UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarter Ended
June 30, 2004
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 1-4034
DAVITA INC.
601 Hawaii Street
El Segundo, California 90245
Telephone number (310) 536-2400
The Registrant has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and has been subject to such filing requirements for the past 90 days.
The Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
As of July 30, 2004, there were approximately 100.5 million shares of the Registrant’s common stock (par value $0.001) outstanding.
INDEX
Item 1.
Item 2.
Item 3.
Item 4.
Risk Factors
Item 6.
Signature
Note: Items 2, 3 and 5 of Part II are omitted because they are not applicable.
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CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(unaudited)
(dollars in thousands, except per share data)
Three months ended
June 30,
Six months ended
Net operating revenues
Operating expenses and charges:
Patient care costs
General and administrative
Depreciation and amortization
Provision for uncollectible accounts
Minority interests and equity income, net
Total operating expenses and charges
Operating income
Debt expense
Other income
Income before income taxes
Income tax expense
Net income
Earnings per share:
Basic
Diluted
Weighted average shares for earnings per share:
STATEMENTS OF COMPREHENSIVE INCOME
Unrealized gain on securities, net of tax of $3,630 and $1,989
Comprehensive income
See notes to condensed consolidated financial statements.
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CONSOLIDATED BALANCE SHEETS
2004
ASSETS
Cash and cash equivalents
Accounts receivable, less allowance of $57,264 and $52,554
Medicare lab recoveries
Inventories
Other current assets
Deferred income taxes
Total current assets
Property and equipment, net
Amortizable intangibles, net
Investments in third-party dialysis businesses
Other long-term assets
Goodwill
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable
Other liabilities
Accrued compensation and benefits
Current portion of long-term debt
Income taxes payable
Total current liabilities
Long-term debt
Other long-term liabilities
Minority interests
Commitments and contingencies
Shareholders’ equity:
Preferred stock ($0.001 par value, 5,000,000 shares authorized; none issued)
Common stock ($0.001 par value, 195,000,000 shares authorized; 134,862,283 and 134,806,204 shares issued)
Additional paid-in capital
Retained earnings
Treasury stock, at cost (34,714,719 and 38,052,028 shares)
Accumulated comprehensive income valuations
Total shareholders’ equity
2
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to cash provided by operating activities:
Stock option expense and tax benefits
(Gain) loss on divestitures
Non-cash debt expense
Equity investment income
Minority interests in income of consolidated subsidiaries
Distributions to minority interests
Changes in operating assets and liabilities, net of effect of acquisitions and divestitures:
Accounts receivable
Other current liabilities
Income taxes
Net cash provided by operating activities
Cash flows from investing activities:
Additions of property and equipment, net
Acquisitions and divestitures, net
Investments in and advances to affiliates, net
Intangible assets
Net cash used in investing activities
Cash flows from financing activities:
Borrowings
Payments on long-term debt
Stock option exercises
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Unless otherwise indicated in this Form 10-Q “the Company”, “we”, “us”, “our” and similar terms refer to DaVita Inc. and its subsidiaries.
The condensed consolidated interim financial statements included in this report are prepared by the Company without audit. In the opinion of management, all adjustments consisting only of normal recurring items necessary for a fair presentation of the results of operations are reflected in these consolidated interim financial statements. All significant intercompany accounts and transactions have been eliminated. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. The most significant estimates and assumptions underlying these financial statements and accompanying notes generally involve revenue recognition and provisions for uncollectible accounts, impairments and valuation adjustments, accounting for income taxes and variable compensation accruals. The results of operations for the six months ended June 30, 2004 are not necessarily indicative of the operating results for the full year. The consolidated interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2003. All share and per share data has been restated to reflect the effects of a stock split during the second quarter of 2004 (see Note 4).
Stock-based compensation
If the Company had adopted the fair value-based compensation expense provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 123 upon the issuance of that standard, net earnings and net earnings per share would have been adjusted to the pro forma amounts indicated below (shares in 000’s):
Pro forma - As if all stock options were expensed
Net income:
As reported
Add: Stock-based employee compensation expense included in reported net income, net of tax
Deduct: Total stock-based employee compensation expense under the fair value-based method, net of tax
Pro forma net income
Pro forma basic earnings per share:
Pro forma net income for basic earnings per share calculation
Weighted average shares outstanding
Vested restricted stock units
Weighted average shares for basic earnings per share calculation
Basic net income per share—Pro forma
Basic net income per share—As reported
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
Pro forma diluted earnings per share:
Debt expense savings, net of tax, from assumed conversion of convertible debt
Pro forma net income for diluted earnings per share calculation
Assumed incremental shares from stock plans
Assumed incremental shares from convertible debt
Weighted average shares for diluted earnings per share calculation
Diluted net income per share—Pro forma
Diluted net income per share—As reported
The reconciliation of the numerators and denominators used to calculate basic and diluted earnings per share is as follows (shares in 000’s):
Basic:
Weighted average shares outstanding during the period
Weighted average shares for basic earnings per share calculations
Basic net income per share
Diluted:
Net income for diluted earnings per share calculations
Weighted average shares for diluted earnings per share calculations
Diluted net income per share
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For the three and six months ended June 30, 2003, the calculation of diluted earnings per share assumes conversion of both the 5 5/8% convertible subordinated notes and the 7% convertible subordinated notes. All convertible subordinated notes were redeemed or converted into shares of the Company’s common stock during the second half of 2003.
