Renal Care: Growth in Dialysis

09/10/2004 12:00 am EST


James Stack

President, Stack Financial Management

"Health care stocks have traditionally been considered a defensive investment in uncertain times, but at first glance this sector has failed to live up to its reputation," says Jim Stack, editor of Investech. "But there’s more to the story." Here he looks at one favorite.

"The health care sector encompasses a diverse group of industries ranging from drug manufacturers to health care providers and hospital management. While the broad group has underperformed the market, it’s problems rest primarily with drug and related biotech stocks, while several areas such as advanced medical device or equipment manufacturers have been more resilient. Meanwhile, we continue to feel that several factors make this sector particularly attractive over the longer-term. Demographic studies of the richer developed nations show an increasingly aging population. And, as the standard of living improves in emerging markets, these regions seek better medical care, which will increase global demand for products and services. Meanwhile, health care is a dynamic market, with constant technology and product advances. And since medical care is considered essential, this is typically a defensive, non-cyclical sector. Here, we’ve asked Bruce Morison, the senior portfolio manager at Stack Financial Management to review a featured investment for this issue.

"Our investment philosophy is centered on the goal of building wealth in a prudent and patient fashion. In the security selection process our goal is to buy excellent companies at reasonable prices as a further way to reduce risk, while preserving the opportunity to compound wealth. Excellent businesses often share many of the same characteristics. These frequently include: niche markets or a controlling market share position to protect the business from competition, high returns on capital, and strong cash flow generation. Our featured investment, Renal Care Group (RCI NYSE), exhibits all these attractive characteristics.

"RCI is a specialized dialysis services company that provides care to patients with kidney disease at more than 395 owned outpatient dialysis facilities. The firm enjoys the ‘Best in Class’ reputation in the industry, reflecting lower mortality and higher health and recovery statistics versus their peers. The dialysis industry in the US is highly fragmented with more than 4,000 dialysis centers. Of these, 67% are owned by four companies (including RCI), with the remaining one-third being unconsolidated physician-owned or affiliated with hospitals. When RCI enters a new market, the company works to develop and maintain market share targeted at a minimum of 30%. The business generates a strong recurring revenue stream and predictable cash flow growth, which when combined with low debt levels, has allowed RCI to aggressively acquire and integrate other facilities in an immediately accretive manner.

"The company’s operational model has produced an impressive growth record. Over the past five and ten year periods, earnings per share have increased at annual compound rates of 21% and 25%, respectively. The competitive advantage generated by RCI’s controlling market share has translated into high returns on equity, which currently is in excess of 20%. The growth record the company has achieved and its bright future have not gone unnoticed by the investment community, as evidenced by its 28% gain over the past 52 weeks versus a gain of 9% for the S&P 500. While pricing will continue to come under pressure due to low single-digit increases in Medicare reimbursement rates, earnings growth prospects remain superb. In addition, continued facility build-out emphasizing best care practices, selective acquisitions, and an aggressive share repurchase program all suggest further gains in shareholder value can be expected."

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