德維特 (DVA) 2013 Q2 法說會逐字稿

Good afternoon. My name is Ian, and I will be your conference operator today. At this time, I would like to welcome everyone to the DaVita HealthCare Partners Q2 2013 earnings conference call. All lines have been placed on mute to prevent background noise. After today's remarks, there will be a question-and-answer session.

(Operator Instructions)

Thank you. Jim Gustafson, you may now begin your conference.

Thank you, Ian. And welcome, everyone, to our second-quarter conference call. We appreciate your continued interest in our Company. I'm Jim Gustafson, Vice President of Investor Relations. With me today are Kent Thiry, our CEO, Bob Margolis, the CEO of HealthCare Partners, Matthew Mazdyasni, HealthCare Partners' Executive Vice President and CFO, Jim Hilger, our Chief Accounting Officer and Interim CFO, and LeAnne Zumwalt, Vice President.

I would like to start with our forward-looking disclosure statements. During this call, we may make forward-looking statements within the meaning of the federal securities laws. All of these statements are subject to known and unknown risks and certainties that could cause actual results to differ materially from those described in the forward-looking statements. For further details concerning these risks and uncertainties, please refer to our SEC filings, including our most recent quarterly report on Form 10-Q, and annual report on Form 10-K. Our forward-looking statements are based on information currently available to us, and we do not intend and undertake no duty to update these statements for any reason.

Additionally, we would like to remind you that during this call, we will discuss some non-GAAP financial measures. A reconciliation of these non-GAAP measures to the most comparable GAAP financial measures is included in our Form 8-K submitted to the SEC, and available on our website. I'll now turn the call over to Kent Thiry, our Chief Executive Officer.

Okay. Thank you, Jim. And thanks to all of you out there for your interest in our enterprise. This quarter, as many of you have noted by seeing the press release, we experienced mixed results, with continued soft performance in our Kidney Care business, but results below your and our expectations at HealthCare Partners.

I will cover six topics. Number one, clinical performance. Number two, HealthCare Partners' performance. Number three, Kidney Care performance. Number four, a policy update. Number five, a quick comment on investigations. And number six, our outlook going forward.

Starting with one, clinical outcomes, which we always present first, but that is what comes first. As you probably know we serve about one out of every three dialysis patients in America at this point. Our adequacy at 98% of our patients with a Kt/V grade of 1.2 is outstanding. Our vascular access, with 72% of our patients having fistulas is outstanding. We've talked about those metrics in the past.

We would like to comment on an additional one this time, and then talk about our strides in reducing the peritonitis rates for our PD patients, which represent between 9% and 10% of our patients. The international guidelines for peritonitis is one episode per 18 months. Our data, one episode for every 45 months, about one-third the rate of issue, and that's across a very substantial patient population. Overall, as you've heard many times, our patient outcomes compare very favorable to national averages, and that is both good for patients and saves taxpayers money.

I would also like to start talking more about the wonderful clinical outcomes at HealthCare Partners. We can compare our 2012 performance in California, for example, to the national HEDIS data for Medicare HMO patients. We are still harmonizing the rest of the HealthCare Partners data across our three markets, and so in the future, we'll be able to provide aggregate metrics. Right now, California, which is the biggest market by far, our Medicare Advantage patients once again, several years in a row, scored near the top across a wide variety of metrics, including above the 90th percentile with respect to colorectal cancer, above the 90th percentile with respect to female patients screened for breast cancer, and near the 90th percentile, with respect to diabetic LDL less than 100. For these and many other outcomes, HealthCare Partners leads the HealthCare Partners partner markets.

Next, turning to HealthCare Partners' operating performance, which I'm sure is the subject of primary focus for many of you. It was a weak quarter. No two ways around it. What's the right way to think about and diagnose that weakness and its implications going forward? First of all, if you take our guidance for the year, which was OI of $400 million to $450 million take the midpoint $425 million, Just divide evenly, that would be about $106 million per quarter. Then you allow for in general long-term trend being second half better than first half of each year, probably tweak that down to $103 million or so. Which means were $22 million what someone might have expected. Of course, I'm picking single point numbers, when I would normally use a range, but I'm trying to simplify things.

Well, about half of that $10 million was a normal seasonal decline that happens in Q2, about of that magnitude. Last year was a little bit higher, and you should expect a similar seasonal -- the other half was. First subpoint under that category is sequestration, which started April 1, and that explains about $7 million, so it's over half of the remaining $12 million, sequestration, which as you know, might very well recur for some time. Of that remaining 40% or so, (technical issues) Albuquerque was the single biggest chunk of the variance. We do expect to be slightly better in Q3 and Q4, than Q1 and Q2, hence our lowering of the full-year HealthCare Partners' expectations, which I'll talk about in a minute.

Regarding growth, very important to us and to you, total member months did decline 2% sequentially in Q2 compared to Q1, due to our ending a relationship that had unfavorable rates. That one's actually good news for you. But more important, we had 20% year-on-year growth of Medicare Advantage patients in our three legacy markets, of which 12, 60%, or 12 of the 20 was organic, and 8% through a series of small, but important acquisitions at reasonable multiples. Please note that the year-on-year comparisons incorporate days prior to the completion of our merger, which was in the middle of the fourth quarter last year. I will now move on to Kidney Care performance. I think I can handle that quite concisely from my point of view, although Jim Hilger will go into more detail, just by saying our Kidney Care business continues to operate solidly all across the board in the quarter, and year-to-date.