Shares associated with stock options that have exercise prices greater than the average market price of shares outstanding during the period were not included in the computation of diluted earnings per share because they were anti-dilutive. These excluded shares were as follows:
Stock option shares not included in computation (shares in 000’s)
Exercise price range of shares not included in computation:
Low
High
Long-term debt was comprised of the following:
December 31,
2003
Term loan A
Term loan B
Capital lease obligations
Acquisition obligations and other notes payable
Less current portion
Scheduled maturities of long-term debt at June 30, 2004 were as follows:
2005
2006
2007
2008
2009
Thereafter
Subsequent to June 30, 2004, the Company amended its existing credit facilities in order to modify certain restricted payment covenants principally for acquisitions and share repurchases and extended the maturity of the Term Loan B until June 30, 2010. The Company also borrowed an additional $250,000 under a new Term Loan C. The new Term Loan C currently bears interest at LIBOR plus 1.75% for an overall effective rate of 3.23%. The aggregate annual principal payments for the amended Term Loan B and the Term Loan C are approximately $56,000 and $11,900 in the first five years of the agreement, and $974,200 and $238,100 in the sixth year, respectively, due no later than June 30, 2010.
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The Company entered into an interest rate swap agreement during 2003, that had the economic effect of fixing the LIBOR-based interest rate at 5.39% based upon a 2.00% margin in effect on June 30, 2004, on an amortizing notional amount of $135,000 of the Term Loan B outstanding debt. The agreement expires in November 2008 and requires quarterly interest payments. As of June 30, 2004, the notional amount of the swap was $135,000 and its fair value was $1,038, resulting in comprehensive income during the second quarter of 2004 of $2,900, net of tax.
In 2004, the Company entered into another interest rate swap agreement that had the economic effect of fixing the LIBOR-based interest rate at 5.08% based upon a 2.00% margin in effect on June 30, 2004, on an additional amortizing notional amount of $135,000 of the Term Loan B outstanding debt. The agreement expires in January 2009 and requires quarterly interest payments. As of June 30, 2004, the notional amount of the swap agreement was $135,000 and its fair value was a $2,547 liability, resulting in comprehensive income during the second quarter of 2004 of $2,780, net of tax.
As a result of these swap agreements, the Company’s effective interest rate on its entire credit facility was 3.93% based upon a 2.00% margin in effect on June 30, 2004.
In May 2004, the Company’s Board of Directors approved a three-for-two stock split of the Company’s common stock in the form of a stock dividend payable on June 15, 2004 to stockholders of record on June 1, 2004. As a result, the outstanding shares of Company common stock increased to 99.8 million shares on June 15, 2004. The Company’s stock began trading on a post-split basis on June 16, 2004. Shares and per share data for all periods presented have been restated to reflect the effects of the stock split.
On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed statement, Share-Based Payment, an amendment of FASB Statements No. 123 and 95, that would require companies to account for stock-based compensation to employees using a fair value method as of the grant date. The proposed statement addresses the accounting for transactions in which a company receives employee services in exchange for equity instruments such as stock options, or liabilities that are based on the fair value of the company’s equity instruments or that may be settled through the issuance of such equity instruments, which includes the accounting for employee stock purchase plans. This proposed statement would eliminate a company’s ability to account for share-based awards to employees under APB Opinion 25, Accounting for Stock Issued to Employees but would not change the accounting for transactions in which a company issues equity instruments for services to non-employees or the accounting for employee stock ownership plans. The proposed statement, if adopted, would be effective for all existing unvested awards and new awards effective January 1, 2005. The Company currently allocates pro forma compensation expense for stock options on a grant-level basis under the provisions of the currently effective SFAS No. 123. The proposed statement would require share-based compensation expense on new awards to be recognized over the individual vesting periods, which would result in an accelerated expense allocation. The Company is in the process of assessing the potential impact of this proposed statement on the Company’s consolidated financial statements.
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The majority of the Company’s revenues are from government programs and may be subject to adjustment as a result of: (1) examination by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to finalize; (2) differing interpretations of government regulations by different fiscal intermediaries or regulatory authorities; (3) differing opinions regarding a patient’s medical diagnosis or the medical necessity of services provided; (4) retroactive applications or interpretations of governmental requirements; and (5) claims for refunds from private payors.
Florida laboratory
The Company’s Florida-based laboratory subsidiary has been under an ongoing third-party carrier review for Medicare reimbursement claims since 1998. Prior to the third quarter 2002, no Medicare payments had been received since May 1998. Following a favorable ruling by an administrative law judge in June 2002 relating to review periods from January 1995 to March 1998, the carrier began releasing funds for lab services provided subsequent to May 2001. During the fourth quarter of 2002, the carrier also released funds related to review periods from April 1998 through May 2001. During the second half of 2002, the carrier paid the Company a total of $68,778, of which $58,778 related to prior years’ services. The carrier’s hearing officer recently rendered partially favorable decisions relating to review periods from April 1998 to May 2000, which resulted in the Company’s recognition of additional recoveries of $24,000 in the fourth quarter of 2003, of which approximately $5,000 had been received previously and the balance of $19,000 was received during the first quarter of 2004. The Company has filed requests for appeal for the remaining unpaid claims with an administrative law judge for approximately $8,000, and with the carrier’s hearing officer for approximately $3,000. Any unfavorable ruling by the carrier’s hearing officer can be appealed to an administrative law judge. The Company cannot be assured of any further recoveries with respect to these claims.
