One big deal can easily beget an-
other. When a merger between
two companies threatens to displace a third company from an advantageous market position, we often see the affected company pursue its own deal to regain and shore up its cherished position. This gambit is being played out this month in the dialysis services sector.

Last December, when DaVita (NYSE: DVA) announced it was acquiring Gambro Healthcare USA from its Swedish parent for nearly $3.1 billion, it was, in effect, throwing down the gauntlet to other providers of dialysis services. That transaction, when completed, would make DVA the country’s largest provider of dialysis services (see the chart on page 3), conferring on it all the benefits of being top dog. But it was just a matter of time before the company that DaVita was implicitly challenging would react.

And react it did. A scarce four months later, Fresenius National Medical Care (NYSE: FMS) took up DVA’s challenge to its first-place standing in the U.S. dialysis market by announcing that it would acquire competitor Renal Care Group (NYSE: RCI) in a deal valued at $4.0 billion.

Owned by Germany’s Fresenius Medical Care AG, Fresenius is the largest provider of dialysis services in the United States. It provides these services to 85,500 patients with end-stage renal disease (ESRD) in North America (and a total of 124,400 worldwide). In North America alone, FMS provides care at 1,130 dialysis centers where in 2004 it provided 12,908,788 dialysis treatments.

While the majority of its revenue comes directly from dialysis, Fresenius also derives revenue from ancillary services such as lab tests and the provision of erythropoietin, which is used to manage the anemia that can accompany dialysis treatments. On a trailing 12-month basis, FMS generated worldwide revenue of $6 billion, EBITDA of $1 billion and net income of $386 million. Of that amount, $4.2 billion in revenue came from its U.S. operations.

Fresenius entered the U.S. market in a big splash in 1996 when it acquired W.R. Grace’s (NYSE: GRA) dialysis operations, National Medical Care, for $2.3 billion. Since that grand gesture, the company has gotten used to being regarded as the single largest provider of dialysis services in the country. In this role, it has been in an enviable position to negotiate with payors and vendors. True, the majority of its revenue comes from Medicare and Medicaid, which offers just so much leeway in negotiating payments for ESRD treatments, but FMS also has third-party payors. Its size also gives it some market clout in negotiating with vendors such as Amgen (NASDAQ: AMGN), the sole provider of erythropoietin.

Fresenius has long been content to extend its number one position through a constant stream of acquisitions, albeit modest ones, making 14 acquisitions of dialysis centers and dialysis-related businesses in the past nine years. But that all changed when DaVita moved to challenge its preeminence in the industry.

Based in Nashville, Kentucky, Renal Care Group was formed in March 1996 through a consolidation IPO of five smaller dialysis companies that served approximately 2,660 patients. That IPO was worth nearly $141 million, which was valued at 1.98x revenue, or $53,000 per ESRD patient.

Since that time, RCI has undertaken 48 acquisitions. During this period, the price to revenue multiple has averaged 1.7x and the price per ESRD patient $60,000. Most RCI acquisitions have been fairly small, but in February 2004, it acquired National Nephrology Associates in a $345 million deal, valued at 1.75x revenue.

Currently and as a result of all this activity, Renal Care Group provides dialysis services to 30,400 ESRD patients at over 425 owned outpatient centers. RCI also manages dialysis programs at over 210 hospitals. On a trailing 12-month basis, RCI generated revenue of $1.4 billion, EBITDA of $331 million and net income of $125 million. Apart from attractive margins, what makes RCI stand out in the industry is that 43% of its patients are privately insured rather than dependent on Medicare or Medicaid.

Under terms of the deal, FMS will pay $48 per share in cash for a total of $3.5 billion. By adding in $500 million of assumed debt, the purchase price rises to $4 billion. This transaction, which is to be all-debt financed, offers RCI shareholders a 22% premium over the stock’s prior-day price. Banc of America Securities and Morgan Stanley & Co. acted as RCI’s financial advisors while Cravath, Swaine & Moore LLP and Alston & Bird LLP served as its legal counsel.

The combination of these two would create an organization with $6.0 billion in revenue ($7.5 billion worldwide), serving 117,000 ESRD patients (154,000 worldwide) at over 1,560 dialysis clinics in North America.

While FMS moves back into the top slot with this deal, it does so at a price. It is paying nearly 2.8x revenue, 13x EBITDA and $131,600 per ESRD patient, all hefty multiples for a dialysis company. Insiders at RCI will be happy, of course, cashing out with millions. But on the other side of the coin, even FMS admits that the cost-saving synergies of $50 million a year do not necessarily justify the high price. So what is in it for the buyer?

One possible upside of this deal is the potential refinancing of FMS’ debt, which currently has a cost of around 7.5%. FMS’ existing $1.2 billion credit agreement is to be replaced by a $5.0 billion senior credit facility. Financing commitments have already been received from Bank of America and Deutsche Bank. Another perk of the deal is RCI’s high level of private pay, but once that is blended with FMS’ current level, the overall level will rise only slightly.

So we might view this deal as "strategic" in a sense often encountered in health care M&A, namely that the transaction does not make purely financial sense (lots of debt, lots of goodwill).

The preoccupation with size for size’s sake is one often associated with personal rather than business motives. In this vein, it should be noted that FMS’s German parent is proposing a reorganization to change from a stock company (AG) to a partnership (KGaA) with general and limited liability partners. Along with this transformation of legal form, preference shares are to be converted into ordinary shares, expanding the amount of shares freely circulating from 49% to 63%, thereby helping to protect Fresenius AG’s position in the benchmark DAX-30 index. But both moves also have a pointedly personal upshot: they help Fresenius’ main shareholder retain management control over the company.