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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
For the Quarter Ended June 30, 2002
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
Commission File Number: 1-4034
 
 
DAVITA INC.
 
21250 Hawthorne Blvd., Suite 800
Torrance, California 90503-5517
Telephone # (310) 792-2600
 
Delaware
  
51-0354549
(State of incorporation)
  
(I.R.S. employer identification no.)
 
 
The Registrant has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and has been subject to such filing requirements for the past 90 days.
 
As of July 31, 2002, there were approximately 63.9 million shares of the Registrant’s common stock (par value $0.001) outstanding.
 

 
DAVITA INC.
 
INDEX
 
         
Page No.
    
PART I.    FINANCIAL INFORMATION
 
     
Item 1.
   
Condensed Consolidated Financial Statements:
     
       
1
       

2
       

3
       
4
Item 2.
      
14
Item 3.
      
18
  
19
      
    
PART II.    OTHER INFORMATION
 
     
Item 1.
      
23
Item 2.
      
23
Item 4.
      
23
Item 6.
      
24
  
25
Note: Items 3 and 5 of Part II are omitted because they are not applicable.
 

i

DAVITA INC.
 
CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands, except per share data)
 
    
June 30, 2002
     
December 31, 2001
  
ASSETS
                  
Cash and cash equivalents
   
$
137,020
 
   
$
36,711
 
Accounts receivable, less allowance of $54,765 and $52,475
   
 
347,064
 
   
 
333,546
 
Inventories
   
 
31,769
 
   
 
34,901
 
Other current assets
   
 
13,852
 
   
 
9,364
 
Deferred income taxes
   
 
61,607
 
   
 
60,142
 
    
  
Total current assets
   
 
591,312
 
   
 
474,664
 
Property and equipment, net
   
 
267,335
 
   
 
252,778
 
Amortizable intangibles, net
   
 
67,987
 
   
 
73,108
 
Investments in third-party dialysis businesses
   
 
3,449
 
   
 
4,346
 
Other long-term assets
   
 
1,876
 
   
 
2,027
 
Goodwill
   
 
852,691
 
   
 
855,760
 
    
  
    
$
1,784,650
 
   
$
1,662,683
 
    
  
LIABILITIES AND SHAREHOLDERS’ EQUITY
                  
Accounts payable
   
$
77,374
 
   
$
74,630
 
Other liabilities
   
 
98,739
 
   
 
111,164
 
Accrued compensation and benefits
   
 
94,880
 
   
 
88,826
 
Current portion of long-term debt
   
 
8,299
 
   
 
9,034
 
Income taxes payable
   
 
11,036
 
   
 
15,027
 
    
  
Total current liabilities
   
 
290,328
 
   
 
298,681
 
Long-term debt
   
 
1,316,153
 
   
 
811,190
 
Other long-term liabilities
   
 
6,077
 
   
 
5,012
 
Deferred income taxes
   
 
37,045
 
   
 
23,441
 
Minority interests
   
 
21,613
 
   
 
20,722
 
Shareholders’ equity:
                  
Preferred stock ($0.001 par value; 5,000,000 shares authorized; none issued or outstanding)
                  
Common stock ($0.001 par value, 195,000,000 shares authorized; 88,033,939 and 85,409,037 shares issued)
   
 
88
 
   
 
85
 
Additional paid-in capital
   
 
507,788
 
   
 
467,904
 
Retained earnings
   
 
100,356
 
   
 
56,008
 
Treasury stock, at cost (20,716,437 and 888,700 shares)
   
 
(494,798
)
   
 
(20,360
)
    
  
Total shareholders’ equity
   
 
113,434
 
   
 
503,637
 
    
  
    
$
1,784,650
 
   
$
1,662,683
 
    
  
 
See notes to condensed consolidated financial statements.

1

DAVITA INC.
 