The carrier is also currently conducting a study of the utilization of dialysis-related laboratory services to determine appropriate frequencies for tests and supporting documentation. During the course of the study, the carrier has suspended dialysis laboratory prepayment screens. In its initial findings from the study, the carrier had determined that some of its prior prepayment screens were invalidating appropriate claims. The Company cannot determine what prepayment screens, post-payment review procedures, documentation requirements or other program safeguards the carrier may implement as a result of its study or other developments. The carrier has also informed the Company that any claims that it reimburses during the study period may also be subject to post-payment review and retraction if the reimbursements are later determined to have been inappropriate. Medicare lab revenue for current period services is being recognized based on estimated allowances for future claim denials, and changes in estimated Medicare lab revenue will be recognized based on ongoing denial experience trends.
In November 2001, the Company closed a smaller laboratory that it operated in Minnesota and combined its operations with those of the Florida laboratory. The Medicare carrier for the Minnesota laboratory is conducting a post-payment review of Medicare reimbursement claims for the period January 1996 through December 1999. The scope of the review is similar to the review of our Florida laboratory. The Company responded to the most recent request from the carrier for claims documentation in May 2001. At this time, the Company is unable to determine how long it will take the carrier to complete this review. There is currently no overpayment determination with respect to the Minnesota laboratory. Medicare revenues at the Minnesota laboratory, which was much smaller than the Florida laboratory, were approximately $15,000 for the period under review.
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United States Attorney inquiry
In February 2001, the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted the Company and requested its cooperation in a review of some of the Company’s historical practices, including billing and other operating procedures and its financial relationships with physicians. The Company cooperated in this review and provided the requested records to the United States Attorney’s Office. In May 2002, the Company received a subpoena from the Philadelphia office of the Office of Inspector General of the Department of Health and Human Services, or OIG. The subpoena required an update to the information the Company provided in its response to the February 2001 request, and also sought a wide range of documents relating to pharmaceutical and other ancillary services provided to patients, including laboratory and other diagnostic testing services, as well as documents relating to the Company’s financial relationships with physicians and pharmaceutical companies. The subpoena covers the period from May 1996 to May 2002. The Company has provided the documents requested and continues to cooperate with the United States Attorney’s Office and the OIG in its investigation. This inquiry remains at an early stage. As it proceeds, the government could expand its areas of concern. If a court determines that there has been wrongdoing, the penalties under applicable statutes could be substantial.
Other
In addition to the foregoing, the Company is subject to claims and suits in the ordinary course of business. Management believes that the ultimate resolution of these additional pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
The Company has obligations to purchase the interests of its partners in several joint ventures. These obligations are in the form of put options, exercisable at the third-party owners’ discretion, and require the Company to purchase the partners’ interests at either the appraised fair market value or a predetermined multiple of cash flow or earnings. As of June 30, 2004, the Company’s potential obligations under these put options totaled approximately $67,000, of which approximately $42,000 was exercisable within one year. Additionally, the Company has certain other potential working capital commitments relating to managed and minority-owned centers of approximately $15,000 that could be called in the event of non-performance of the centers over the next five years.
The Company holds mandatorily redeemable instruments in connection with certain consolidated partnerships, consisting of obligations to liquidate the minority partners’ interests in these limited-life entities when they dissolve after terms of ten to fifty years. As of June 30, 2004, such distributions would be valued at less than the related minority interests balances in the consolidated financial statements.
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Forward-looking statements
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These statements involve known and unknown risks and uncertainties, including risks resulting from the regulatory environment in which we operate, economic and market conditions, competitive activities, other business conditions, accounting estimates, and the risk factors set forth in this Form 10-Q. These risks, among others, include those relating to the concentration of profits generated from PPO and private indemnity patients and from the administration of pharmaceuticals, possible reductions in private and government reimbursement rates, changes in pharmaceutical practice patterns or reimbursement policies, the Company’s ability to maintain contracts with physician medical directors and legal compliance risks, such as the ongoing review by the U.S. Attorney’s Office and the HHS Office of Inspector General in Philadelphia. Our actual results may differ materially from results anticipated in our forward-looking statements. We base our forward-looking statements on information currently available to us, and we have no current intention to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.
The following should be read in conjunction with our disclosures and discussions contained in our annual report on Form 10-K for the year ended December 31, 2003.
