Profitable Niche
Once you look at the business, it is not hard to understand why Ted Weschler — one of two managers hand-picked by Warren Buffett to invest Berkshire’s cash — has owned the company since 2001. He first built a position at his hedge fund, Peninsula Capital, and rebuilt the position at Berkshire Hathaway Inc. (NYSE:BRK.B) when Buffett gave him the job.
The dialysis market is dominated by DaVita and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) — the two combine for a 70% market share in the United States. However, the rest of the market is highly fragmented. This gives the two largest companies an enormous advantage in economies of scale.
Investors will appreciate just how important economies of scale are when they look at the gross margins in comparison to operating margins.
DaVita’s gross margins are pretty low compared to many other industries. However, its operating margin is surprisingly high — over 15% in most years. Fresenius’ margins are similar to DaVita’s.
It’s hard to imagine smaller competitors earning a 15% operating margin considering they are unable to spread out fixed costs to the extent DaVita HealthCare Partners Inc (NYSE:DVA) and Fresenius can. In fact, the two companies could squeeze out all other competitors simply by lowering prices to absurd levels for a few years.
This market dominance enables the two companies to earn stable margins because profitability is only destabilized by fierce competition (and volatile demand).
Slow, Predictable Growth
Demand for dialysis services has grown at 4% per annum over the last decade. With an aging population and rising rates of diabetes and obesity, it is likely that the industry will continue to grow at least this quickly over the next decade.
While the industry grew at 4% per year, DaVita’s sales have grown at 16.7% per year over the last 10 years. Clearly, the company has gained significant market share over this time.
Fresenius’ sales growth was not far behind DaVita’s, coming in at 10.7% per year since 2002.
Both companies produce a healthy amount of free cash flow. DaVita averaged an 8% free cash flow margin over the last 10 years, whereas Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) averaged a 6.75% free cash flow margin.
If you apply historical free cash flow margins to both companies’ current revenues, you get a “normal” free cash flow yield of 5.54% for DaVita and 4.56% for Fresenius.
After you add in 4% annual sales growth for both companies — far below their historical sales growth rates and assumes they do not gain any additional market share — then investors in DaVita HealthCare Partners Inc (NYSE:DVA) will receive a 9.54% annual return and investors in Fresenius will receive an 8.56% annual return.
These are “pretty good” estimates of what the two companies’ stocks will return for investors who buy in today. The returns could easily be higher if the two companies gain market share, but changes in Medicare payments can also derail the investment.
Either way, an 8% to 9.5% annual return is likely to beat the market over the next decade.
International Competition
Besides changes to Medicare, the biggest threat to DaVita and Fresenius is international competition. Neither firm has a foothold in non-U.S. markets, but DaVita seems keen on investing overseas anyway. Free cash flow does shareholders no good if it is re-invested in unprofitable operations, so it is important to evaluate the company’s likelihood of success overseas.
Baxter International Inc. (NYSE:BAX)
Final Thoughts
DaVita and Fresenius operate in a niche industry that is expected to continue growing as the American diet continues to wreak havoc on the health of U.S. citizens. Both companies have a competitive advantage in the form of economies of scale and profit from a virtual duopoly.
So it’s not hard to see why Ted Weschler is crazy about DaVita HealthCare Partners Inc (NYSE:DVA). DaVita is not especially cheap right now, thought it should provide above-market returns over the next 10 years. Both DaVita and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) are good choices to round out a diversified portfolio — but neither will be a home run at current levels.
The article Ted Weschler’s Favorite Health Care Company originally appeared on Fool.com and is written by Ted Cooper.
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