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(unaudited)
(dollars in thousands, except per share data)
 
    
Three months ended
June 30,
     
Six months ended
June 30,
  
    
2002
     
2001
     
2002
     
2001
  
Net operating revenues
   
$
442,677
 
   
$
400,640
 
   
$
870,342
 
   
$
786,857
 
Operating expenses:
                                    
Dialysis centers and labs
   
 
300,552
 
   
 
271,545
 
   
 
592,186
 
   
 
532,519
 
General and administrative
   
 
42,024
 
   
 
32,417
 
   
 
78,077
 
   
 
64,230
 
Depreciation and amortization
   
 
15,698
 
   
 
26,624
 
   
 
31,503
 
   
 
52,772
 
Provision for uncollectible accounts
   
 
5,882
 
   
 
(378
)
   
 
11,137
 
   
 
(8,563
)
Impairments and valuation adjustments
   
 
(2,390
)
            
 
(2,390
)
         
    
  
  
  
Total operating expenses
   
 
361,766
 
   
 
330,208
 
   
 
710,513
 
   
 
640,958
 
    
  
  
  
Operating income
   
 
80,911
 
   
 
70,432
 
   
 
159,829
 
   
 
145,899
 
Other income, net
   
 
3,283
 
   
 
1,120
 
   
 
3,848
 
   
 
2,468
 
Debt expense
   
 
17,139
 
   
 
18,715
 
   
 
32,211
 
   
 
38,439
 
Minority interests in income of consolidated subsidiaries
   
 
(2,827
)
   
 
(2,269
)
   
 
(5,260
)
   
 
(4,726
)
    
  
  
  
Income before income taxes and extraordinary item
   
 
64,228
 
   
 
50,568
 
   
 
126,206
 
   
 
105,202
 
Income tax expense
   
 
26,500
 
   
 
22,000
 
   
 
52,500
 
   
 
45,700
 
    
  
  
  
Income before extraordinary item
   
 
37,728
 
   
 
28,568
 
   
 
73,706
 
   
 
59,502
 
Extraordinary (loss) gain related to early extinguishment of debt, net of tax of $19,572 in 2002 and $652 in 2001
   
 
(29,358
)
   
 
977
 
   
 
(29,358
)
   
 
977
 
    
  
  
  
Net income
   
$
8,370
 
   
$
29,545
 
   
$
44,348
 
   
$
60,479
 
    
  
  
  
Comprehensive income
   
$
8,370
 
   
$
29,545
 
   
$
44,348
 
   
$
60,479
 
    
  
  
  
Basic earnings per share:
                                    
Income before extraordinary item
   
$
0.47
 
   
$
0.34
 
   
$
0.91
 
   
$
0.72
 
Extraordinary (loss) gain, net of tax
   
 
(0.37
)
   
 
0.01
 
   
 
(0.36
)
   
 
0.01
 
    
  
  
  
Net income
   
$
0.10
 
   
$
0.35
 
   
$
0.55
 
   
$
0.73
 
    
  
  
  
Diluted earnings per share:
                                    
Income before extraordinary item
   
$
0.43
 
   
$
0.32
 
   
$
0.83
 
   
$
0.67
 
Extraordinary (loss) gain, net of tax
   
 
(0.30
)
   
 
0.01
 
   
 
(0.29
)
   
 
0.01
 
    
  
  
  
Net income
   
$
0.13
 
   
$
0.33
 
   
$
0.54
 
   
$
0.68
 
    
  
  
  
 
See notes to condensed consolidated financial statements.

2

 
DAVITA INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)
 
    
Six months ended
June 30,
  
    
2002
     
2001
  
Cash flows from operating activities:
                  
Net income
   
$
44,348
 
   
$
60,479
 
Adjustments to reconcile net income to cash provided by operating activities:
                  
Depreciation and amortization
   
 
31,503
 
   
 
52,772
 
Impairments and valuation adjustments
   
 
(2,390
)
         
(Gain) loss on divestitures
   
 
(462
)
   
 
362
 
Deferred income taxes
   
 
11,843
 
   
 
4,469
 
Non-cash debt expense
   
 
1,526
 
   
 
1,155
 
Stock options, principally tax benefits
   
 
16,304
 
   
 
9,931
 
Equity investment (income)
   
 
(960
)
   
 
(1,070
)
Minority interests in income of consolidated subsidiaries
   
 
5,260
 
   
 