Results of operations
For the quarter ended June 30, 2004, we experienced no significant changes in our business fundamentals or major risk factors. Our operating results for the second quarter of 2004 compared with the prior sequential quarter and the same quarter of last year were as follows:
Provision for uncollectible accounts, net of recoveries
Minority interest and equity income, net
Dialysis treatments
Average dialysis treatments per treatment day
Average dialysis revenue per dialysis treatment
Net Operating Revenues
Net operating revenue. Net operating revenues increased $62 million, or approximately 13%, compared with the second quarter of 2003. An increase in the number of dialysis treatments accounted for approximately 8% of the increase in revenue and approximately 3% was attributable to increases in the average reimbursement rate per dialysis treatment. The balance of the increase in net operating revenue was due to additional lab and other revenue. The increase in the number of dialysis treatments was principally attributable to non-acquired annual growth rates of approximately 4.5%, and growth through acquisitions. We continue to expect the
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non-acquired growth rate to remain in the range of 3% to 5% throughout 2004. The average dialysis revenue per treatment (excluding lab and clinical research revenues and management fee income) was $312 in the second quarter of 2004 compared with $302 for the second quarter of 2003. The increase in average dialysis revenue per treatment was primarily due to changes in intensity of physician-prescribed pharmaceuticals.
Compared with the first quarter of 2004 net operating revenues for the second quarter of 2004 increased approximately 3%. The increase was primarily due to an increase in the number of dialysis treatments. The increase in the average dialysis revenue per treatment in the second quarter of 2004 was less than $1 per treatment.
Operating Expenses and Charges
Patient care costs. Patient care costs were approximately 68% of net operating revenues in the first and second quarters of 2004, compared to 69% for the second quarter of 2003. On a per-treatment basis, patient care costs were approximately the same as the first quarter of 2004, and increased approximately $7 from the second quarter of 2003. The increase in the second quarter of 2004 compared to the second quarter of 2003 was primarily attributable to labor and pharmaceutical costs, and changes in the intensity of physician-prescribed pharmaceuticals.
General and administrative expenses. General and administrative expenses were approximately 8% of net operating revenues in the first and second quarters of 2004, compared to 9% for the second quarter of 2003. In absolute dollars, general and administrative expenses for the second quarter of 2004 increased by approximately $3 million or 7%. The increase in the second quarter of 2004 as compared to both previous periods was primarily attributable to higher labor and benefit costs, and the timing of certain expenditures.
Provision for uncollectible accounts receivable. The provisions for uncollectible accounts receivable were approximately 1.8% of current period net operating revenues for all periods presented.
Debt expense. Debt expense of $11.3 million in the second quarter of 2004 was approximately the same as the first quarter of 2004, and was $8.2 million lower than the second quarter of 2003. The decrease in the second quarter of 2004 compared to the second quarter of 2003 was due to the lower average interest rates and lower average debt balances. The average effective interest rate for the second quarter of 2004 was 3.8% compared to 5.1% for the second quarter of 2003.
Minority interests and equity income, net. Minority interests net of equity income increased from approximately $3.1 million in the first half of 2003 to $6.2 million in the first half of 2004. This increase reflects an ongoing trend toward a higher percentage of our new centers having minority partners as well as the revenue growth of joint ventures.
Outlook
Outlook. We are currently projecting operating income to be between $385 and $400 million for 2004. Regarding 2005, Centers for Medicare and Medicaid Services (CMS) recently released proposed policy changes with respect to EPO utilization and the 2003 Medicare Modernization Act (MMA) implementation that have the potential to have a materially negative impact on our operating income going forward. Our current assessment, which captures a majority of the likely outcomes, is that operating income could be impacted by $15 to $30 million annually. Taking this uncertainty into account, we currently expect 2005 operating income to be flat to 6% higher than the 2004 level.
These projections and the underlying assumptions involve significant risks and uncertainties, and actual results may vary significantly from these current projections. These risks, among others, include those relating to the concentration of profits generated from PPO and private indemnity patients and from the administration of pharmaceuticals, possible reductions in private and government reimbursement rates, changes in pharmaceutical practice patterns or reimbursement policies, our ability to maintain contracts with our physician medical
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directors, and legal compliance risks such as the ongoing review by the United States Attorney’s Office and the HHS Office of Inspector General in Philadelphia. We undertake no duty to update these projections, whether due to changes in current or expected trends, underlying market conditions, decisions of the United States Attorney’s Office, the Department of Justice or the OIG in any pending or future review of our business, or otherwise.
Liquidity and Capital Resources
Liquidity and capital resources.Cash flow from operations during the second quarter of 2004 amounted to $91 million, compared to $79 million during the second quarter of 2003. Non-operating cash outflows for the second quarter of 2004 included capital asset expenditures of $30 million, including $16 million for new center development, and $15 million for acquisitions (net of divestitures). Non-operating cash outflows for the second quarter of 2003 included capital asset expenditures of $20 million, including $10 million for new center development, and approximately $46 million for acquisitions. During the second quarter of 2004 we acquired a total of 7 dialysis centers and opened 13 new dialysis centers. During the second quarter of 2003 we acquired 11 new dialysis centers and opened 8 new dialysis centers.
Cash flow from operations during the first six months of 2004 amounted to $217 million including after-tax Medicare lab recoveries of $12 million, compared to $159 million during the first six months of 2003. Non-operating cash outflows for the first six months of 2004 included capital asset expenditures of $55 million, including $35 million for new center development, and $32 million for acquisitions (net of divestitures). During the first six months of 2004, we acquired a total of 12 dialysis centers and opened 18 new dialysis centers.
In July 2004, we acquired 10 additional centers for approximately $60 million and entered into a definitive agreement to acquire Physicians Dialysis, Inc. (PDI) for approximately $150 million in cash. The acquisition of PDI, which currently operates 24 centers, is expected to close by the end of the third quarter.
