DaVita Steady at Neutral

We have reiterated our Neutral recommendation on DaVita Inc. ( DVA - Analyst Report ) based on strong top-line growth in the third quarter of 2011, which was partially offset by higher operating expenses.

The company reported third-quarter operating earnings of $1.45 per share, exceeding the Zacks Consensus Estimate by a penny as well as $1.15 per share earned in the comparable quarter of 2010.

DaVita has been generating strong operating cash flow, which increased at a 4-year CAGR (2007–2010) of 13.1%. Higher-than-expected cash flow during the first three quarters of 2011 also allowed the company to raise the 2011 operating cash flow guidance to $1.02–1.10 billion from $900–980 million.

Additionally, DaVita has been following the strategy of growth through acquisitions. Acquisition of dialysis centers and businesses that own and operate dialysis centers, as well as other ancillary services and strategic initiatives have been the company’s preferred business strategy for years.

Pursuant to the strategy, in November 2011, the company announced the acquisition of ExtraCorp, a German company that owns two dialysis centers and manages two others. Further, in September 2011, DaVita completed the acquisition of rival company DSI Renal Inc. (DSI).

Moreover, during the first nine months of 2011, DaVita acquired and opened a total of 198 dialysis centers (including 113 centers associated with the DSI acquisition), sold one center, closed four centers and divested 28 centers (as a condition for the DSI acquisition).

Additionally, the company is slowly moving into the international market. DaVita’s strong worldwide reputation provides competitive advantage to the company in terms of global acquisitions.

However, a significant portion of DaVita’s dialysis and related lab services revenues are generated from patients who have commercial payors as the primary payor. Moreover, high unemployment may result in shifting of people from commercial insurance schemes to government schemes due to the wide disparity in payment rates.

In fact, the mix of treatments reimbursed by non-government payors, as a percentage of total treatments, has been falling consistently over the years. The shift in payor mix will be additionally harmful as the Medicaid rate has been reduced by many states in 2011 and many states are considering the possibility of reducing the rate.

Also, there is a high chance of Medicare rates being reduced by up to 2% in 2013, which is expected to put additional pressure on the company as almost 87% of DaVita’s patients already use Medicare or Medicaid programs. Thus, inadequacy of government reimbursements will substantially affect the company’s profitability.

Additionally, the company has high financial leverage and depends upon future borrowings for growth and to fund other liquidity needs. The financial leverage has further increased with the $100 million increase in revolving credit facility and $200 million by way of term loan taken in August 2011.

Currently, the Zacks Consensus Estimate for DaVita’s fourth-quarter earnings is $1.48 per share, up about 31% year over year. None of the 13 firms covering the stock have revised their estimates in the last 30 days.

For 2011, earnings are expected to be about $5.05 per share, climbing about 15% year-over-year. The company competes with Gentiva Health Services Inc. ( GTIV - Analyst Report ) and HealthSouth Corporation ( HLS - Snapshot Report ) .

Currently, DaVita caries a Zacks #2 Rank, implying a short-term Buy rating.