4,726
 
Extraordinary loss (gain)
   
 
29,358
 
   
 
(977
)
Changes in operating assets and liabilities, excluding acquisitions and divestitures:
                  
Accounts receivable
   
 
(20,471
)
   
 
(2,368
)
Inventories
   
 
2,436
 
   
 
(23,456
)
Other current assets
   
 
(4,533
)
   
 
(957
)
Other long-term assets
   
 
151
 
   
 
137
 
Accounts payable
   
 
9,315
 
   
 
4,031
 
Accrued compensation and benefits
   
 
6,367
 
   
 
9,143
 
Other current liabilities
   
 
(536
)
   
 
13,485
 
Income taxes payable
   
 
15,878
 
   
 
2,767
 
Other long-term liabilities
   
 
1,118
 
   
 
129
 
    
  
Net cash provided by operating activities
   
 
146,055
 
   
 
134,758
 
    
  
Cash flows from investing activities:
                  
Additions of property and equipment, net
   
 
(43,691
)
   
 
(18,583
)
Acquisitions and divestitures, net
   
 
(1,426
)
   
 
(51,124
)
Investments in affiliates, net
   
 
1,857
 
   
 
20,646
 
Intangible assets
   
 
(30
)
   
 
(10
)
    
  
Net cash used in investing activities
   
 
(43,290
)
   
 
(49,071
)
    
  
Cash flows from financing activities:
                  
Borrowings
   
 
1,323,335
 
   
 
1,305,824
 
Payments on long-term debt
   
 
(819,107
)
   
 
(1,331,617
)
Debt redemption premium
   
 
(40,910
)
         
Deferred financing costs
   
 
(10,781
)
   
 
(9,972
)
Purchases of treasury stock
   
 
(474,438
)
   
 
(2,494
)
Proceeds from issuance of common stock
   
 
23,583
 
   
 
10,295
 
Distributions to minority interests
   
 
(4,138
)
   
 
(3,672
)
    
  
Net cash used in financing activities
   
 
(2,456
)
   
 
(31,636
)
    
  
 
Net increase in cash
   
 
100,309
 
   
 
54,051
 
Cash and cash equivalents at beginning of period
   
 
36,711
 
   
 
31,207
 
    
  
Cash and cash equivalents at end of period
   
$
137,020
 
   
$
85,258
 
    
  
 
See notes to condensed consolidated financial statements.
 

3

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(dollars in thousands, except per share data)
 
Unless otherwise indicated in this Form 10-Q “the Company”, “we”, “us”, “our” and similar terms refer to DaVita Inc. and its subsidiaries.
 
1.    Condensed consolidated interim financial statements
 
The condensed consolidated interim financial statements included in this report are prepared by the Company without audit. In the opinion of management, all adjustments consisting only of normal recurring items necessary for a fair presentation of the results of operations are reflected in these consolidated interim financial statements. All significant intercompany accounts and transactions have been eliminated. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. The most significant estimates and assumptions underlying these financial statements and accompanying notes generally involve revenues and bad debt provisions, and, correspondingly, accounts receivable. The results of operations for the six month period ended June 30, 2002 are not necessarily indicative of the operating results for the full year. The consolidated interim financial statements should be read in conjunction with the Management’s Discussion and Analysis and consolidated financial statements and notes thereto included in the Company’s 2001 Form 10-K. Certain reclassifications have been made for consistent presentation.
 
2.    Significant new accounting standards
 
The Company has adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Under SFAS No. 142, goodwill is not amortized effective January 1, 2002. SFAS No. 142 also requires that the goodwill balance be regularly assessed for possible valuation impairment and that there be an impairment charge against current earnings if the recorded goodwill balance exceeds fair value. If this standard had been implemented as of January 1, 2001, amortization expense would have been reduced by approximately $6,300 and $12,600 net of tax, for the three and six months ended June 30, 2001. Income before extraordinary item and diluted income before extraordinary item per share would have been approximately $34,900 and $72,100 and $0.38 and $0.80 per share for the same periods.
 