Subsequent to June 30, 2004, we amended our existing credit facilities in order to modify certain restricted payment covenants principally for acquisitions and share repurchases and extended the maturity of the Term Loan B until June 30, 2010. We also borrowed an additional $250 million under a new Term Loan C to fund potential acquisitions and/or share repurchases. The remaining board authorization for share repurchases is currently $145 million. The new Term Loan C currently bears interest at LIBOR plus 1.75% for an overall effective rate of 3.23%. The aggregate annual principal payments for the amended Term Loan B and the Term Loan C are approximately $56 million and $11.9 million in the first five years of the agreement, and $974.2 million and $238.1 million in the sixth year, respectively, due no later than June 30, 2010.
We have two interest rate swap agreements on our Term Loan B outstanding debt, expiring in November 2008 and in January 2009. As of June 30, 2004, the total notional amount of the swap agreements was $270 million and the fair value was $3.6 million, resulting in comprehensive income during the second quarter of 2004 of $5.7 million, net of tax.
Accounts receivable at June 30, 2004 amounted to $402 million, an increase of approximately $2 million from March 31, 2004. The June 30, 2004 accounts receivable balance represented 68 days of revenue, compared to 70 days as of March 31, 2004.
We believe that we will have sufficient liquidity and operating cash flows to fund our scheduled debt service and other obligations over the next twelve months.
Significant New Accounting Standards
On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed statement, Share-Based Payment, an amendment of FASB Statements No. 123 and 95, that would require companies to account for stock-based compensation to employees using a fair value method as of the grant date. The proposed statement addresses the accounting for transactions in which a company receives employee services in exchange for equity instruments such as stock options, or liabilities that are based on the fair value of the company’s equity
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instruments or that may be settled through the issuance of such equity instruments, which includes the accounting for employee stock purchase plans. This proposed statement would eliminate a company’s ability to account for share-based awards to employees under APB Opinion 25, Accounting for Stock Issued to Employees but would not change the accounting for transactions in which a company issues equity instruments for services to non-employees or the accounting for employee stock ownership plans. The proposed statement, if adopted, would be effective for all existing unvested awards and new awards effective January 1, 2005. The Company currently allocates pro forma compensation expense for stock options on a grant-level basis under the provisions of the currently effective SFAS No. 123. The proposed statement would require share-based compensation expense on new awards to be recognized over the individual vesting periods, which would result in an accelerated expense allocation. We are in the process of assessing the potential impact of this proposed statement on our consolidated financial statements.
Interest rate sensitivity
The table below provides information, as of June 30, 2004, about our financial instruments that are sensitive to changes in interest rates.
Total
Fair
Value
AverageInterest
Rate
Long-term debt:
Fixed rate
Variable rate
The Company entered into an interest rate swap agreement during 2003 that had the economic effect of fixing the LIBOR-based interest rate at 5.39% based upon a 2.00% margin in effect on June 30, 2004, on an amortizing notional amount of $135 million of the Term Loan B outstanding debt. The agreement expires in November 2008 and requires quarterly interest payments. As of June 30, 2004, the notional amount of the swap was $135 million and its fair value was $1.0 million, resulting in other comprehensive income during the second quarter of 2004 of $2.9 million, net of tax.
In 2004, the Company entered into another interest rate swap agreement that had the economic effect of fixing the LIBOR-based interest rate at 5.08% based upon a 2.00% margin in effect on June 30, 2004, on an additional amortizing notional amount of $135 million of the Term Loan B outstanding debt. The agreement expires in January 2009 and requires quarterly interest payments. As of June 30, 2004, the notional amount of the swap agreement was $135 million and its fair value was $2.6 million, resulting in other comprehensive income during the second quarter of 2004 of $2.8 million, net of tax.
Management maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the reports filed by the Company pursuant to the Securities Exchange Act of 1934, as amended, or Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and regulations, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosures. Management recognizes that these controls and procedures can provide only reasonable assurance of desired outcomes, and that estimates and judgments are still inherent in the process of maintaining effective controls and procedures.
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As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures in accordance with the Exchange Act requirements. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures provide reasonable assurance for timely identification and review of material information required to be included in the Company’s Exchange Act reports, including this report on Form 10-Q.
We have established and maintain a system of internal controls over financial reporting designed to provide reasonable assurance that transactions are executed with proper authorization and are properly recorded in the Company’s records, and that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period. Internal controls over financial reporting are periodically reviewed and revised if necessary, and are augmented by appropriate oversight and audit functions.
There has not been any change in the Company’s internal control over financial reporting during the fiscal quarter covered by this report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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RISK FACTORS
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These forward-looking statements include statements regarding our expectations for treatment growth rates, revenue per treatment, expense growth, levels of the provision for uncollectible accounts receivable, operating income, and capital expenditures. We base our forward-looking statements on information currently available to us, and we do not intend to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.
These statements involve known and unknown risks and uncertainties, including risks resulting from economic and market conditions, the regulatory and reimbursement environment in which we operate, competitive activities and other business conditions. Our actual results may differ materially from results anticipated in these forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include those set forth below. The risks discussed below are not the only ones facing our business.
If the average rates that private payors pay us decline, then our revenues, cash flows and earnings would be substantially reduced.
