TEXT-S&P rates DaVita proposed term loans BB-
Overview -- Standard & Poor's Ratings Services expects Denver-based dialysis provider DaVita Inc. to pay $3.66 billion in cash, financed with new debt, and to issue 9.38 million new common shares for Torrance, Calif.-based HealthCare Partners LLC (HCP; BBB-/Watch Neg/--). -- We are lowering our ratings on DaVita's senior secured debt to 'BB-' from 'BB' and removing the ratings from CreditWatch, because the size of this debt class will increase substantially relative to our estimate of the enterprise's value in the event of default. -- We are assigning our 'BB-' credit rating and '3' recovery rating to DaVita's proposed $1,350 million term loan A-3 due 2017 and $1,650 million term loan B-2 due 2019. -- The rating outlook is stable. Although the acquisition will raise DaVita's lease-adjusted debt to about 4.5x pro forma EBITDA, we expect adjusted debt leverage to return to the 3.5x to 4.0x range, where leverage is today. Rating Action On July 27, 2012, Standard & Poor's Ratings Services affirmed its 'BB-' corporate credit rating on Denver-based DaVita Inc. The rating outlook is stable. We lowered our rating on DaVita's senior secured debt to 'BB-', the same as the corporate credit rating, from 'BB', and removed it from CreditWatch, where it was placed with negative implications on May 22, 2012, following the acquisition announcement. We lowered the rating because the size of this debt class will increase substantially relative to our estimate of the enterprise's value in the event of default. We revised our recovery rating on this debt to '3', indicating our expectation for meaningful (30% to 50%) recovery of principal in the event of payment default, from '2', indicating an expectation for substantial (70% to 90%) recovery. We assigned our 'BB-' credit rating, the same as the corporate credit rating, to DaVita's proposed $1,350 million term loan A-3 due 2017 and $1,650 million term loan B-2 due 2019. We assigned our '3' recovery rating to this debt, indicating our expectation for meaningful (30% to 50%) recovery of principal in the event of payment default. We affirmed our 'B' rating, two notches below the corporate credit rating, on DaVita's senior unsecured debt. We affirmed our '6' recovery rating on this debt, indicating our expectation for negligible (0 to 10%) recovery of principal in the event of payment default. Rationale The rating on Denver-based DaVita Inc. reflects its "aggressive" financial risk profile (according to our criteria), distinguished by robust discretionary cash flow, which will enable fairly rapid deleveraging following its acquisition of HCP. We estimate pro forma adjusted debt to EBITDA is about 4.5x, compared with DaVita's actual adjusted leverage of 3.7x as of March 31, 2012. Our adjustments include the capitalization of operating leases; we add stock compensation to EBITDA; and we deduct net income attributable to noncontrolling interests (NCIs) from EBITDA when measuring leverage. We believe DaVita's acquisition of HCP does not alter its "fair" business risk profile because DaVita will remain substantially dependent on the treatment of a single disease and its exposure to potential adverse changes in reimbursement may be compounded by the addition of HCP to its business portfolio. Its fair business risk profile also recognizes positive attributes of the dialysis sector, such as steady demand from patients with end-stage renal disease for essential dialysis treatments. Both the dialysis and HCP businesses benefit from favorable demographic trends and relatively low investment requirements. We expect DaVita's revenues to grow about 25% in 2012, assuming one quarter of HCP results and incorporating DaVita's September 2011 acquisition of DSI Renal Inc. We expect revenues of both the dialysis and managed care businesses to grow at a mid-single-digit annual rate over the medium term. We expect treatment growth at DaVita's existing centers to slightly exceed the 3.5% to 4.0% annual growth in total U.S. dialysis patients, with incremental revenue growth coming from newly opened and acquired clinics. Although we expect DaVita's EBITDA margin to decline about 150 basis points over the next two years, from the unusually strong 20.8% posted in 2011, we expect it to continue generating substantial discretionary cash flow (DCF). This is a key credit factor. Payor mix is also an important credit consideration for U.S. dialysis service companies, contributing to our fair business risk assessment. Medicare does not fully reimburse dialysis providers for treatment cost, and government programs (mainly Medicare and Medicare Advantage) pay for about 90% of the treatments DaVita provides. DaVita loses money on each Medicare treatment. Thus, the percent of treatments that commercial insurers cover, the commercial insurers' pricing, and efficient management practices are important. In recent years, DaVita has experienced some erosion in the percent of revenue from private payors, most likely because of high unemployment and improved patient mortality (commercial insurance does not cover more than 33 months of treatments). Moreover DaVita has experienced downward pressure on its realized payment rates from commercial payors. In 2011, commercial insurers accounted for 34% of DaVita's dialysis revenue, down from 35% in 2008, but only 11% of 2011 treatments were covered by commercial payors (10% in the first quarter of 2012). We expect commercial payors will continue to be very aggressive in their negotiations with dialysis-service providers. Medicare reimbursement also presents challenges. We believe changes in the years ahead likely will trim DaVita's profit margins, compared to the levels in recent quarters. As proposed, in 2014, oral drugs will be added to the bundled reimbursement rate for services and injected pharmaceuticals, which could place further pressure on DaVita's profitability. We believe increases in Medicare's base reimbursement rate (2.1% in 2012 and 2.5% in 2013) over the medium term may not cover DaVita's cost increases. Moreover, the 2011 Budget Control Act will result in a 2% across-the-board cut (sequestration) in Medicare reimbursement in 2013 unless the law is amended. Although this rate cut is not in our base-case scenario, we estimate it could reduce DaVita's 2013 revenue and EBITDA by about $140 million (including the potential effect on HCP). We believe Medicare's Quality Incentive Program will have a modest negative effect on DaVita. As of March 31, 2012, DaVita served approximately 145,000 patients through a network of more than 1,800 outpatient centers and 950 hospitals. Similar to some other health care firms with