3.    Recapitalization and shareholders’ equity
 
In March 2002, the Company initiated a recapitalization plan consisting of debt restructuring and repurchases of common stock.
 
On April 26, 2002 the Company completed the initial phase of the recapitalization plan by repurchasing all of its $225,000 outstanding 9¼% Senior Subordinated Notes due 2011 at a total cost of approximately $266,000. The difference between the reacquisition price and the net carrying amount of the Senior Subordinated Notes, together with the write-off of deferred financing costs associated with extinguishing the existing senior credit facilities and notes, resulted in a net extraordinary loss of $29,358.

4

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
On June 6, 2002, the Company completed the next phase of the recapitalization plan with the repurchase of 16,682,337 shares of its common stock for approximately $402,000, or $24 per share, through a modified dutch auction tender offer.
 
On May 30, 2002, the Company’s Board of Directors authorized management to repurchase up to an additional $225,000 of common stock over the next eighteen months. As of June 30, 2002, 199,700 shares had been purchased for $4,748. As of July 31, 2002, 3,676,200 shares at a cost of $78,652, have been repurchased under this authorization. For the six months ended June 30, 2002, stock repurchases totaled 19,827,737 shares for a total cost of approximately $474,000, or a composite average of $23.93 per share.
 
The Company secured a new senior credit facility agreement in the amount of $1,115,000 to finance these transactions and to pay down all outstanding amounts under the previously existing senior credit facilities. The new senior credit facility consists of a Term Loan A for $150,000, a Term Loan B for $850,000 and a $115,000 undrawn revolving credit facility, which includes up to $50,000 available for letters of credit. The Term Loan A and the revolving credit facility bear interest at a rate equal to LIBOR plus a margin ranging from 1.5% to 2.75% based on the Company’s leverage ratio. The Term Loan B bears interest at LIBOR plus 3.00%. As of June 30, 2002, $850,000 of the Term Loan B had been drawn. The Company is currently evaluating its current and future liquidity requirements for potential borrowings under the Term Loan A but has no obligation to draw the loan. The lenders’ commitment to fund the undrawn portion of the Term Loan A will expire in January 2003. If the entire $1,000,000 term credit facility is drawn, the aggregate annual principal reductions will range from $16,000 to $51,000 in years one through five, and will be $403,000 in each of years six and seven, with the balance due not later than 2009. The new senior credit facility is secured by all personal property of the Company and its wholly-owned subsidiaries, along with the stock of the Company’s subsidiaries. The new senior credit facility also contains certain financial and operating covenants and limits the Company’s investments. As of June 30, 2002, the Company was in compliance with the financial and operating covenants of the credit facility in all material respects.
 
Long-term debt was comprised of the following:
 
    
June 30, 2002
     
December 31, 2001
  
Senior secured credit facilities
   
$
846,075
 
   
$
114,000
 
Senior subordinated notes, 9¼%, due 2011
   
 
—  
 
   
 
225,000
 
Convertible subordinated notes, 7%, due 2009
   
 
345,000
 
   
 
345,000
 
Convertible subordinated notes, 5 5/8%, due 2006
   
 
125,000
 
   
 
125,000
 
Acquisition obligations and other notes payable
   
 
512
 
   
 
5,455
 
Capital lease obligations
   
 
7,865
 
   
 
5,769
 
    
  
    
 
1,324,452
 
   
 
820,224
 
Less current portion
   
 
(8,299
)
   
 
(9,034
)
    
  
    
$
1,316,153
 
   
$
811,190
 
    
  

5

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
Scheduled maturities of long-term debt at June 30, 2002 were as follows:
 
2002
   
3,559
2003
   
9,518
2004
   
8,993
2005
   
8,877
2006
   
133,930
2007
   
307,042
Thereafter
   
852,533
 
4.    Earnings per share
 
The reconciliation of the numerators and denominators used to calculate basic and diluted earnings per share is as follows:
 
    
Three months ended
June 30,
   
Six months ended
June 30,
    
2002
   
2001
   
2002
   
2001
Basic:
                            
Income before extraordinary item
   
$
37,728
   
$
28,568
   
$
73,706
   
$
59,502
    
  
  