Approximately 42% of our dialysis revenues are generated from patients who have private payors as the primary payor. The majority of these patients have insurance policies that reimburse us at rates materially higher than Medicare rates. Based on our recent experience in negotiating with private payors, we believe that pressure from private payors to decrease the rates they pay us may increase. If the average rates that private payors pay us decline significantly, it would have a material adverse effect on our revenues, cash flows and earnings.
If the number of patients with higher paying commercial insurance declines, then our revenues, cash flows and earnings would be substantially reduced.
Our revenue levels are sensitive to the percentage of our reimbursements from higher-paying commercial plans. A patient’s insurance coverage may change for a number of reasons, including as a result of changes in the patient’s or a family member’s employment status. If there is a significant change in the number of patients under higher-paying commercial plans relative to plans that pay at lower rates (for example, a reduction in the average number of patients under indemnity and PPO plans compared with the average number of patients under HMO plans and government programs) it would negatively impact our revenues, cash flows and earnings.
Changes in clinical practices and reimbursement rates or rules for EPO and other drugs could substantially reduce our revenues and earnings.
The administration of EPO and other drugs accounts for approximately one third of our net operating revenues. Changes in physician practice patterns and accepted clinical practices, changes in private and governmental reimbursement criteria, the introduction of new drugs and the conversion to alternate types of administration (for example, from intravenous administration to subcutaneous or oral administration, that may in turn result in lower or less frequent dosages) could materially reduce our revenues and earnings from the administration of EPO and other drugs. For example, some Medicare fiscal intermediaries are seeking to implement local medical review policies for EPO and vitamin D analogs that would effectively limit utilization of and reimbursement for these drugs. CMS has proposed a draft national coverage decision that will direct all fiscal intermediaries with respect to reimbursement coverage for EPO. It is possible that the draft policy, if finalized, will affect physician prescription patterns and the timing of our cash flows due to changes in auditing methodology by fiscal intermediaries.
Congress and CMS have indicated that the current drug reimbursement scheme is under review and may be modified. Congress and CMS are currently considering a proposal which would expand the drugs and services
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that are included in the composite rate. Any reduction in private and government reimbursement rates for EPO or other pharmaceutical drugs that we administer would reduce our net earnings and cash flows. Congress has already taken action that will change the way we are reimbursed for certain drugs that are currently billed outside of the composite rate, including EPO. This change will go into effect in 2005 and will result in a lower reimbursement rate for these drugs and a higher composite rate.
Future changes in the structure of, and reimbursement rates under, the Medicare ESRD program could substantially reduce our operating earnings and cash flows.
CMS is studying further changes to the ESRD program, including whether the Medicare composite rate for dialysis should be modified to include additional services that are now separately billable, such as laboratory and other diagnostic tests and the administration of EPO and other pharmaceuticals, in the composite rate. If Medicare began to include in its composite reimbursement rate any ancillary services that it currently reimburses separately, our revenue would decrease to the extent there was not a corresponding increase in that composite rate. In particular, Medicare revenue from EPO is approximately 25% of our total Medicare revenue. If EPO were included in the composite rate, and if the rate were not increased sufficiently, our operating earnings and cash flow could decrease substantially.
Adverse developments with respect to EPO and the introduction of Aranesp® could materially reduce our net earnings and cash flows and affect our ability to care for our patients.
Amgen is the sole supplier of EPO and may unilaterally decide to increase its price for EPO at any time. For example, Amgen unilaterally increased its base price for EPO by 3.9% in each of 2002, 2001 and 2000. Although we have entered into contracts for EPO pricing for a fixed time period that includes discount variables depending on certain clinical criteria, we cannot predict whether we will continue to receive the discount structure for EPO that we currently receive, or whether we will continue to achieve the same levels of discounts within that structure as we have historically achieved. An increase in the cost of EPO could have a material adverse effect on our net earnings and cash flows.
Amgen has developed and obtained FDA approval for Aranesp®, a new drug used to treat anemia that may replace EPO or reduce its use with dialysis patients. Unlike EPO, which is generally administered in conjunction with each dialysis treatment, Aranesp® can remain effective for between two and three weeks. In the event that Amgen begins to market Aranesp® for the treatment of dialysis patients, we may realize lower margins on the administration of Aranesp® than are currently realized with EPO. In addition, some physicians may begin to administer Aranesp® in their offices, which would prevent us from recognizing revenue or profit from the administration of EPO or Aranesp® to those physicians’ patients.
Future declines, or the lack of further increases, in Medicare reimbursement rates would reduce our net earnings and cash flows.
Approximately 50% of our dialysis revenues are generated from patients who have Medicare as their primary payor. The Medicare ESRD program reimburses us for dialysis and ancillary services at fixed rates. Unlike most other Medicare programs, the Medicare ESRD program does not provide for periodic inflation increases in reimbursement rates. Increases of 1.2% in 2000 and 2.4% in 2001 were the first increases in the composite rate since 1991, and were significantly less than the cumulative rate of inflation since 1991. For 2002 through 2004, there has been no increase in the composite rate. In 2005, there will be an increase of only 1.6%. Increases in operating costs that are subject to inflation, such as labor and supply costs, have occurred and are expected to continue to occur regardless of whether there is a compensating increase in reimbursement rates. We cannot predict with certainty the nature or extent of future rate changes, if any. To the extent these rates are not adjusted to keep pace with inflation, our net earnings and cash flows would be adversely affected.