Enough on that. I'll move on to public policy, starting here with Kidney Care and the proposed 2014 Medicare reimbursement cuts. This is exceptionally frustrating, given already dialysis providers lose money on Medicare patients, and charge private patients significantly more in order to subsidize government patients. It is our understanding at this point that CNS felt compelled to focus on a very narrow sliver of the bundle, having to do with pharmaceutical utilization, and felt circumscribed from not being able to take into account other factors. We actually disagree with that interpretation, and are making that point vigorously, and hope in this comment period that our protest with respect to that logic is taken seriously. Time will tell.

If they cut reimbursement, there will be changes to patient access to care. There's no two ways around it for the nationwide community. I could provide a list of the potential consequences, but the most significant one is that almost inevitably, some centers will close. Actually, inevitably, some centers will close, and they will tend to be those centers that serve the most vulnerable patients. We have carried a lot of centers that lose money overall in aggregate, trying to be a good citizen of the system, but if they cut reimbursement at some point, it becomes impossible to do that everywhere.

Moving on to health care policy, the big policy issue, as you know, is around Medicare Advantage. We have no material update on this to provide. It is nice to reflect on the facts, however, that Medicare Advantage remains a superior value proposition, both in terms of clinical outcomes and overall cost to taxpayers. Let's go back to Kidney Care for a moment. Another aspect of policy, and that is the ESRD seamless care organizations, or ESCOs, first, we do want to publicly thank CMS for all the time that they have put into this whole process and the ESCO design.

Second, however, we are, we are very, very disappointed that the small changes to the proposed ESCO design will not make it one that merits significant investment, and to implement the kind of spectacular success that we've had in integrated care, proven success we've had in integrated care does take a bunch of upfront investment. And we simply can't put a lot of your capital at risk in that way, when we know we could generate a return through improving quality and reducing costs with the right architecture of the program and the right duration of the program. But we can't make all those formidable investments if in fact, after we make all of those improvements, there won't any return, because of course you would not allocate any more capital to us to continue to grow what could be a beautiful program. We will not give up hope for the future, and once again, we're grateful for the hard work that CMS put in. It's a complicated subject, no doubt. But you can tell by our remarks, and the consistency of our remarks over many years now, that we believe strongly in coordinated care, that it is a win, win, win for the patient, for the taxpayer, and for the enterprise, and that we have proven that this is the case, and it can be scaled.

Next topic, quick update on investigations and lawsuits. On the physician relationship side, we continue to have discussions with the government, but have not reached any settlement or resolution yet. And then two pieces of really strong, good news. We had two previously disclosed lawsuits against HealthCare Partners. The [Jondrus] suit and the [Swelbin] suit, both previously disclosed, as I mentioned. In each of them, the judges ordered that the cases be dismissed with prejudice, meaning the plaintiffs cannot refile those claims, in both cases dismissed before they got very far at all, because the claims were so meritless and our advocacy was so appropriately and justifiably strong. So two very nice pieces of good news on the legal front.

Last, our thoughts looking forward. As you have probably read already, we have made changes to our 2013 guidance, decreasing HealthCare Partners' OI guidance by $20 million, so there's now a range of $380 million to $430 million, and on the other hand, increasing Kidney Care OI guidance by $50 million to the range of $1.45 billion to $1.50 billion, and the net impact is, what you probably already calculated, is a net increase to the bottom and top end of our consolidated operating income guidance, of $30 million. In other words, to somewhere between $1.83 billion to $1.93 billion. Of course, this guidance excludes the impact of any legal settlement related to the physician relationship matters or anything else, as well as any impact from a change in value of the 2013 earn out associated with the HealthCare Partners marriage. As always, all the guidance that I have mentioned, and we've referred to in our documents, capture a majority of the probabilistic outcomes, based on a whole wide number of swing factors, and it could happen that we end up outside the guidance, above or beyond.

Looking beyond 2013, we are unfortunately unable to provide any useful guidance on 2014 right now. You all know of the significant reimbursement cuts. You all know, we've operated reasonably efficiently in the past, so simply too many variables at this point to provide useful guidance to you, and we wish we could, but to provide guidance that's too speculative doesn't do anyone any good. So we will not succumb to that temptation.

Looking longer, the good news is, we are well-positioned. A, we have strong relative value propositions on both sides of the enterprise. This both in absolute terms and relative to the competition. B, a second piece of good news, we have strong business development opportunities at HealthCare Partners. C, the bad news is that muscle, the new market muscle, the business development muscle, still needs to be developed at HealthCare Partners. But D, fourth and finally, the good news is we have very robust and secure cash flows, as we proceed down the path of building those capabilities, and taking advantage of our strong relative value propositions.

Thank you very much. I look forward to the Q&A. And I'll now turn it over to Jim Hilger. Take it away.

Thanks, Kent. First, I would like to cover a few more dialysis operating metrics. Our non-acquired growth was 5%, when normalized for days of the week, and our commercial mix improved slightly in the quarter. Our US dialysis revenue per treatment was down $1.58 from the prior quarter, reflecting the impact of the 2% Medicare sequestration cuts, which went into effect in April, partially offset by improved commercial mix. Our dialysis G&A per treatment was down $1.28 from the first quarter, due primarily to seasonal fluctuations, including compensation expense. And during the quarter, we experienced $6 million in international losses, in line with our prior expectations.

Now, next a comment about HCP. We have reduced the estimated fair value of the contingent liability with the HealthCare Partners' earn out for 2013, creating a gain of $57 million, which is reflected in our operating income. We're adjusting the expected fair value of the earn out based on the first-half performance of HCP and the expected operating performance for the remainder of the year. We'll continue to value this liability each quarter until the earn out is finalized, so we may continue to see some swings in the value, if the value changes.