  
Weighted average shares outstanding during the period
   
 
79,743
   
 
83,548
   
 
81,324
   
 
82,997
Vested deferred stock units
   
 
42
          
 
42
       
    
  
  
  
Weighted average shares for basic earnings per share calculations
   
 
79,785
   
 
83,548
   
 
81,366
   
 
82,997
    
  
  
  
Basic income before extraordinary item per share
   
$
0.47
   
$
0.34
   
$
0.91
   
$
0.72
    
  
  
  
Diluted:
                            
Income before extraordinary item
   
$
37,728
   
$
28,568
   
$
73,706
   
$
59,502
Debt expense savings, net of tax, resulting from assumed conversion of convertible debt
   
 
4,915
   
 
1,055
   
 
9,830
   
 
2,111
    
  
  
  
Income before extraordinary item for diluted earnings per share calculations
   
$
42,643
   
$
29,623
   
$
83,536
   
$
61,613
    
  
  
  
Weighted average shares outstanding during the period
   
 
79,743
   
 
83,548
   
 
81,324
   
 
82,997
Vested deferred stock units
   
 
42
          
 
42
       
Assumed incremental shares from stock option plans
   
 
3,238
   
 
4,266
   
 
3,570
   
 
4,386
Assumed incremental shares from convertible debt
   
 
15,394
   
 
4,879
   
 
15,394
   
 
4,879
    
  
  
  
Weighted average shares for diluted earnings per share calculations
   
 
98,417
   
 
92,693
   
 
100,330
   
 
92,262
    
  
  
  
Diluted income before extraordinary item per share
   
$
0.43
   
$
0.32
   
$
0.83
   
$
0.67
    
  
  
  

6

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
For the three and six months ended June 30, 2002, the calculation of diluted earnings per share includes conversion of both the 55/8% convertible subordinated notes and the 7% convertible subordinated notes. For the three and six months ended June 30, 2001, the calculation of diluted earnings per share includes conversion of the 55/8% convertible subordinated notes, but does not include conversion of the 7% convertible subordinated notes as they were anti-dilutive.
 
Shares associated with stock options that have exercise prices greater than the average market price of shares outstanding during the period, which were not included in the computation of earnings per share assuming dilution because they were anti-dilutive, are as follows:
 
    
Three months ended
June 30,
   
Six months ended
June 30,
    
2002
   
2001
   
2002
   
2001
Shares associated with stock options not included in computation (shares in 000’s)
   
 
978
   
 
1,544
   
 
808
   
 
1,637
Exercise price range of shares not included in computation:
                            
Low
   
$
24.06
   
$
18.10
   
$
23.84
   
$
17.44
High
   
$
33.00
   
$
33.00
   
$
33.00
   
$
33.00
 
5.    Impairments and valuation adjustments
 
Impairments and valuation adjustments for the quarter ended June 30, 2002, consisted of the following:
 
Losses (gains):
         
Continental U.S. operations
   
$
(1,001
)
Non-continental U.S. operations
   
 
(1,389
)
    
    
$
(2,390
)
    
 
The impairments and valuation adjustments net gain of $1,001 recognized in the second quarter of 2002 for continental U.S. operations consisted of a realized gain of approximately $2,200 on a previously impaired investment offset by certain operating asset impairment losses. On June 1, 2002, the Company completed the divestiture of its remaining non-continental U.S. operations, all of which were located in Puerto Rico. As a result, the Company also recognized a recovery gain of $1,389 on assets previously impaired in contemplation of the closing of this sale.
 
6.    Contingencies
 
Health care provider revenues may be subject to adjustment as a result of (1) examination by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to finalize; (2) differing interpretations of government regulations by different fiscal intermediaries or regulatory authorities; (3) differing opinions regarding a patient’s medical diagnosis or the medical necessity of services provided; (4) retroactive applications or interpretations of governmental requirements; and (5) claims for refunds from private payors.
 