a "fair" business risk profile, DaVita has a strong position in a relatively narrow business with considerable risks. DaVita and Fresenius SE & Co. KGaA (BB+/Watch Neg/--), with U.S. dialysis market share of about 33% and 36%, respectively, are by far the leading players. The remainder of the market is fairly fragmented, although consolidation is occurring. DaVita's size and geographic diversity give it advantages over smaller competitors because it can more easily undertake increased spending for information technology infrastructure and it has leverage to negotiate with large commercial payors and suppliers. DaVita and Fresenius have had similar returns on capital. Fresenius also has an aggressive financial risk profile, but we view Fresenius' business risk more favorably because it is substantially more diverse, both geographically and in the range of services and products it offers. We believe HCP's Medicare Advantage business, which accounted for 67% of its 2011 revenue and a significantly larger portion of profits, is likely to be hurt as Medicare implements rate parity for managed care and fee-for-service care. This contributes to our assessment of its business risk profile. More rapid expansion under DaVita's ownership also creates risks. HCP's revenue from managed care is heavily concentrated in southern California with other operations in Las Vegas and parts of Florida. Its lack of geographic diversity exposes it to changes in the economic and competitive environment in those narrow markets and Medicaid reimbursement risks in those states. These business vulnerabilities are mitigated by HCP's superior operating efficiency, evidenced by a good track record of profitability and enrollment retention. Our base-case forecast indicates DaVita's return on capital will slip to 11% to 12% following the HCP acquisition, from 14.4% for the 12 months ended March 31, 2012. We believe both the dialysis and managed care businesses are likely to be hurt by government and private efforts to restrain health care costs, probably more in 2014 than 2013. We expect reimbursement pressure to depress profit margins. Yet, we recognize DaVita's demonstrated ability to manage its costs, integrate dialysis acquisitions, and adapt to evolving third-party reimbursement. We expect adjusted leverage to decline from the 4.5x pro forma level to below 4.0x within 2 to 3 years, as a result of EBITDA growth and scheduled debt amortization. Over time, we expect DaVita's adjusted leverage to average about 4.0x, consistent with an aggressive financial risk profile, and it may temporarily exceed 4.0x for acquisitions and/or share repurchases. We project the adjusted funds from operations (FFO) to debt ratio to be in the 15% to 20% range. Liquidity DaVita's liquidity is "adequate," underpinned by its consistent and substantial generation of discretionary cash flow (DCF) after distributions to NCIs, but recognizing that about $3.7 billion of incremental borrowing will be required to finance its acquisition of HCP. DaVita's internally generated funds easily finance capital expenditures and modest working capital requirements, and we expect HCP to continue generating DCF. We assume HCP will use its own cash to repay all of its debt when it is acquired, and DaVita will curtail share repurchases during the remainder of 2012. Our view of DaVita's liquidity profile incorporates the following assumptions and expectations: -- We expect sources of liquidity to exceed uses by more than 2.0x over the next 12-24 months. For 2013 (including a full year of HCP), we expect funds from operations of about $1.4 billion, capital spending of about $400 million, and modest, if any, working capital requirements. -- We assume DaVita will pay $275 million of contingent consideration for HCP in 2012 and 2013. -- We expect that net sources would be positive, even with an unlikely 15% drop in EBITDA. -- As of March 31, 2012, DaVita had $449 million of cash and $298 million of funds available from a $350 million revolving credit facility, after deducting $52 million committed for letters of credit. DaVita is establishing a $500 million receivables-backed credit facility that will provide additional liquidity. -- Beginning in 2013, we assume DaVita will spend about $400 million per year on acquisitions, or alternatively stock repurchases. We expect it to acquire both dialysis centers and managed care operations. -- We assume the financial covenants in its credit agreement will be amended as proposed, providing adequate headroom following the HCP acquisition. Recovery analysis For the complete recovery analysis, please see our recovery report on DaVita, to be published following this report on RatingsDirect. Outlook Our outlook on DaVita is stable. We expect operating trends of the combined companies will be sustained near current levels, allowing for some deleveraging in 2013. We believe DaVita will continue to generate strong cash flow from its position as a market leader in the dialysis service sector, and it is well-placed relative to others to respond to the evolving reimbursement environment. We believe DaVita will continue to execute substantial acquisitions that will average about $400 million annually. If DaVita makes larger-than-expected debt-financed acquisitions or stock repurchases, or takes other shareholder-friendly actions such that leverage climbed above 5x, we could lower our ratings. Debt-financed stock repurchases of about $1.0 billion, in addition to the HCP financing, would boost adjusted leverage above 5.0x, based on pro forma EBITDA for the 12 months ended March 31, 2012. Although not likely, we could also lower our ratings if adverse trends, possibly attributable to payor mix, reimbursements, regulatory-based developments or unexpected problems at HCP weaken DaVita's business risk profile and reduce its EBITDA margin 300 basis points more than we expect. Over the medium term, if we are convinced that DaVita will choose to direct cash to debt reduction, leading to lease-adjusted debt to EBITDA averaging about 3.5x on a sustained basis, we could raise our ratings on DaVita. Related Criteria And Research -- Credit FAQ: How Standard & Poor's Evaluates U.S. Health Care Service Companies That Invest In Joint Ventures, Oct. 20, 2011 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 Ratings List DaVita Inc. Rating Affirmed Corporate Credit Rating BB-/Stable/-- Rating Assigned $1,350 mil. term loan A-3 due 2017 BB- Recovery Rating 3 $1,650 mil. term loan B-2 due 2019 BB- Recovery Rating 3 Downgraded; CreditWatch Action To From Senior secured debt BB- BB/Watch Neg Recovery Rating 3 2
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