AI And Clinical Platform Spending Will Depress Margins Before Long Term Kidney Care Benefits Emerge

Catalysts

About DaVita

DaVita provides kidney care services, including dialysis and value based care programs for patients with chronic and end stage kidney disease.

What are the underlying business or industry changes driving this perspective?

• DaVita is investing in its next generation clinical platform and AI tools that could eventually support lower patient care costs. However, the company is currently absorbing higher G&A and IT spending, which may limit any near term improvement in operating margins and earnings.
• Broad kidney disease prevalence and an aging population can support long term demand for dialysis. At the same time, recent headwinds such as severe flu, a hurricane and a cyber incident highlight how sensitive treatment volume and admissions are to external shocks, which can pressure revenue growth and scale benefits.
• DaVita Clinical Research is working on middle molecule clearance and other therapies that could support better outcomes and potentially longer time on therapy. However, the company expects these clinical processes to take roughly three years to show results, which delays any possible uplift to treatment volume, revenue and net margins.
• Value based care through Integrated Kidney Care may provide an additional income stream over time. Management also notes that program timing and payer data are hard to predict, which creates ongoing volatility in the recognition of IKC operating income and earnings.
• Ongoing work in revenue operations, including automation and AI to improve collections, can support revenue per treatment and operating income. Management also points out that payer mix and items like premium tax credits and Medicare Advantage enrollment remain uncertain, which can offset improvements in revenue per treatment and overall profitability.

Assumptions

This narrative explores a more pessimistic perspective on DaVita compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming DaVita's revenue will grow by 4.8% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 5.8% today to 5.2% in 3 years time.
• The bearish analysts expect earnings to reach $803.0 million (and earnings per share of $13.63) by about January 2029, up from $771.9 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $1.1 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 11.3x on those 2029 earnings, up from 10.2x today. This future PE is lower than the current PE for the US Healthcare industry at 22.9x.
• The bearish analysts expect the number of shares outstanding to decline by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.19%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Persistent pressure on treatment volumes, including the recent 1.5% year over year decline in U.S. treatments per day and elevated missed treatment rates, could indicate a weaker long term growth base for the core dialysis business. This would weigh on revenue and operating income.
• Ongoing shifts in payer mix, including uncertainty around Medicare Advantage enrollment and potential changes to enhanced premium tax credits on exchanges, could reduce the share of higher paying commercial patients. This would lower revenue per treatment and net margins.
• Large, multi year IT and AI investments that are currently lifting G&A and patient care costs may take longer than expected to translate into cost efficiencies. This would keep operating expenses elevated and limit growth in earnings and free cash flow.
• The Integrated Kidney Care business is still loss making, with an adjusted operating loss of US$21 million in the quarter and timing of government and payer settlements that remains unpredictable. Prolonged or wider losses here could offset profitability from the core dialysis segment and limit earnings growth.
• Secular clinical initiatives, such as work on middle molecule clearance and models to reduce hospitalizations, aim to improve mortality and time on therapy but are expected to take several years to show results. If these efforts do not materially improve long term patient retention, the company may not see the hoped for lift in treatment volume, revenue and net margins.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for DaVita is $126.0, which represents up to two standard deviations below the consensus price target of $143.0. This valuation is based on what can be assumed as the expectations of DaVita's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $186.0, and the most bearish reporting a price target of just $126.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $15.3 billion, earnings will come to $803.0 million, and it would be trading on a PE ratio of 11.3x, assuming you use a discount rate of 8.2%.
  
• Given the current share price of $111.01, the analyst price target of $126.0 is 11.9% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.