DVA

DaVita Inc. 2006 Annual Report (10-K) Summary

Business Context and Reporting Period

Company: DaVita Inc.
Reporting Period: Fiscal year ended December 31, 2006.
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, 2006, the company operated or provided administrative services to approximately 1,300 outpatient dialysis centers in 42 states and the District of Columbia, serving approximately 103,000 patients. The company also provides acute inpatient dialysis services in approximately 770 hospitals.
Key Event: In October 2005, DaVita completed the acquisition of DVA Renal Healthcare, Inc. for approximately $3.06 billion, significantly expanding its footprint. The results of DVA Renal Healthcare are included in the financial statements from October 1, 2005.

Key Financial Metrics

Note: Revenue growth was primarily driven by the DVA Renal Healthcare acquisition. Operating margins declined slightly due to higher labor costs, integration expenses, and the adoption of SFAS No. 123(R) for stock-based compensation.

Material Changes vs. Prior Period

• Revenue Growth: Net operating revenues increased 64% to $4.88 billion, driven by a 60.3% increase in treatment volume. Approximately 51.5% of this volume growth was attributable to the DVA Renal Healthcare acquisition.
• Profitability: Operating income increased 59% to $739.4 million. However, the operating margin decreased from 15.6% in 2005 to 15.2% in 2006 (excluding one-time items, the margin declined from 15.5% to 14.4%).
• Cost Structure: Patient care costs rose to 69.5% of revenues (from 68.5% in 2005) due to higher labor rates, benefit costs, and increased pharmaceutical intensities. General and administrative expenses increased to 9.3% of revenues due to legal/compliance fees and integration costs.
• Debt Reduction: Long-term debt decreased by approximately $355 million due to principal prepayments on term loans totaling $400 million during the year.
• Valuation Gain: The company recorded a non-cash valuation gain of approximately $38 million resulting from the amendment of its Alliance and Product Supply Agreement with Gambro Renal Products, which reduced purchase obligations.

Guidance, Outlook, and Risks

2007 Outlook: Management estimates 2007 operating income to be in the range of $700 million to $760 million. The company expects to generate operating cash flow between $440 million and $510 million. Capital expenditures are projected at $310 million to $340 million ($110-$120 million for maintenance and $200-$220 million for growth).

Key Risks and Contingencies:

• Government Investigations: The company is cooperating with multiple U.S. Attorney inquiries (Eastern District of Missouri, Eastern District of New York, and Eastern District of Texas) regarding billing practices, pharmaceutical administration (EPO), and relationships with physicians. While no proceedings have been initiated, negative findings could result in substantial penalties or exclusion from Medicare/Medicaid.
• Regulatory Environment: Significant reliance on government payors (87% of patients, 65% of revenue) exposes the company to risks of payment rate reductions, changes in reimbursement structures, and regulatory scrutiny under the Anti-Kickback Statute and Stark Law.
• Pharmaceutical Costs: Approximately 30% of dialysis revenue is associated with pharmaceuticals, primarily EPO. Changes in physician practice patterns, the introduction of alternative drugs (e.g., Aranesp), or pricing changes by the sole supplier (Amgen) could materially impact margins.
• Commercial Payor Mix: A decline in the percentage of patients with higher-paying commercial insurance as they transition to Medicare could reduce average revenue per treatment.

Investor Verification Checklist

• Regulatory Status: Monitor the status of ongoing U.S. Attorney investigations and the DVA Renal Healthcare Corporate Integrity Agreement compliance.
• Reimbursement Rates: Verify the impact of the 1.6% Medicare rate increase effective April 1, 2007, and any potential bundling of pharmaceutical payments.
• Commercial Mix: Track the ratio of commercial to government patients to assess revenue per treatment stability.
• Debt Service: Review the company's ability to service its substantial debt load ($3.73 billion long-term) amidst rising interest rates and potential refinancing needs.
• Integration Progress: Assess the successful integration of DVA Renal Healthcare's billing and clinical systems to ensure collection performance remains stable.