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Dialysis Provider DaVita Loses Pricing Control

Dialysis provider DaVita posted solid second-quarter financial results, yet chief financial officer Rich Whitney admitted to analysts on the earnings call that Medicare composite rate adjustment provided for in 2009 and 2010 would not be sufficient to compensate for anticipated increases in forward operating costs subject to inflation, such as labor and pharmaceutical supplies. Whitney opined that the dialysis provider would likely continue the trend of steady growth and consistent cash flow going forward. However, it is possible that operating profitability could tumble if the defined scope of new Medicare bundling rules, scheduled to be implemented in 2011, limit coverage for higher-cost cases and cap the utilization of prescribed erythropoiesis-stimulating agents (ESAs), such as Amgen's Epogen.

The company generates approximately 65 percent of its sales from Medicare patients, but nearly all of its profits are derived from the 35 percent of its patients who have commercial health insurance, as rates from private insurers have historically paid on terms that are significantly higher than government programs (the average Medicare composite rate was $157 per treatment in 2008). Even lucrative payments from these private insurers, however, are unlikely to offset cuts expected in payment rates under the Medicare ESRD program, according to the second-quarter 2009 regulatory 10-Q filing:

In July 2008, the Medicare Improvements for Patients and Providers Act for 2008 was passed by Congress. This legislation provides for an increase in the composite rate of 1% in 2009 and in 2010. In addition this legislation introduces a new payment system for dialysis services beginning in January 2011 whereby ESRD payments will be made under a "bundled" payment rate which will provide for a fixed rate for all goods and services provided during the dialysis treatment, including laboratory services and the administration of pharmaceuticals. The initial 2011 bundled rate will be set 2% below the payment ra te that providers would have received under the historical fee for service payment methodology. Beginning in 2012, a new single bundled payment base rate will be adjusted annually for inflation based upon a market basket index, less 1% of such index.

The two-percent reimbursement cut will reduce Medicare revenues by an estimated $60 million, according to Whitney. As DaVita operates principally as a dialysis and related lab services business, the company does not have the ability to quickly offset the hit to revenues. What the company can do, however, is continue to focus on cost-control initiatives, such as increased use of cheaper drugs where possible. For example, a generic alternative to Watson Pharmaceuticals' Ferrlecit, an intravenous iron supplement for the treatment of nemia in hemodialysis patients receiving supplemental epoetin therapy, is expected to enter the market later this year. Ferrlecit currently has about 30 percent of the $660 million U.S. IV iron-replacement therapy market, according to IMS Health, a pharmaceutical market researcher.

Prior to bundling, use of branded iron was a benefit, for DaVita was reimbursed at average selling price plus six-percent. Come 2011, a bundling system that includes one payment for treatment plus drug use will likely motivate DaVita to extract margin gains through clinical outcome efficiencies. For example, several studies suggest regular IV iron-supplementation can reduce the total amount of the more expensive EPO needed by patients. Avoiding the high cost of EPO therapy is not without its own set of risks for DaVita, however, as Epogen currently accounts for approximately 20 percent of dialysis and related lab services revenues.

Analysts estimate that 60 percent of the 345,000 U.S. dialysis patients with ESRD now frequent either DaVita or its larger rival, Fresenius. This stronghold on the dialysis market, however, means little when it is the U.S. government that ultimately controls pricing power.

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