The Company’s Florida-based laboratory subsidiary is the subject of a third-party carrier review of its Medicare reimbursement claims. The carrier has issued formal overpayment determinations in the amount of $5,600 for the review period from January 1995 to April 1996 and $15,000 for the review period from May 1996

7

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

to March 1998. The carrier also has determined that $16,100 of the suspended claims for the review period from April 1998 to August 1999 and $11,600 of the suspended claims for the review period from August 1999 to May 2000 were not properly supported by the prescribing physicians’ medical justification. The carrier has alleged that approximately 99% of the tests the laboratory billed for the review period from January 1995 to April 1996, 96% of the tests billed for the period from May 1996 to March 1998, 70% of the tests billed for the period from April 1998 to August 1999, and 72% of the tests billed for the period from August 1999 to May 2000 were not properly supported by the prescribing physicians’ medical justification. In March 2002, the carrier requested selected patient records for two additional review periods, June 2000 to December 2000 and December 2000 to May 2001, which the Company provided in May 2002.
 
The Company is disputing the carrier’s determinations and has provided supporting documentation of its claims. The Company has initiated the process of a formal review of each of the carrier’s determinations. The first step in this formal review process is a hearing before a hearing officer at the carrier. The hearing regarding the initial review period from January 1995 to April 1996 was held in July 1999. In January 2000, the hearing officer issued a decision upholding the overpayment determination of $5,600. The hearing regarding the second review period from May 1996 to March 1998 was held in April 2000. In July 2000, the hearing officer issued a decision upholding $14,200 of the overpayment determination. The Company filed a consolidated appeal of both decisions to a federal administrative law judge.
 
The judge divided the appeal into two separate hearings. The first took place in January 2002 and addressed the validity of the two statistical samples the carrier used to support its determinations. In June 2002, the administrative law judge ruled that the sampling procedures and extrapolations used as the basis of the Medicare carrier’s overpayment determinations were invalid. This decision invalidated the carrier’s overpayment determinations for the first two review periods, totaling $19,800. The judge’s decision did not address the individual claims in the two samples that were used to support the overpayment extrapolations, which were to be addressed in the second hearing. These claims totaled approximately $90. The Company has withdrawn its appeal of the carrier’s decisions with respect to these $90 in claims. The judge has not yet entered her final order but is expected to do so shortly. After the entry of the final order there is a 60-day period in which the Medicare Appeals Council can decide to review the decision.
 
We are also appealing the carrier’s decisions with respect to the third and fourth review periods. These appeals are still at the carrier hearing officer level. For the fifth and sixth review periods, the carrier is reviewing the records we have submitted and has not yet made an initial determination. The administrative law judge’s decision on the first two review periods does not impact the remaining four review periods in any way, as each review period is evaluated independently. Moreover, the carrier’s sampling procedures have varied from period to period, and the conclusions the judge arrived at with respect to the first two periods may not hold for the subsequent periods.
 
In addition to the formal appeal process with the carrier and the federal administrative law judge, beginning in the third quarter of 1999 the Company sought a meeting with the Department of Justice, or DOJ, to begin a process to resolve this matter. The carrier had previously informed the local office of the DOJ and the Department of Health and Human Services, or HHS, of this matter and the Company had provided requested information to the DOJ. The Company met with the DOJ in February 2001, at which time the DOJ requested additional information, which the Company provided in September 2001. The discussions with the DOJ are ongoing.

8

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
The carrier had also previously suspended all payments of Medicare claims from the laboratory beginning in May 1998. In May 2002, the carrier lifted the payment suspension, and will begin paying the laboratory’s Medicare claims with dates of service as early as June 2001. The carrier is also conducting a study of the utilization of dialysis-related laboratory services. During the study period, estimated to be at least 90 days, the carrier will suspend all of its previously existing dialysis laboratory prepayment screens. The purpose of the study is to determine what ongoing program safeguards are appropriate. The Company cannot determine what prepayment screens, post-payment review procedures, documentation requirements or other program safeguards the carrier may ultimately implement as a result of its study. The carrier has also informed the Company that any claims that it reimburses during the study period may also be subject to post-payment review and refund if determined inappropriate.
 