As far as the overall enterprise goes, our debt expense was $108 million in the second quarter, and this is consistent with what we guided last quarter. This should be a good run rate for the remainder of the year. Our effective tax rate attributable to DaVita HealthCare Partners was 39.5% in the quarter, excluding the accounting adjustment for the HCP earn out. Note that we now expect a tax rate of between 39% to 40% for 2013, excluding the loss contingency reserve we recorded in Q1, as well as the HCP earn out adjustment.

Now, turning to cash flow, our operating cash flow was $307 million in the second quarter. We are raising the bottom end of our 2013 operating cash flow guidance, and our current expectation is for operating cash flow to now be between $1.4 billion and $1.5 billion for the year. This guidance excludes the impact of any legal settlements we may reach from the physician relationship investigations. With that, operator, let's go ahead and open it up for Q&A.

(Operator Instructions)

And your first question comes from the line of Matt Weight. And your line is now open.

Kent, I was wondering if you could start with rebasing here, and clearly there was several discussions you had with CMS. When I look at the disconnect here, is this a function of just poorly written legislation to begin with? Or did CMS more or less disagree with your analytical analysis, I guess?

Fair question. Let me stumble for a moment and then you come back and see if I've added any value. Right now, they are maintaining that they have a different interpretation of the legislation. And so that is a part of what is going on, and we are asking for a more senior legal review, based on the premise that hasn't happened yet. And so that is potentially one variable. Based on what we've been told, it is one variable.

And then second is, of course, just their overall view of the sector in a world where they want to find Medicare savings and there, it's impossible to say for sure what their real view of our economics are. On the one hand, we know the facts are we lose money on Medicare on average across America. On the other hand, they see that we and other providers are in aggregate successful, and so how much of what drove their preliminary recommendation or idea or proposal was driven by category A versus B, we can only speculate.

Do you feel -- sounds like you don't feel there would necessarily need to be a new bill that would almost replace what was written in the fiscal cliff, though?

No. What they need to do is absorb the comments, which they are, and we're grateful for the fact that they are listening. They are hearing a lot from the Kidney Care community, because there are a lot of people, big and small, that are worried about closing centers, restricting hours, et cetera, et cetera. So there's an awful lot of feedback being provided to them, which is exactly what they want, in order to make their final decision, which they will make in a couple months, after hearing from us and parts of Congress. And then depending on what happens, of course, we always have the recourse of trying to go to Congress if we feel we've been unfairly harmed. But we all know what a tortuous path that is.

Okay. Thanks. And in the past, you've discussed, at times anywhere from maybe 150 to 200 of your centers do operate at a loss. So to the extent the proposed rule isn't adjusted, would you say a majority of those clinics are at risk?

We're not talking about an aggregate number because so much will be driven by what they ultimately decide. Suffice it to say, it won't be zero. I mean, we are first and foremost, a care-giving company. And the notion of closing a center where we're taking care of Kidney Care patients, is pretty much anathema to us, which you can see by our track record. At the same time, at some point, the reimbursement has to be fair in covering the costs of those centers that don't have enough private patients in order to subsidize the government. And we wish there was some magic wand where they could just increase Medicare reimbursement, where there aren't enough private patients to subsidize, because that would at least be a move towards a more rational system. But right now, while we know the number won't be zero for us, it won't be zero for the industry, nonetheless, we're not talking about an aggregate number, because it would be totally speculative, and it just hurts too much to even think about it.

Fair enough. I'm assuming obviously you are not just sitting on your hands here. So what kind of levers can you look to pull? I know you already run an efficient model there. But there's clearly going to be some pressure. So can you help us think about some of the levers?

Your words are exactly correct, as much as we think both HealthCare Partners and Kidney Care have done very nice jobs in managing productivity and efficiency over time. You just can't stare at reimbursement cuts of this magnitude and do nothing. It just doesn't make sense, just as you wouldn't do nothing in your family household if suddenly your income was dramatically impaired. So, so we will be looking at every single expense, and I'm confident we'll find some savings. Right now, we can't put a number on it, and unfortunately, it's not going to be big enough to change the fact that we're going to take quite a hit.

All right. One more and then I'll jump back in queue. Switching just briefly over the HCP. I think, Kent, you made the comment in your prepared remarks that the new market muscle still needs to be developed there. So I'm curious if you could expand on that, what's maybe taken a little bit longer. And then also I know these are small acquisitions, but curious that HCP acquired in Nevada in March a hospice operator and cancer center in June in Nevada, too. So any color on what's the strategic thinking with that kind of acquisition versus an IPA would be helpful color. Thanks.

Well, I'll let Bob comment on the hospice and cancer center acquisitions. But before he does that, as to the new market muscle, it's pretty straightforward, which is HealthCare Partners has an amazing track record in the three legacy markets, clinically, economically, patient service, patient satisfaction, physician satisfaction, HEDIS ratings, star rating, et cetera. They focused on those three markets, and did beautiful things in all those dimensions. They did not go out into new markets. They did not go out and do different models.

So it's a new thing, and I think we're making steady, not impressive, but steady progress in building that capability. Can not at this point translate that into numbers for you. The pipeline is very robust, because of our capabilities on that side of the house. Lots of folks are interested in working with us, and so that's wonderful news. Exactly how long it will take us to develop all the right capabilities of transferring those capabilities and implementing them with Partners, right now we just can't put the kind of number on that you would legitimately want. But let me go ahead and turn to Bob for the hospice and oncology, and then you can come back at me, if you would like.

It's an interesting question. Certainly there are acquisitions related to new doctors, new IPAs, medical groups, new markets, and that's perhaps what you think of when you think of acquisition. But first and foremost, we're a care-giving company. And the opportunity to manage and coordinate the full continuum of care is an important driver in the clinical results that we want, of all of our systems, and so a hospice acquisition made a lot of sense, because of the opportunity in Las Vegas to coordinate the very difficult time at the end of life care, in a fully seamless and compassionate way, relative to the continuum of care. And likewise, cancer care or an earlier cardiology acquisition that you may have mentioned, or similarly, so that we could have the full integrated services delivered to our patient, the populations we serve in that market. We may do similar things in other markets where a buy versus build decision pushes us in that direction.