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Future declines in Medicaid reimbursement rates would reduce our net earnings and cash flows.
Approximately 5% of our dialysis revenues are generated from patients who have Medicaid as their primary coverage. In addition approximately 4% of our dialysis revenues are from Medicaid secondary coverage. Approximately 45% of our Medicaid revenue is derived from patients in California. If state governments change Medicaid programs or the rates paid by those programs for our services, then our revenue and earnings may decline. Some of the states’ Medicaid programs have reduced rates for dialysis services, and others have proposed such reductions or other changes to eligibility for Medicaid coverage. Any actions to limit Medicaid coverage or further reduce reimbursement rates for dialysis and related services would adversely affect our revenue and earnings.
The pending federal review of some of our historical practices could result in substantial penalties against us.
We are voluntarily cooperating with the Civil Division of the United States Attorney’s Office and the OIG in Philadelphia in a review of some of our practices, including billing and other operating procedures, financial relationships with physicians and pharmaceutical companies, and the provision of pharmaceutical and other ancillary services. The Department of Justice has also requested and received information regarding these laboratories. We are unable to determine when these matters will be resolved, whether any additional areas of inquiry will be opened or any outcome of these matters, financial or otherwise. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.
If we fail to adhere to all of the complex government regulations that apply to our business, we could suffer severe consequences that would substantially reduce our revenues and earnings.
Our dialysis operations are subject to extensive federal, state and local government regulations, including Medicare and Medicaid reimbursement rules and regulations, federal and state anti-kickback laws, and federal and state laws regarding the collection, use and disclosure of patient health information. The regulatory scrutiny of healthcare providers, including dialysis providers, has increased significantly in recent years. In addition, the frequency and intensity of Medicare certification surveys and inspections of dialysis centers have increased markedly since 2000.
We endeavor to comply with all of the requirements for receiving Medicare and Medicaid reimbursement and to structure all of our relationships with referring physicians to comply with the anti-kickback laws; however, the laws and regulations in this area are complex and subject to varying interpretations. In addition, our historic dependence on manual processes that vary widely across our network of dialysis centers exposes us to greater risk of errors in billing and other business processes.
Due to regulatory considerations unique to each of these states, all of our dialysis operations in New York and some of our dialysis operations in New Jersey are conducted by privately-owned companies to which we provide a broad range of administrative services. These operations account for approximately 7% of our dialysis revenues. We believe that we have structured these operations to comply with the laws and regulations of these states, but we can give no assurances that they will not be challenged.
If any of our operations are found to violate these or other government regulations, we could suffer severe consequences, including:
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If businesses we acquire failed to adhere to regulations that apply to our business, we could suffer severe consequences that would substantially reduce our revenues and earnings.
Businesses we acquire may have unknown or contingent liabilities, including for failure to adhere to laws and regulations governing dialysis operations. We generally seek indemnification from the sellers of businesses we acquire, but such liabilities may not be covered or may be greater than contractual limits or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, we could suffer severe consequences that would substantially reduce our revenues and earnings.
If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, our revenues and earnings would decline.
If a significant number of physicians stop referring patients to our centers, it could have a material adverse effect on our revenue and earnings. Many physicians prefer to have their patients treated at dialysis centers where they or other members of their practice supervise the overall care provided as medical directors of the centers. As a result, the primary referral source for most of our centers is often the physician or physician group providing medical director services to the center. If a medical director agreement terminates, whether before or at the end of its term, and a new medical director is appointed, it may negatively impact the former medical director’s decision to treat his or her patients at our center. Additionally, both current and former medical directors have no obligation to refer their patients to our centers. Also, if quality of service levels at our centers deteriorate, it may negatively impact patient referrals and treatment volumes.
Our medical director contracts are for fixed periods, generally five to ten years. Medical directors have no obligation to extend their agreements with us. As of July 1, 2004, there were 31 centers, accounting for nearly 5% of our treatment volume, at which the medical director agreements required renewal on or before June 30, 2005.
We also may take actions to restructure existing relationships or take positions in negotiating extensions of relationships to assure compliance with the safe harbor provisions of the anti-kickback statute and other similar laws. These actions could negatively impact physicians’ decisions to extend their medical director agreements with us or to refer their patients to us. In addition, if the terms of an existing agreement were found to violate applicable laws, we may not be successful in restructuring the relationship, which could lead to the early termination of the agreement, or force the physician to stop referring patients to the centers.
If our joint ventures are found to violate the law, we could suffer severe consequences that would substantially reduce our revenues and earnings.