The timing of the final resolution of this matter is highly uncertain and beyond the Company’s control or influence. If this matter is resolved in a manner adverse to the Company, the government could impose additional fines and penalties, which could be substantial. During 2000, the Company stopped accruing Medicare revenue from this laboratory because of the uncertainties regarding both the timing of resolution and the ultimate revenue valuations. Because of the recent lifting of the payment suspension, the carrier will be processing payments beginning in the third quarter of 2002. For the prior period billings, the Company will recognize revenue only to the extent that the carrier makes payments to the laboratory and the risk of potential refund of such payments is considered minimal. For current period billings, the Company will assess what, if any, revenue should be recognized based on the carrier’s payment of current period claims and the outcome of the carrier’s study.
 
The Medicare carrier for our Minnesota laboratory is conducting a post-payment review of Medicare reimbursement claims for the period January 1996 through December 1999. The scope of the review is similar to the review being conducted at our Florida laboratory. At this time, the Company is unable to determine how long it will take the carrier to complete this review. There is currently no overpayment determination with respect to the Minnesota laboratory. The DOJ has also requested information with respect to this laboratory, which the Company has provided. Medicare revenues at the Minnesota laboratory, which was much smaller than the Florida laboratory, were approximately $15,000 for the period under review. In November 2001, the Company closed the Minnesota laboratory and combined the operations of this laboratory with its Florida laboratory.
 
In February 2001, the Civil Division of the United States Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted the Company and requested its cooperation in a review of some of the Company’s historical practices, including billing and other operating procedures and its financial relationships with physicians. The Company cooperated in this review and provided the requested records to the United States Attorney’s office. In May 2002, the Company received a subpoena from the Philadelphia office of the Office of Inspector General for HHS, or OIG. The subpoena requires an update to the information the Company provided in its response to the February 2001 request, and also seeks a wide range of documents relating to pharmaceutical and other ancillary services provided to patients, including laboratory and other diagnostic testing services, as well as documents relating to the Company’s financial relationships with physicians and pharmaceutical companies. The subpoena covers the period from May 1, 1996 to the present. The Company has provided some documents, and will provide additional documents requested over the next several months. The inquiry remains at an early stage. As it proceeds, the government could expand its areas of concern. If a court determines that there has been wrongdoing, the penalties under applicable statutes could be substantial.
 
In addition to the foregoing, DaVita is subject to claims and suits in the ordinary course of business. Management believes that the ultimate resolution of these additional pending proceedings, whether the

9

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

underlying claims are covered by insurance or not, will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
 
7.    Condensed consolidating financial statements
 
The following information is presented as required under the Securities and Exchange Commission Financial Reporting Release No. 55 in connection with the Company’s publicly traded debt. The operating and investing activities of the separate legal entities included in the consolidated financial statements are fully interdependent and integrated. Revenues and operating expenses of the separate legal entities include intercompany charges for management and other services.
 
The $125,000 55/8% Convertible Subordinated Notes Due 2006, issued by the wholly-owned subsidiary Renal Treatment Centers, Inc., or RTC, are guaranteed by DaVita Inc.

10

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
Condensed Consolidating Balance Sheets
 
    
DaVita Inc.
   
RTC
   
Non-
guarantor
subsidiaries
   
Consolidating adjustments
     
Consolidated total
As of June 30, 2002
                                     
Cash and cash equivalents
   
$
137,009
   
$
11
                   
$
137,020
Accounts receivable, net
   
 
204,257
   
 
114,012
   
$
28,795
            
 
347,064
Other current assets
   
 
83,194
   
 
21,276
   
 
2,758
            
 
107,228
    
  
  
  
  
Total current assets
   
 
424,460
   
 
135,299
   
 
31,553
            
 
591,312
Property and equipment, net
   
 
175,838
   
 
67,447
   
 
24,050
            
 
267,335
Investments in subsidiaries
   
 
353,710
                 
$
(353,710
)
       
Receivables from subsidiaries
   
 
138,814
                 
 
(138,814
)
       