And Matt, I think it's time for us to go to someone else. We probably should try to take that normal convention of one to two questions each, and then back in the queue, if that's okay.

Thank you very much.

And your next question comes from Gary Lieberman at Wells Fargo. Your line is open.

I guess maybe just to go back at the HCP muscle development, or the business development, can you maybe share with us what your expectations were, and if they fell short, or that you didn't know what to expect and it's maybe going slower? How would you characterize that?

Okay. It's a fair question. I don't know that we, if we asked everyone in the room, or in the rooms, that question, you would get the same answer because I think different people had different expectations. Overall, if you look at the expectations we talked about when we made the announcement of the combination, that we still have a shot of being on track with that here in the first couple of years, which we always said were years that had some headwinds, both because of the integration of the two companies, and because of what was going to go on in the reimbursement environment. So I think in that sense, there's no surprise. But then if you ask, have we performed superbly, excellently, medium, average, or terribly, unfortunately, we're not yet operating at the excellent level, just because it is a new, a new muscle. So I think how you net those two facts together, we're probably a little bit behind in capability, and still okay and in the game with respect to the numbers themselves, because for the first X quarters of our time after the announcement, the operating performance was so much stronger than we expected.

Okay. So is there -- can you lay out any details on the plan going forward or timing? Is it a manpower issue? Is it finding the right, the right integration or the right structure for the organization?

It's primarily a resource question and you can't, of course, just go out and hire two people and have them be wonderful day one or 20 people and you can't suddenly take 10 people and shift them from one job to another. So it's all the normal nitty-gritty operating stuff. But at the core of it is just having enough of the right bodies in order to deliver that which we know how to deliver, with partners who want us to deliver it. So lots of good news if we can drive ourselves to a new level of capability quickly.

Okay. Jim, could you explain the earn out contingent fair value in a little bit more detail? If I'm doing the math correctly, it looked like it declined from $126 million to $57 million, which would seem like a relatively big change in the fair value of something, so maybe walk us through the math there?

Sure. You've got the numbers pretty much spot-on, Gary. When we acquired HCP, in our purchase accounting, we had to estimate the fair value at that time. We had a probable likelihood that they would achieve their 2013 earn out being quite high, and we initially valued it in purchase accounting at roughly the $125 million number. Our assessment at the end of the second quarter was -- it was more of a 50/50 matter. And so the value of it is approximately 50% of the total earn out, which is $137.5 million.

Okay, and is that -- forgive me for not knowing this, but is that the earn out for 2013, or is that over a longer period of time?

It's for 2013. If you recall in the original architecture of the transaction, there was a $275 million potential earn out related to the achievement of EBITDA in 2012 and 2013. HCP achieved the earn out in 2012, and that's been paid. And then in 2013, the other 50% of the $275 million is the opportunity for HCP, and we are handicapping the likelihood that they will achieve that at roughly 50%.

Okay, and the goal there was, that was $600 million of EBITDA? Is that the number that's the target?

That is the target.

Okay. And then maybe if I could get one more question in on HCP and I'll jump back in the queue. Could we maybe get a little bit more detail on the update into Mexico?

Sure. We continue to -- what are the right words? We have not yet nailed down a sustainable partnership there. That's the bad news. It would be good if that was done. The good news, there are multiple people who want us to be their long-term partner, and we're making good progress in figuring out who is going to be the right one. But in the meantime, we're taking some hits in the context of the overall enterprise, not huge, but nonetheless, versus what we expected when we were developing the guidance for 2013. They are higher than what we had planned on. Is that responsive?

Yes, that's helpful. And maybe just to follow up, it's essentially the same issue that's been fairly well documented in the press, or has there been any change in that dynamic?

It's pretty much the same.

Okay. All right. I'll jump back in the queue. Thanks.

And your next question comes from the line of Justin Lake at JPMorgan. Your line is open.

Thanks. First, I'll start on HCP. You mentioned on your last call that approximately half of the rate pressure in Medicare Advantage next year could be mitigated by fault plan bidding. Given those bids were filed in June, I'm hoping you can give us an update on how we should think about HCP going into next year in this regard.

Bob Margolis here. We won't know that unfortunately until the plans officially are approved by CMS. And that's not until the October timeframe. So as you may know, the plans hold fairly close to the vest, their decisions on benefits for competitive reasons, give us some indications that they may or may not be moving to greater beneficiary responsibility. And we've continued to estimate, as we said before, that perhaps half of that allowable portion of MA cuts could be mitigated through benefit changes. But we do not have new information at this point.

So this isn't a two-way discussion between you and the plans in terms of how they are going to set benefits? At the end of the day, they are going to set them where they feel like they need to and you'll respond in terms of either accepting them or not? Is that the way to think about it?

That is generally a true statement. I wouldn't say we do not have significant conversations and input with our plan partners. More with the ones where we have a large penetration of their membership, and less when we have a smaller penetration. But ultimately, for competitive reasons, they make decisions about margin versus market share that are broader than their relationship just with us.

Got it. And then my follow-up question, I just wanted to go back to the interactions with DC and the CMS. If we -- clearly, I think, Kent, you give a lot of color on how these rate cuts have iterated, and in and of themselves, it's clear that dialysis isn't the only industry going through this in terms of CMS looking for dollars. But when you add it on top of the oral meds being delayed by Congress, the integrated care demo being disappointing, curious if you can expand a little bit in terms of how you feel with the relationship with DC is currently, versus what I call at least in my 10-plus years following the Company, the partnership that the industry has enjoyed with DC over time?

