Healthcare Reform's Impact on DaVita's Dialysis Profits

Although DaVita (DVA-$52.38), posted solid second-quarter financial results, chief financial officer Rich Whitney admitted to analysts on the earnings call that Medicare composite rate adjustment provided for in 2009 and 2010 would not be sufficient to compensate for anticipated increases in forward operating costs subject to inflation, such as labor and pharmaceutical supplies. Whitney opined that the dialysis provider would likely continue the trend of steady growth and consistent cash flow going forward, but the 10Q Detective believes that operating profitability could tumble if the defined scope of new MediCare bundling rules, scheduled to be implemented in 2011, limit coverage for higher-cost cases and cap the utilization of prescribed erythropoiesis-stimulating agents (ESAs), such as Amgen’s Epogen (for end-stage renal disease (ESRD) patients with anemia).

Highlights of Business Operations

For the three-months ended June 30, DaVita said second-quarter revenue rose 8 percent year-on-year to $1.5 billion, driven principally by additional treatment days and average revenue per treatment (helped along by a one-percent increase in the Medicare composite rate), and gains in prescribed pharmaceuticals and average selling prices of drug reimbursement rates. The gains were partially offset by higher procurement costs for heparin and a seasonal decline in lab testing.

Operating income increased year-on-year by 8 percent to $236 million, due to an increase in average dialysis revenue per treatment, improved labor productivity, and lower operating costs of dialysis centers (due to the timing of certain expenses previously recorded in the first quarter of 2009).

Cash flow from operations during the quarter was $212 million, up from $147 million last year. The main contributors to this increase were the gain in net income and positive working capital changes (such as comparable declines in accounts receivables and inventories).

Implications of Medicare Bundling Rate Changes

DaVita generates approximately 65 percent of its sales from Medicare patients, but nearly all of its profits are derived from the 35 percent of its patients who have commercial health insurance, as rates from private insurers have historically paid on terms that are significantly higher than government programs (the average Medicare composite rate was $157 per treatment in 2008). Even lucrative payments from these private insurers, however, are unlikely to offset cuts expected in payment rates under the Medicare ESRD program, according to the second-quarter 2009 regulatory 10-Q filing:

In July 2008, the Medicare Improvements for Patients and Providers Act for 2008 was passed by Congress. This legislation provides for an increase in the composite rate of 1% in 2009 and in 2010. In addition this legislation introduces a new payment system for dialysis services beginning in January 2011 whereby ESRD payments will be made under a “bundled” payment rate which will provide for a fixed rate for all goods and services provided during the dialysis treatment, including laboratory services and the administration of pharmaceuticals. The initial 2011 bundled rate will be set 2% below the payment rate that providers would have received under the historical fee for service payment methodology. Beginning in 2012, a new single bundled payment base rate will be adjusted annually for inflation based upon a market basket index, less 1% of such index.

The two-percent reimbursement cut will reduce Medicare revenues by an estimated $60 million, according to Whitney. As DaVita operates principally as a dialysis and related lab services business, the company does not have the ability to quickly offset the hit to revenues. What the company can do, however, is continue to focus on cost-control initiatives, such as increased use of cheaper drugs where possible. For example, a generic alternative to Watson Pharmaceuticals’ Ferrlecit, an intravenous iron-supplement for the treatment of iron deficiency anemia in hemodialysis patients receiving supplemental epoetin therapy, is expected to enter the market later this year. Ferrlecit currently has about 30 percent of the $660 million U.S. IV iron-replacement therapy market, according to IMS Health, a pharmaceutical market researcher.

Prior to bundling, use of branded iron was a benefit, for the company was reimbursed at average selling price plus six-percent. Come 2011, a bundling system that includes one payment for treatment plus drug use likely motivates DaVita to extract margin gains through clinical outcome efficiencies. For example, several studies suggest regular IV iron-supplementation can reduce the total amount of the more expensive EPO needed by patients. Avoiding the high cost of EPO therapy is not without its own set of risks for DaVita, however, as Epogen currently accounts for approximately 20 percent of dialysis and related lab services revenues.

Analysts estimate that 60 percent of the 345,000 U.S. dialysis patients with ESRD now dialyze at either DaVita or its larger rival, Fresenius. This stronghold on the dialysis market, however, means little when it is the U.S. government that ultimately controls pricing power.

Editor David J Phillips does not hold a financial interest in any stocks mentioned n this article. The 10Q Detective has a Full Disclosure Policy.