that more than offset a 1.6% increase in the composite rate. A case-mix adjustment methodology is planned for April 1, 2005.
• Pharmaceutical Dependency: Approximately 40% of dialysis revenue is associated with physician-prescribed pharmaceuticals, primarily EPO, supplied by a single manufacturer (Amgen). The introduction of Amgen's new product, Aranesp, could reduce EPO usage and margins.

Unusual Items

Medicare Lab Recoveries: The company recognized $8.3 million in recoveries related to prior years' services from its Florida-based laboratory in 2004, following a favorable administrative law judge decision. Less than $4 million in disputed billings remain unresolved.

Investor Verification Checklist

• Gambro Acquisition Status: Monitor the outcome of the FTC antitrust review and potential divestiture requirements.
• Regulatory Investigations: Track developments in the U.S. Attorney's Office inquiries regarding billing and physician relationships.
• Medicare Rate Impact: Assess the actual financial impact of the 2005 Medicare reimbursement changes and the April 2005 case-mix adjustment.
• Pharmaceutical Costs: Verify pricing stability for EPO and monitor the adoption rate of Aranesp.
• Debt Servicing: Review the company's ability to service increased debt levels associated with the Gambro acquisition financing.