It's a fair question, Justin. And I guess when you cite the facts as you just did and as we have, it's clear that they made some decisions that we really wish they hadn't, and in particular, in a couple cases, really affecting our ability to take the quality of care and the effectiveness of each taxpayer dollar to a whole 20nother level, so it's profoundly frustrating. I don't think there's been any big change in our effectiveness as a community, or how we're viewed as a community. Maybe some change, because sometimes when a couple of companies are successful, then they become more tempting targets. But also we don't want to throw out as some convenient excuse if we're not doing the right job of advocacy and doing it the right number of years ahead of time. So as you know, it's kind of an unanswerable question, because there's so many different people in CMS, there's so many different people in Congress, so many different people in Medpac, I'm kind of stumbling here. I think it's a fair question and certainly we haven't done as well the last couple of years as we did the prior 10, but I don't think it's because of a dramatic shift in either of those two areas. But if someone asserted there had been some shift, I certainly couldn't prove them wrong.

Great. Okay. Thanks for all the color.

And your next question comes from the line of Kevin Fischbeck at Bank of America. Your line is now open.

I think that not many providers feel like CMS is treating them terribly well nowadays. Maybe we'll go back to Justin's first question, around how the bidding process actually works. I guess I understand the concept of not being able to see the plan's full benefits and understanding exactly how that flows through, but I guess just trying to understand, the way that I interpreted your response to that question was that you would not really know what rate you're going to get paid until October from the health plans, and I would think that would make it very difficult for the health plans to bid appropriately, not knowing if a major provider is going to be in their network or out of network. They don't go to you to run your business for the following year without that kind of visibility into October. So I just want to make sure I understood that dynamic correctly, and to the extent that I did, I'm curious of rate volatility in the past, how outside of the expectations could a rate come? How often do you end up terminating in October, when you finally see the rates?

Let me take a shot at that and perhaps Matthew will chime in as well. We do not generally need to renegotiate the contracts based on benefit changes, because we've prenegotiated that material benefit changes, that have financial impact, will be readjudicated. And the benefit change is often just member responsibility or beneficiary responsibility versus plan. So we have the opportunity, if there is a shift of copayments, et cetera, to the beneficiary, to collect that directly, which has a bit of a neutral offset. So the significant benefit changes that were detrimental to us would and almost all of our contracts require a negotiation, which, since we are major providers to the health plan, and they have been traditionally excellent partners, I would say has low probability of the terminations that you suggested.

Okay, but so do you have preliminary indications at this point? Or is that really still an October timeframe when you get that visibility?

We will not know the final benefit design of the plans until October.

Okay. So you won't know till October. Okay. And then I guess kind of alluded to the problems at ABQ. But is it purely an issue of volume shortfall that's creating the problem? Or is there something on the medical management side that's falling short? I'm still not clear about what exactly is the shortfall there.

Yes, I don't think I want to go into too much detail on one market and some of the competitive dynamics. It's just not in your best interest. But suffice it to say, when a leading physician group and a leading hospital get into a battle, it's expensive, and it's because of what happens with volume, what happens with rates, what happens with referral patterns, what happens with administrative expenses, legal expenses, PR expenses, lobbying expenses. So put all those together, and it means that everybody is distracted and not doing as well financially.

Okay. I guess going back to the commentary before about centers that are unprofitable and closing, including potentially at risk for closing, if the rate cut was to go through, as proposed. Is there any way to get a ballpark number as to how much money is actually being lost in those centers? Is it $50 million or bigger than that? How do we think about the relative size of that?

Yes, and I think -- I know we've not disclosed that, and at least for now, won't disclose it. In some cases, it's a tricky analysis because a center that loses money is part of our broader network of centers where we're strongly affiliated with a particular physician group or hospital, and so talking about the losses of a particular center in the form of an exact number is kind of tricky, and exactly what would happen if you closed it. And then many other centers are much more pure play independent centers that lose money. So for right now, we've not gone through the exercise of trying to segment them into the different categories. We're just focused on looking at which ones we would very sadly have to close if reimbursement made that a necessity.

Okay. And maybe last question, on a very different topic, one we haven't -- I don't think talked about for a couple quarters, but I'm not going to be surprised by this next year, any thoughts on exchanges now that we've gone through the exchange contracting, how has that been going for you? Are you getting really close to commercial? Is there any reason to expect any kind of disruption as far as whether dialysis is or is not covered under the payer part on the exchange, or that the rates aren't substantially different than commercial at this point?

Yes, in general, our position is that our commercial rates are our commercial rates, and exchanges are commercial patients and commercial enterprises. As to the impact of exchanges overall, of course, anybody who forecasts that with certainty should not be trusted. But what we said in general is that if you look at the number of additional insured patients we might have, who weren't insured before, and the rates that they will be reimbursed at versus patients that are currently reimbursed high and move to an exchange, where for some reason because of a change in plan or something else, or plan design, have lower reimbursement rates, that the net of those four different vectors, we think for us is more likely to be a negative than a positive. But that's just repeating the same thing we've said for two years now. And beyond that, like everyone else, we're watching what's going on in every state and don't know what's going to happen.

Okay, great. Thanks.

I do think -- I appreciate the questions and we can come back to you again a little bit later in the queue if that's okay.

Thanks.

And your next question comes from the line of Kevin Ellich at Piper Jaffray -- sorry, at Bank of America. Your line is now open.

He had it right. It was Piper Jaffray. Good afternoon. Thanks for taking the questions. I guess just going back to HealthCare Partners, Kent, did you say in your prepared remarks that you had exited a contract and if so, I was just wondering, is that why the membership is down sequentially? How much of an impact did that have?

