The growing obesity epidemic is putting a strain on the U.S. health care system. But not everyone loses from this trend. Dialysis providers DaVita HealthCare Partners Inc (NYSE:DVA) and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) Medical Care are poised to profit from the proliferation of obesity and related diseases, namely diabetes.
Once you look at the business, it is not hard to understand why Ted Weschler — one of two managers hand-picked by Warren Buffett to invest Berkshire’s cash — has owned the company since 2001. He first built a position at his hedge fund, Peninsula Capital, and rebuilt the position at Berkshire Hathaway Inc. (NYSE:BRK.B) when Buffett gave him the job.
The dialysis market is dominated by DaVita and Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) — the two combine for a 70% market share in the United States. However, the rest of the market is highly fragmented. This gives the two largest companies an enormous advantage in economies of scale.
Investors will appreciate just how important economies of scale are when they look at the gross margins in comparison to operating margins.
DaVita’s gross margins are pretty low compared to many other industries. However, its operating margin is surprisingly high — over 15% in most years. Fresenius’ margins are similar to DaVita’s.
It’s hard to imagine smaller competitors earning a 15% operating margin considering they are unable to spread out fixed costs to the extent DaVita HealthCare Partners Inc (NYSE:DVA) and Fresenius can. In fact, the two companies could squeeze out all other competitors simply by lowering prices to absurd levels for a few years.
This market dominance enables the two companies to earn stable margins because profitability is only destabilized by fierce competition (and volatile demand).
Slow, Predictable Growth
Demand for dialysis services has grown at 4% per annum over the last decade. With an aging population and rising rates of diabetes and obesity, it is likely that the industry will continue to grow at least this quickly over the next decade.
While the industry grew at 4% per year, DaVita’s sales have grown at 16.7% per year over the last 10 years. Clearly, the company has gained significant market share over this time.
Fresenius’ sales growth was not far behind DaVita’s, coming in at 10.7% per year since 2002.
Both companies produce a healthy amount of free cash flow. DaVita averaged an 8% free cash flow margin over the last 10 years, whereas Fresenius Medical Care AG & Co. (ADR) (NYSE:FMS) averaged a 6.75% free cash flow margin.
If you apply historical free cash flow margins to both companies’ current revenues, you get a “normal” free cash flow yield of 5.54% for DaVita and 4.56% for Fresenius.