Follow Buffett Into This Healthy Name

 | Nov 20, 2012 | 1:00 PM EST
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Famed investor Warren Buffett has increased its stake in DaVita HealthCare (DVA) by more than 16.5% since the end of the third quarter, per a Form 4 filed Friday. The most recent purchases by his Berkshire-Hathaway (BRK.A) show that the mega-investor has added another 1 million shares in the range of $112.30 to $113 apiece. Buffett first took notice of DaVita in the fourth quarter of last year, when he reported his original 2.7-million-share position. Since that time, the billionaire and Berkshire have been steadily increasing the size of their position in DaVita to nearly 12 million shares, around 12% of the company's common stock outstanding.

A provider of dialysis services for patients with chronic kidney failure, DaVita should benefit from the healthcare reform law, which will expand medical coverage to more than 30 million Americans by 2019. Benefits are expected to begin to take effect by 2014, as dialysis service providers will profit from an aging population and lower expected drug costs.

Other major kidney center dialysis and lab operators include Fresenius Medical Care (FMS), LabCorp (LH), Mednax (MD) and Quest Diagnostics (DGX).

Fresenius, for one, expects robust revenue growth of 9% in 2012 and 7% in 2013. Much like DaVita, the company is looking to gain more exposure internationally with acquisitions while reducing reliance on Medicare and Medicaid. These two government programs account for 35% of Fresenius' sales.

Clinical lab operator LabCorp is expecting to see modest sales increases in 2012 and 2013 as patients forgo physician visits during the continually slow economic recovery. The company is heavily exposed to esoteric testing, with the service accounting for more than 40% of its total top line. It's also looking to diversify, which should put pressure on margins in the interim, and generally lower efficiency overseas won't help the situation.

Separately, Mednax reported third-quarter earnings per share of $1.32, beating consensus by $0.06. Margins are expected to continue contracting as the company grows its anesthesiology mix -- for earnings before interest, taxes, depreciation and amortization, margins came to 24.4%, representing a 50-basis-point year-over-year decline. Also over this time, general and administrative expenses have seen a 120-bps increase as a percentage of revenue.

Finally, Quest will also see modest growth over the next couple of years, with flat sales in 2012 and 2% expected growth in 2013. It's seeing higher sales from esoteric tests, but volume remains weak as sluggish physician office visits continue. Quest also has a major contract up for renewal with Cigna (CI), and will continue to see near-term margin pressure due to acquisitions.

As for DeVita, besides Berkshire's 11.8 million-share ownership, other top funds also invested in the name are Viking Global and billionaire Stephen Mandel's Lone Pine Capital. Here is the entire list.

Granted, during the third quarter, DaVita missed estimates for the first time in the past year, reporting EPS of $1.50 vs. the $1.56 target. However, the company has also just finalized its merger with HealthCare Partners, and the associated synergistic cost savings should help boost DaVita's profitability while adding customers and diversifying its revenue base.

The company has one of the industry's top growth rates, expected at 13% annually over the next five years, and its price-to-earnings ratio relative to growth (PEG) is a moderately attractive 1.6. DeVita's stock has risen more than 50% year to date, while its peers have turned in relatively flat performances -- yet its forward-earnings valuation is at only 16x, with no deserved premium to its peers.

It appears, then, that investors may be discounting DaVita's growth too heavily. We agree with Buffett that there is still upside to DaVita -- and, based on management's low guidance for earnings before interest and taxes in 2012, the stock only trades at a price-to-EBIT multiple of 8.2x, below its peers and under the company's historical average. Now might not be a bad time to "monkey" one of the most successful investors of our time.

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