Yes, it's exactly right. The sequential decline from Q1 was because we had bad rates in one arrangement, and it wasn't going to change. In fact, it was going the wrong direction. And so we exited. It just didn't make sense. It's so important, as you know, to maintain rate discipline.

Will you say -- can you tell us which market that was in?

Don't think that's a good idea for you, for us to get into too many individual market competitive dynamics. More often than not, that could actually impair our ability to execute on our strategy, and through the arrangements that you want us to, it's much more likely than helping us.

Got it. Okay. And then I was just wondering if you could maybe talk about the utilization trends that you saw during the quarter, and kind of the puts and takes and how that impacted the HCP business?

Before I let Bob or Matthew answer that, let me go back, because I was being a little tentative in one of my answers, and I now know I don't need to be. With respect to rates and the exchanges, up to this point for health plans that want access to our network, where we've agreed on them having access to our network, we've been successful in getting commercial rates, that is the dominant reality in that sphere. And then I'll go back to one thing that Justin brought up, too, before they answer the question, which is part of what was a little puzzling and surprising about the ESCO announcement is that very senior people at CMS, I mean, very senior, expressed a real desire to have integrated care happen for a lot more Medicare patients in the Kidney Care program, and to get a proposal back that's so inconsistent with that was -- is a little bit puzzling, although we've got our hypotheses. But now to the answer to your question, I'll turn to Bob or Matthew.

Nothing specific to add on utilization. There is volatility, as Kent has described in quarter-to-quarter numbers in HealthCare Partners. In the second quarter, we had higher than anticipated utilization. There's a variety of reasons why that happens, but I don't think it's useful to go into great deal on that. And so on a long-term trend, we were higher than expected, with our great expectation that our coordinated care services and attention to detail will get us back on trend.

Bob, I just kind of want to follow up on that. It seems like every place else, where all the other providers are really talking about lower utilization. Is it really just the patient population in the markets that you are in, which is why you were seeing higher than expected utilization trends?

I think this was a one -- a quarterly issue. And I think overall, our utilization trends compare very favorably with what you're seeing in the market. We did have -- which ultimately we believe will be good news, significant new member growth, which Kent described, and those new members often come in with deferred healthcare needs, which, of course, we take care of as quickly as we can. So I think that may play a part of it. I think as you saw, 20% year-over-year growth in MA in our legacy markets is very substantial, and a hopeful sign for future margins on that patient volume.

Got it. And then just one more on dialysis, if I could. A lot's been talked about with rebasing in the proposal. But I think Jim said LeAnn is on the call. I'm wondering what the conversations are like on the Hill and DC, and how the efforts are going?

LeAnn, take it away.

Yes, we have been working right in the last three weeks with the House, and we did get a letter in support of looking fairly at reimbursement from 205 signators, so that was very good. We are also working with the Senate Finance Committee, as we did before the rule was out, to take a next step in pursuing appropriate reimbursement. We're also working with some non-Finance Senate members and feel like we are getting good education and good response to help us work appropriately with the Agency. Is that responsive?

Yes, that's helpful. Thank you.

And LeAnn, is it -- can you go ahead and disclose -- I know the entire community is scared and communicating proportionate to that fear. Can you -- is it fair to let the group know how many e-mails and letters have come from the DaVita community alone, to people on the Hill?

Sure. We have topped the 80,000 mark, and as Kent said, a number of the other organizations and coalition have letter-writing campaigns and advocacy campaigns. And those numbers are getting quite significant as well. So very good uniform effort through the community.

There's never been such pervasive fear.

Got it. Thank you.

Operator, you can go on to the next person, please.

And your next question comes from Matthew Borsch at Goldman Sachs. Your line is open.

Maybe if you can talk about how are you working with private payers on reimbursement and that front? I guess the question I'm asking is, are you seeing any pushback there on their effective subsidization of the dialysis program? Or is the fact that they can also see this Medicare rate update scaring them away from even trying to impact the reimbursement on the commercial side?

The answer is, they will push back on rates as aggressively as they always have, and as we would if we were in their chairs. Now, having said that, the laws of gravity can't be disputed, and if we take a reimbursement cut, that means we and all sorts of dialysis providers will have to draw a different line in the sand in trading off-price versus volume, because you can't survive otherwise. So they will push as vigorously as they always have. However, a cut does mean that everybody has to be even stronger in their resistance to that, because it's so important.

And if I could ask a question on the pipeline for HealthCare Partners. As you think about those opportunities relative to opportunities that have come up since you closed, or even before you closed, and any instances where hospitals and health plans have been willing maybe to offer higher amounts than you thought was prudent for some of these physician groups, where they have come up for sale. Is that dynamic something that you expect to change? Do you think that there are groups that are willing to think longer term than just the immediate price that they might get, and think longer term about which model will work best?

Well, we certainly believe so and hope so. The attractiveness, we believe, of a patient and physician centric clinical model is very attractive to physicians everywhere, and as you referenced, the robustness of our pipeline is not just physician groups that we're talking to, but payers that would like our model to be translated into markets that they have significant market share, shared participation arrangements with hospitals, that are trying to learn how to take on and manage risk. And so, I think there's a much broader universe than just the relative number of physician groups up for sale, some of whom will gravitate towards highest price, and some of them towards cultural alignment.

And is the challenge for the Company now to have the, to build up the business development assets to be able to simultaneously go at different complicated opportunities in many different geographic markets?

I think that's a fair statement. And I can't reference the significant work we're doing to build the, as he puts it, the muscles of our business development team, using a lot of the growth and knowledge and experience of our DaVita teammates who have done this for years successfully, and the HealthCare Partner capabilities translated into coordinated and accountable care in many, many more markets, where we believe the country is moving inexorably away from fee-for-volume to fee-for-value.

