TEXT-S&P rates DaVita proposed term loans BB-

Fri Jul 27, 2012 3:32pm EDT

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