We operate 102 dialysis centers that are owned by joint ventures in which we own a controlling interest and one or more physicians or physician practice groups have a minority interest. The physician owners may also provide medical director services to those centers or other centers we own and operate. Because our relationships with physicians are governed by the “anti-kickback” statute contained in the Social Security Act, we have sought to satisfy as many safe harbor requirements as possible in structuring these joint venture arrangements. However,
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our joint venture arrangements do not satisfy all elements of any safe harbor under the federal anti-kickback statute. Also, we believe we have structured the physician relationships in these joint ventures in a way that meets applicable exceptions of the Stark I and Stark II provisions under the Omnibus Budget Reconciliation Acts of 1989 and 1993 or that otherwise complies with the Stark provisions. If the joint ventures were found to be in violation of the anti-kickback statute or the Stark provisions, we could be required to restructure the joint ventures or refuse to accept referrals for designated health services from the physicians with whom the joint venture centers have a relationship. We also could be required to repay to Medicare amounts received by the joint ventures pursuant to prohibited referrals, and we could be subject to monetary penalties. If the joint venture centers are subject to any of these penalties, we could suffer severe consequences that would substantially reduce our revenues and earnings.
If the current shortage of skilled clinical personnel continues, we may experience disruptions in our business operations and increases in operating expenses.
We are experiencing increased labor costs and difficulties in hiring nurses due to a nationwide shortage of skilled clinical personnel. We compete for nurses with hospitals and other health care providers. This nursing shortage may limit our ability to expand our operations. If we are unable to hire skilled clinical personnel when needed, our operations and our same center growth will be negatively impacted.
Provisions in our charter documents and compensation programs may deter a change of control that our stockholders would otherwise determine to be in their best interests.
Our charter documents include provisions that may deter hostile takeovers, delay or prevent changes of control or changes in our management, or limit the ability of our stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting our stockholders from acting by written consent, requiring 90 days advance notice of stockholder proposals or nominations to our Board of Directors and granting our Board of Directors the authority to issue up to five million shares of preferred stock and to determine the rights and preferences of the preferred stock without the need for further stockholder approval, and a poison pill that would substantially dilute the interest sought by an acquirer that our board of directors does not approve.
In addition, most of our outstanding employee stock options include a provision accelerating the vesting of the options in the event of a change of control. We have also adopted a change of control protection program for our employees who do not have a significant number of stock options, which provides for cash bonuses to the employees in the event of a change of control. Based on the shares of our common stock outstanding and the market price of our stock on June 30, 2004, these cash bonuses would total approximately $116 million if a control transaction occurred at that price and our Board of Directors did not modify the program. These compensation programs may affect the price an acquirer would be willing to pay.
These provisions could also discourage bids for our common stock at a premium and cause the market price of our common stock to decline.
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PART II
OTHER INFORMATION
The information in Note 6 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this report is incorporated by this reference in response to this item.
Items 2 and 3 are not applicable.
Our annual meeting of stockholders was held on May 24, 2004.
Proposal 1 submitted to our stockholders at the meeting was the election of directors. The following directors were elected at the meeting with the number of votes cast for each director or withheld from each director set forth after the director’s respective name.
Name
Nancy-Ann DeParle
Richard B. Fontaine
Peter T. Grauer
Michele J. Hooper.
C. Raymond Larkin, Jr.
John M. Nehra
William L. Roper
Kent J. Thiry
Item 5 is not applicable.
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(a) Exhibits
Description
Amended and Restated Bylaws of DaVita Inc. (formerly Total Renal Care Holdings, Inc.) dated June 3, 2004.ü
Employment Agreement, effective as of June 7, 2004, by and between DaVita Inc. and Tom Kelly.ü*
Third Amended and Restated Credit Agreement, dated as of July 30, 2004, among DaVita Inc., the lenders party thereto, Credit Suisse First Boston, Cayman Islands Branch as Joint Book Manager, and Administrative Agent and Sole Book Manager for the Term Loan B and the Term Loan C, Banc of America Securities LLC as Joint Book Manager and Bank of America N.A., as Syndication Agent.ü
Guarantee Supplement, dated July 30, 2004, made by the subsidiaries of DaVita Inc., named therein in favor of the lenders party to the Third Amended and Restated Credit Agreement.ü
Security Agreement Supplement, dated July 30, 2004, made by the subsidiaries of DaVita Inc. named therein in favor of the lenders party.ü
Certification of the Chief Executive Officer, dated August 3, 2004, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ü
Certification of the Chief Financial Officer, dated August 3, 2004, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. ü
Certification of the Chief Executive Officer, dated August 3, 2004, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ü
Certification of the Chief Financial Officer, dated August 3, 2004, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ü
(b) Reports on Form 8-K
Current report on Form 8-K dated May 17, 2004, furnished under Item 5, “ Other Events and Regulation FD Disclosure” announcing a three-for-two stock split of Company’s common stock. A copy of the press release was attached to the Form 8-K as Exhibit 99.1.
Current report on Form 8-K dated July 22, 2004, furnished under Item 5, “Other Events and Regulation FD Disclosure” announcing that the Company had entered into a definitive agreement to acquire Physicians Dialysis Inc. A copy of the press release was attached to the Form 8-K as Exhibit 99.1.
Current report on Form 8-K dated August 3, 2004, furnished under Item 12, “Disclosure of Results of Operations and Financial Condition”, announcing the Company’s financial results for the quarter ended June 30, 2004. A copy of the press release announcing the Company’s financial results for the quarter ended June 30, 2004 was attached to the Form 8-K as Exhibit 99.1.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
By:
/s/ GARY W. BEIL
Gary W. Beil
Interim Chief Financial Officer,
Vice President and Controller*
Date: August 3, 2004
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INDEX TO EXHIBITS
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