And let me just, if I could, ask a question on the, on the integrated care pilot. And you've gotten this question before, but have you considered where you could be, maybe an MA plan sponsor yourself, not in competition with payers generally, but just for the purposes of the dialysis patients, and take it on that way?

We would love to. There's a whole bunch of structural obstacles to our being able to do that. However, we think about it every year because we know we have such a powerful value proposition to bring to bear. It's just that there's not a clear rifle shot, nothing close to it in terms of an ability to have that manifest itself in a commercially reasonable and sustainable way.

Okay. All right. Thank you.

And your next question comes from the line of Ben Andrew at William Blair. Your line is now open.

Maybe a question about the dual eligibles opportunity. With some of the states delaying implementation of their programs, it does seem like California might still be moving forward. Is there any update there on plans or how that may shake out for you over the next year or so?

You're absolutely right. The states are all in a state of negotiation and discussion. California does seem committed to rolling out a modified dual-eligible program, and the modified meaning smaller than everybody in the counties that were approved. There is still intense discussion that we're told about, but not participating in between the states and CMS, over how this will be reimbursed, and where the responsibility will lie for certain risks. We believe we are well positioned, if the revenue meets the risk, to be a very active participant in the dual program in the two largest counties, Los Angeles and Orange County, that are going to have approximately 200,000 dually eligible patients in the program.

Interesting. So can you talk a little bit about how that may affect the two different sides of the business? Specifically in dialysis, what that -- is that what you're referring to there, or is that a separate opportunity?

I'm sorry. Could you repeat the question?

The question is how that affects the different parts of the business, because if I was talking about the 200,000 patients, was he specifically referring to your overall HCP business, and then how would that affect perhaps the dialysis side?

So let me speak to the 200,000. That's 200,000 currently fee-for-service duly eligible patients that will be eligible and will be assigned to a managed Medicaid, and presumably a managed Medicare program. So that's where the population tells the healthcare partner piece potentially in the future.

Right.

On the dual side for Kidney Care, about half of our patients are duals. And so to the extent any of them become a part of other programs that are risk programs, we become a very attractive subcontractor to whoever has the global risk. Having said that, there's been a lot of talk about duals for a while, and the pace at which stuff is happening is pretty slow.

Okay. So we shouldn't expect a meaningful update there until sometime probably next year perhaps?

Well, we hope. They are only a couple decisions away, but you never know when they are going to be made. I think the net for you is the good news is, the long-term potential is immense and quite sustainable, because there's so much waste. But predicting when they are going to actually make final decisions and implement, and how much the architecture will really reflect the need to create rational incentives for people to make the big investments, predicting those two things is a, a level of speculation we're not comfortable with.

Okay. And then maybe a quick question for Jim on the expense side, on the international side. It looks like you lost a fair bit less money in international this quarter, even as you were investing. How should we think about that quarterly or over the next year, in terms of the losses versus what you've projected before?

Well, we still expect our international losses to be in the range of $30 million for the year, and that's assuming that we don't do any large, start up any large programs late in the year. If we do, then those numbers may change, but that's -- we were happy to see those losses trimmed down to $6 million in the quarter.

Okay, and then another thing in the P&L we noticed was obviously the gross margin came down, but SG&A came down by a commensurate amount. Do you feel like you have a fair bit more leverage to absorb some of the volatility in HCP, to the extent that materializes? Or how should we think about that margin opportunity as things shake out?

I'm not clear on the question, whether it's HCP or kidney care or consolidated.

It's really consolidated, Kent. I mean, it's thinking through kind of the moving pieces and you missed on gross margin, but you also exceeded in terms of performance on controlling costs on the SG&A side, and how controllable that is versus things that are, if you will, done to you each quarter.

Boy, I don't know how to answer. We certainly can't move G&A down quarter-by-quarter based on retroactive recognition of what happened on the reimbursement side and utilization side. And so first, with respect to whatever happened coincidentally this quarter, I don't think one should draw any broad conclusions from that as to our ability to juggle these things. Second, are we going to look for SG&A savings in 2014 versus 2013 on both sides of the house? The answer is yes. So the -- we will not come back to you with a zero answer on that. Just on the HCP side, it's not going to be enough to offset all the cuts. On the Kidney Care side, we don't know yet if we have a cut to offset. But certainly the one proposed would be impossible to come anywhere close to offsetting.

Okay. Thank you.

And your next question comes from the line of John Ransom at Raymond James. Your line is now open.

I think we're all in discovery mode with HealthCare Partners. I know you're not going to have great information, as you said, until the fall. But maybe if you look back in history, what has happened historically, when your major partners, let's say Humana and United, people like that, you end up getting 5% to 7% cuts sequentially, have you ever seen anything of that magnitude in your history? And historically, how have they acted with their downstream partners versus their benefit design? That might be helpful.

John, Bob and Matthew will answer. Before they do, let me just announce that I've got a conversation booked with a former government official. It's important I go do that. The rest of the team will be here to continue to take questions. And if in any instance there's a question where someone feels that my perspective is important beyond that which the team offered, we can take care of that over the next week or two. Thank you all for your consideration and interest in us, and we will do our best here in the quarters and years to come. But now Bob and Matthew, the question.

