Adult Swim Trade – $DVA, a Berkshire Hathaway Darling

by Enis December 4, 2013 10:58 am • Commentary

One of the best investment blog posts that I’ve read in all of 2013 was a post by Brooklyn Investor a few weeks ago related to DaVita.  Brooklyn is a well-versed value investor of the Warren Buffett school, and his full discussion of DaVita’s merits and risks is a great education in thinking like a value investor.

DaVita, along with Fresenius, is one of the largest operators of dialysis centers in the U.S.  It operates around 2,000 facilities serving more than 150,000 patients.  It is a $12 billion market cap company, and its largest shareholder is Berkshire Hathaway, with 16.5% ownership of the company.

The stock was off to a strong start in 2013 until mid-summer.  The Centers for Medicare and Medicaid Services (CMS) proposed a 9.4% cut to Medicare reimbursement for kidney dialysis on July 2nd, sending the stock down 6%.  On November 22nd after the close, the CMS announced that it had delayed the cuts for 2 years, and DVA stock bounced almost 9% on trading on November 25th.

So that’s the back story.  Brooklyn insightfully asks the important questions:

I looked at this before when Buffett hired Weschler (and everyone started dissecting his hedge fund holdings) and I didn’t think much of it.  I thought, “different strokes for different folks”.   I’ve looked at dialysis center stocks before and remembered their stocks tanking on Medicare payment cuts (or threats).  The common view (ever since at least the late 1990s) was that this is a business that can be destroyed by a single stroke of the pen in Washington DC.  Why invest in a business that an irrational congress can blow up so easily?

I still held this view when I looked at DVA recently.  But this recent purchase made me scratch my head so I decided to dig a little deeper to see what’s going on here.  Weschler is not a reckless gambler/risk-taker.  He is a very rational investor.  So whatever he is doing, he is certainly not betting on the outcome of the impact of the ATRA 2012 (see excerpt below on the American Taxpater Relief Act of 2012), Affordable Care Act and many other factors (you can read a bunch of risk factors in their 10-Qs and 10-Ks).

Ted Weschler is one of Buffett’s recently hired lieutenants, along with Todd Combs.  Weschler has obvious conviction in this investment, enough that he actually owns 1% of DaVita through his own money, in addition to the Berkshire investment.

So what’s the general thought process, if the secular trend is likely towards lower payments for the entire dialysis industry?  Once again, Brooklyn:

After the crisis, people wondered why Buffett kept investing in banks; isn’t the golden age of banking over?  Won’t new regulations and lower leverage make banking a low return business?  Won’t the return on equity of banks going forward be really low?  With interest spreads shrinking, how will banks make money?  Won’t Wells Fargo, one of the biggest, be the hurt most from these trends?

Buffett’s response was simple.  He said that in any industry, the one with the lowest cost wins.   No matter what happens in the economy, if you have the lowest cost, you will win.  This is true in any industry.

His point was that all of these negative trends will hurt all banks equally, but if you have the lowest cost, it will hurt you the least.  The high cost players will be run out of business, and the lowest cost player can probably pick up market share.  This is how it has always been in any industry.

So, getting back to DVA.  DVA is staring at some serious issues going into 2014.  But the key point here is that this is an issue that will face all dialysis (and other healthcare) providers.  Drastic payment reductions will put many small operators out of business.   DVA seems to be a very efficient operator (high margins) with very good patient outcomes (various metrics are disclosed every year in the annual report).

Without going into too much detail, I think we can assume that DVA is one of the most efficient operators out there.

In other words, Berkshire expects DVA to be one of the last men standing when the pain of lower reimbursements works its way through the entire industry.  In the meantime, it might increase market share to make up for the reduced reimbursements, or at least that’s the thesis.

Given Berkshire and Ted Weschler’s conviction and track record, and the strong free cash flow/historical management performance of DaVita, I’d rather be on their side on this name in the future.  This is the type of situation though, where I would rather prefer an options structure than outright long stock.  

DVA has traded between 52 and 66 for the past year:

[caption id="attachment_33281" align="alignnone" width="600"]DVA daily chart, Courtesy of Bloomberg DVA daily chart, Courtesy of Bloomberg[/caption]

I view the 50 to 52.5 area as a strong floor given the current valuation and the aforementioned investor base.  But I also see a move above 65-66 as low probability over the next 6 months given the high comparables after a strong 2013 and the continuing uncertainty over reimbursement rates after 2015.  With that in mind, here’s a structure I’m considering as opposed to buying the stock:

Adult Swim Trade Structure: DVA ($57.84) Sell 1 Apr 52.5 Put to Buy 1 Apr 60/65 Call Spread for $0.15 Debit

-Sell 1 Apr 52.5 Put at 1.35

-Buy 1 Apr 60/65 Call Spread for 1.50

Break-Even on Apr Expiration:

Profits: Between 60.15 and 65, make up to 4.85, with max profit of 4.85 at 65 or above

Losses:  Lose up to 0.15 between 60 and 60.15.  Lose 0.15 between 52.5 and 60.  Put 100 shares of stock at 52.5, losses 1 for 1 with stock below there

Trade Rationale:  DVA is only up 5% in 2013, despite earnings growth of 25% year-over-year, as investors look forward to a less inviting future for the sector.  However, those lowered expectations could be a boon for the stock to start 2014.  Rather than buy the stock though, which is in the middle of its 12 month range, we like the idea above as a way to participate in most of the upside to the top of the range, while only taking the long stock risk at the bottom of the range.