Debt Strategy Seems Sound As Dialysis Firm Recovers

Corporate Focus
by Anthony Palazzo

Davita Inc., the Torrance-based operator of kidney-dialysis centers, was once a broken company. Its return to financial health, underscored by its current Dutch tender offer to buy back as much as $600 million of its stock, proves that with a change of management, anything's possible.

As recently as March 2000, shares of Davita fell as low as $2.06 each. The company, then called Total Renal Care Holdings, was going through severe growing pains. Its acquisition of another competitor, called Renal Treatment Centers, had doubled the size of the company overnight, and the previous management team botched the integration.

"Their back-office infrastructure essentially collapsed under the weight of the company," said Andreas Dirnagl, a Gerard Klauer Mattison analyst who was following the company at the time. "They literally couldn't send out bills on time, their collections process fell apart it was a pretty dire circumstance."

There was hope, but investors weren't yet convinced that a turnaround was under way. In October 1999, a new management team arrived, headed by Chairman and Chief Executive Kent Thiry, and proceeded to clean house. "They spent a whole lot of time and investment in systems and people to fix that back office," Dirnagl said.

The company recovered, and now it's generating strong cash flows. It's the second-largest operator of kidney dialysis centers in the country, one of four firms that dominate a majority of the market. The stock, meanwhile, is trading at a recent price of $24.90. A $10,000 investment in Davita made at its lowest closing price, on March 23, 2000, is now worth more than $97,000; the same $10,000 invested in JDS Uniphase, to name one of the many high fliers of the time, would today be worth less than $450.

"Thiry has really done an excellent job of turning Davita around," Dirnagl said.

Giving back to shareholders

Even more exceptional than the comeback is what Davita's management plans to do next. They've taken the rare step of acknowledging that their cash flow would be better used in returning money to shareholders, via the buybacks, than pursuing new income streams.

"Our current assessment of industry growth prospects suggests that we will have more cash flow and debt capacity than high-return investment opportunities," Thiry said in a March 21 statement on the buyback.

Davita has announced it will buy back up to 24 million of its common shares, for between $20 and $25 each. Under the Dutch auction process, shareholders indicate the lowest price they will accept in the range. The company will pay the lowest price it can to buy back a block of up to 24 million. All selling shareholders will receive the same price. If it buys all 24 million shares at $25 each, the buyback will cost Davita about $600 million.

Davita is also buying back about $225 million of high-yield 9 & #378; percent notes. The company will use bank debt to finance all of this, paying an interest rate of about 5.5 percent.

Taking on more debt

The move does have its risks. Davita will carry more debt coming out of this than it did before, perhaps $1.5 billion compared with just over $800 million. So if the company runs into problems down the road, the debt load may be a hindrance. (A competitor, Renal Care Group, has a similar financial profile, but is holding onto its cash.)

Nevertheless, said Jefferies & Co. analyst Andrew May, "I think it's the right move." The major players have consolidated much of the dialysis market, he said, so opportunities to buy more centers come up only occasionally.

At the same time, payment flows from the federal government, through Medicare, and from private payers such as health insurers, are pretty reliable. With reliable income streams, high levels of debt are reasonable. "There's definitely more risk in having that much more financial leverage, but I think it's a prudent use of the balance sheet" to increase shareholder returns, May said.

By using bank debt, Davita has created a more flexible financial structure, said Dirnagl. It can use its cash flow Davita will generate about $375 million in earnings before interest, taxes, depreciation and amortization in 2002, he estimates to pay down debt without penalties, or it can hold onto the cash for potential acquisitions when the time is right.

Davita just hired an acquisitions vice president, but the lead time on these kinds of deals is 6 to 12 months at a minimum. In the meantime, by shrinking the equity base, Davita can add up to 7 cents a share to quarterly earnings.

"Davita has been out of the acquisitions market now for a number of years, but while you certainly want to get back into it, you want to prime the pump first," Dirnagl said.



Financial Editor Anthony Palazzo can be reached at 323-549-5225, ext. 224, or at tpalazzo@labusinessjournal.com.

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