I think that the quick and easy answer is that the health plans have not been faced with this type of cut in the last many years, and so they are all reacting as well. And not being a health plan executive, I can't pretend to say what they are doing inside of their offices, but I think reflecting the past comments, they are trying to assess the market position relative to their competitors, and whether they are going to lose market share, if they trim benefits too much versus gain market share, and have lower margins if they don't. And the fact is that CMS puts some limits on how much they could push these benefit changes down to the beneficiary. The good news is that in the markets we serve, there remains a considerable difference between the value proposition for MA and Medicare fee-for-service, and none of our markets even have an MA premium, for instance, where that is prevalent in some of the lower paid markets that you might be aware of. So there is a fair amount of room to maintain growth and continue it being a good product, even if some benefit changes to the beneficiaries are in the direction that the beneficiaries would rather not see.

And my other question -- as Humana has said, they want to have much more of their book subcapitated than they have today. Do you see any evidence of that downstream to you, or if so, when might you see, and what would that look like exactly, do you think?

Well, as I think it's a great question and a business opportunity, as you may know, in all of our markets, we are capitated with our major health plans. So when they make that kind of comment, it's not relative to the more sophisticated organizations such as HealthCare Partners, but to other parts of the country, where they have not been able to find capable risk-bearing physician organizations, and of course that is the formula that we plan to use to offer up to accountable organizations elsewhere. So when Humana or others talk to us about new market entry, it's very specifically because of the problem that they are trying to address, which is they would like to go to capitated relationships, allowing incentives, recognizing capitated relationships, the incentives are to keep the patients well, healthy, delay or prevent chronic disease, avoidable admissions, readmissions, and the like, whereas fee-for-service, those incentives do not exist, and it's one of the main drivers of the health care cost conundrum the country faces.

Thank you very much.

And your next question comes from the line of Gary Taylor at Citigroup. Your line is now open.

The first, I was probably hoping to get Kent's perspective, but I'm sure someone else can tackle it. I guess I was hoping you could make reconcile the thought that negative dialysis margins are an important part of the lobbying position of the industry, with respect to the proposed rebasing cuts. And I think this is an important part, so just understanding the reconciliation. If we look at the Medpac report based on the last analysis they did of 2010, they show 2.3% positive margins for the whole industry. I would presume because of DaVita's scale, your margins might be a little better than that. And certainly margins improved once the bundle was implemented in 2011. So how do we get back to negative overall Medicare margins? Is the Medpac analysis just completely flawed, in your opinion?

Yes, this is LeAnn. Let me take that. No, the Medpac analysis is based on the cost reports that we file. As Kent mentioned, one of the most significant drivers of our difference is the, let's call it, uncompensated care bucket. The unreimbursed co-insurance, which is therefore also not reimbursed through the bad debt policies. And so our biggest concern about any analysis that's done by the government, whether that be Medpac or CMS itself, is that their presumption is primarily that the copay is 100% collected and it's not.

Okay. So even net of Medicaid contribution on dual eligibles that would net out to overall negative, including that. That's the case?

Correct. That's, that's a fair point. There's another cost in the cost report, which are not recognized, as we take exception for. But as a vehicle of how they do analysis, they strictly maintain the cost report, filing, data, and don't consider these other factors.

Got it. Thank you. And my second question is a little bit of a cleanup from last quarter, when you booked the legal reserve for the issues with respect to the physician relationships, and I've had a few clients ask the question, so I thought I might pose it here. And the question is, is it contemplated, once that settlement is reached, if it's reached, that there's any material change to physician ownership percentage in the JVs, any material change to operating practices, or if this really is perhaps paperwork type changes, for lack of a better characterization?

Yes, Gary, this is Jim. And those conversations are ongoing. Right now, the settlement, our goal as we said last quarter, is to ensure that we have clarification and that it is a level playing field going forward. But to talk about the nature of those discussions doesn't make sense, until we have clarity on that.

Okay. That's it. Thank you.

And your next question comes from the line of Frank Morgan at RBC Capital Markets. Your line is now open.

Two quick questions. Maybe not answering this specifically, but maybe just a comment about directionally, can you talk about what your commercial mix of business is, which way it's trending on the dialysis side, is it increasing, decreasing or flat?

Yes, I mentioned this earlier in my prepared remarks. This is Jim Hilger, Frank. Our commercial mix in the quarter improved slightly.

Okay. Secondly, on, in terms of, if there is a need to close centers as a result, let's say worst case scenario, this proposed rule stands, is there anything, any type of what would be the characteristics of the synergy would be more likely to close? I mean, are these that are presumably losing more money, are they in the smaller markets, larger markets? Is there anything that we could look for in terms of those centers that might be closed? Thank you.

Yes, this is LeAnn. The commonality of those facilities are that they are high Medicare/Medicaid share. So that could be a very inner-city unit and it can be a very rural unit. Both of those frequently do not have sufficient private pay patients to cross-subsidize the Medicare shortfall.

Okay. So would there be a priority of one over the other in terms of the magnitude of losses, be it inner city versus rural?

No, I think they are both on the list, and each center will be evaluated independently.

Okay. Thanks.

And your next question comes from the line of Dana Nentin at Deutsche Bank. Your line is now open.

Just wanted to clarify something from earlier. Was the earn out adjustment from the original HCP deal, or were there any other subsequent deals in there?

No, that earn out adjustment that we called out in the earnings release and on our call today was related to the HCP acquisition, which closed in November of 2012. And just to make sure I got my numbers right, because I may have juxtaposed a number in there, we had initially recorded a fair value of approximately $125 million to our purchase accounting of HCP in that transaction, and we have adjusted that by $57 million, and are now, the fair value that we are placing on that, on that earn out obligation, is approximately $69 million.

Okay, great. Thank you.

And there are no further questions. Go ahead.

Yes. I was just going to say I believe that's the last of the questions in the queue. So, again, I want to thank everybody for your interest in the Company, and as Kent always says, we will strive to continue to do well with your money over the next quarter, and we'll of course talk to you in the future. Thanks.

This concludes today's conference call. You may now disconnect.