Shares of the two largest kidney care companies in the United States, DaVita HealthCare Partners Inc (NYSE:DVA) and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS), recently plunged after the U.S. Medicare system proposed to reduce payments for dialysis services by 9.4% in 2014. This reduction, which would reduce payment per treatment from $240.36 in 2013 to $216.95 in 2014, was much steeper than Wall Street’s prior expectations for a 4% to 5% reduction.
On July 2, DaVita HealthCare Partners Inc (NYSE:DVA) and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) slid 5.9% and 9.6% respectively, as investors panicked about the future growth of both companies. Should contrarian investors take this opportunity to pick up shares of these two companies, or are lower prices on the horizon?
A new epidemic
Diabetes is a major epidemic in the United States, currently affecting 12% of 45-64 year-olds and 19% of seniors over 65. 95% of American diabetes cases are classified as Type 2, which can be treated with dialysis. Dialysis has been shown to reduce patients’ dependence on insulin, and is a necessary treatment to prevent kidney failure. As seen in the following chart, diabetes cases have increased dramatically starting in the mid-1990s.
Diabetes is apparently rising at an unstoppable rate in the United States. Many physicians have blamed rising obesity trends, unhealthy diets and sedentary lifestyles across the country for causing this spike.
A tale of two market leaders
DaVita HealthCare Partners Inc (NYSE:DVA) currently controls 33% of the U.S. dialysis market, while Fresenius controls 37%. DaVita HealthCare Partners Inc (NYSE:DVA), which is based in Denver, Colorado, expects a rise in diabetes cases to increase its clinic visits by 4% annually, providing it with a steady cash flow. Analysts are Morningstar are even more optimistic, believing that its dialysis services unit will grow 7.3% annually. DaVita HealthCare Partners Inc (NYSE:DVA) plans to use this cash to steadily grow overseas, and to expand its rapidly growing physician group manager, Healthcare Partners.
Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS), on the other hand, is based in Bad Homburg, Germany, and is the world’s largest dialysis service company. It is the dialysis care segment of health care conglomerate Fresenius Group. Fresenius Medical Care was formed in 1996 from a merger between Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) Worldwide Dialysis and the American company National Medical Care. The company offers kidney dialysis services and renal care products.
Fundamentals first
Before we discuss the challenges facing these two companies, we should take a look at their fundamental growth patterns.
| 5-year PEG Ratio | Trailing P/E | Price to Sales (ttm) | Debt to Equity | Profit Margin | Qty. Revenue Growth (y-o-y) | Qty. Earnings Growth (y-o-y) | |
| DaVita Healthcare Partners | 1.21 | 26.93 | 1.32 | 186.79 | 4.65% | 53.00% | -78.50% |
| Fresenius Medical Care | 1.55 | 19.00 | 1.38 | 81.41 | 7.29% | 6.40% | -39.10% |
| Advantage | DaVita | Fresenius | DaVita | Fresenius | Fresenius | DaVita | Fresenius |
Source: Yahoo Finance, 7/4/2013
Based on their PEG and P/E ratios, the market is pricing in fairly robust growth over the next five years. Both companies are better at growing their top lines than their bottom lines, which shouldn’t cause major concern since earnings growth at both companies is fairly cyclical, as seen in the following chart.
For now, investors should focus on revenue growth at both companies. DaVita HealthCare Partners Inc (NYSE:DVA)’s robust revenue growth last quarter was attributed to a higher number of operational centers, higher revenue per treatment, better cost controls, and an improved mix of commercial and Medicare businesses, according to analyst Matthew Borsch at Goldman Sachs. Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) also cited many of the same strengths last quarter, but its revenue growth was throttled by weaker growth in Europe, the Middle East and Africa.
The billion dollar problem
That brings us to the major problem that DaVita and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) investors now face – Medicare’s proposed 9.4% reduction in dialysis payments for 2014. Reducing those payments would impact 90% of DaVita HealthCare Partners Inc (NYSE:DVA)’s patients, which account for 66% of its revenue. DaVita is also more exposed to the cut, since its business is almost entirely domestic, in contrast to Fresenius, which has operations spanning the entire globe.
