DaVita Upgraded to Outperform

We have upgraded our recommendation on DaVita HealthCare Partners Inc. ( DVA - Analyst Report ) to Outperform from Neutral based on the expected growth in its future cash flows and the recent merger with HealthCare Partners. The company’s sturdy balance sheet provides opportunities for meaningful mergers and acquisitions. Consequently, DaVita is rapidly expanding its international presence and actively acquiring domestic companies.

DaVita reported third-quarter 2012 operating earnings of $1.50 per share, lagging the Zacks Consensus Estimate of $1.55. Nevertheless, operating earnings were substantially higher than $1.45 per share reported in the prior-year quarter.

DaVita has been generating strong operating cash flow accruing from improved earnings, robust cash collections and the timing of payments for working capital expenditures. Substantial growth is expected in future as well, as reflected by the operating cash flow guidance of $0.95–$1.05 billion for 2012 and $1.35–$1.50 billion for 2013.

The strong cash flows allow DaVita to fund its capital expenditure, repurchase shares and spend on acquisitions. During the first nine months of 2012, the company acquired 71 dialysis centers, opened 48 centers and merged or sold 8 centers in the U.S., while 10 centers were acquired or opened outside the U.S.

Additionally, DaVita acquired and merged with HealthCare Partners in November 2012. The company also acquired ModernMed, purchased a controlling interest in a Saudi Arabian kidney care company – Lehbi Care – and increased its stake in NephroLife, an India-based kidney care company, so far in 2012.

Further, the company announced a joint venture with 3SBio Inc. ( SSRX - Snapshot Report ) , a China-based biotechnology company, in March 2012, which is expected to be beneficial for DaVita as the Chinese market provides ample scope for growth.

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. Almost 34% of the company’s revenues from dialysis and related lab services came from such patients in 2011 and the first nine months of 2012.

High unemployment and wide disparity in payment rates is resulting in the shifting of people from commercial insurance schemes to government schemes. Consequently, the mix of treatments reimbursed by non-government payors, as a percentage of total treatments, has been falling consistently over the years.

Moreover, DaVita’s debt refinancing continues to keep financial leverage at elevated levels. The company issued senior notes in August 2012 to finance the acquisition of HealthCare Partners, apart from using its free cash balance and senior secured credit facility.

This is expected to increase DaVita’s interest by $57.5 million annually, which will weigh on its already high expenses. The issuance will also increase the company’s total debt, thereby deteriorating its financial leverage.

Nevertheless, the positive factors outweigh the negatives, raising our expectations for growth in the upcoming quarters. DaVita currently carries a Zacks #3 Rank (short-term Hold).