Amortizable intangible assets, net
   
 
45,938
   
 
15,120
   
 
6,929
            
 
67,987
Other assets
   
 
4,549
   
 
735
   
 
41
            
 
5,325
Goodwill
   
 
464,754
   
 
281,512
   
 
106,425
            
 
852,691
    
  
  
  
  
Total assets
   
$
1,608,063
   
$
500,113
   
$
168,998
   
$
(492,524
)
   
$
1,784,650
    
  
  
  
  
Current liabilities
   
$
275,243
   
$
10,620
   
$
4,465
            
$
290,328
Payables to subsidiaries/parent
          
 
114,106
   
 
24,708
   
$
(138,814
)
       
Long-term liabilities
   
 
1,219,386
   
 
135,250
   
 
4,639
            
 
1,359,275
Minority interests
                        
 
21,613
 
   
 
21,613
Shareholders’ equity
   
 
113,434
   
 
240,137
   
 
135,186
   
 
(375,323
)
   
 
113,434
    
  
  
  
  
Total liabilities and shareholders’ equity
   
$
1,608,063
   
$
500,113
   
$
168,998
   
$
(492,524
)
   
$
1,784,650
    
  
  
  
  
As of December 31, 2001
                                     
Cash and cash equivalents
   
$
34,949
   
$
1,762
                   
$
36,711
Accounts receivable, net
   
 
195,074
   
 
111,413
   
$
27,059
            
 
333,546
Other current assets
   
 
81,021
   
 
21,142
   
 
2,244
            
 
104,407
    
  
  
  
  
Total current assets
   
 
311,044
   
 
134,317
   
 
29,303
            
 
474,664
Property and equipment, net
   
 
169,675
   
 
59,717
   
 
23,386
            
 
252,778
Investments in subsidiaries
   
 
326,751
                 
$
(326,751
)
       
Receivables from subsidiaries
   
 
160,150
                 
 
(160,150
)
       
Amortizable intangible assets, net
   
 
49,479
   
 
16,294
   
 
7,335
            
 
73,108
Other assets
   
 
5,649
   
 
680
   
 
44
            
 
6,373
Goodwill
   
 
470,150
   
 
279,185
   
 
106,425
            
 
855,760
    
  
  
  
  
Total assets
   
$
1,492,898
   
$
490,193
   
$
166,493
   
$
(486,901
)
   
$
1,662,683
    
  
  
  
  
Current liabilities
   
$
283,387
   
$
10,728
   
$
4,566
            
$
298,681
Payables to subsidiaries/parent
          
 
140,548
   
 
19,602
   
$
(160,150
)
       
Long-term liabilities
   
 
705,874
   
 
128,976
   
 
4,793
            
 
839,643
Minority interests
                        
 
20,722
 
   
 
20,722
Shareholders’ equity
   
 
503,637
   
 
209,941
   
 
137,532
   
 
(347,473
)
   
 
503,637
    
  
  
  
  
Total liabilities and shareholders’ equity
   
$
1,492,898
   
$
490,193
   
$
166,493
   
$
(486,901
)
   
$
1,662,683
    
  
  
  
  

11

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
Condensed Consolidating Statements of Income
 
    
DaVita Inc.
     
RTC
       
Non-guarantor subsidiaries
   
Consolidating adjustments
     
Consolidated total
  
For the six months ended June 30, 2002
                                             
Net operating revenues
   
$
559,773
 
   
$
279,795
 
     
$
93,988
   
$
(63,214
)
   
$
870,342
 
Operating expenses
   
 
478,314
 
   
 
224,360
 
     
 
71,053
   
 
(63,214
)
   
 
710,513
 
    
  
    
  
  
Operating income
   
 
81,459
 
   
 
55,435
 
     
 
22,935
            
 
159,829
 
Other income
   
 
3,843
 
              
 
5
            
 
3,848
 
Debt expense
   
 
26,470
 
   
 
3,458
 
     
 
2,283
            
 
32,211
 
Minority interests
                              
 
(5,260
)
   
 
(5,260
)
Income taxes
   
 
30,713
 
   
 
21,781
 
     
 
6
            
 
52,500
 
Equity earnings in consolidated subsidiaries
   
 
45,587
 
                     
 
(45,587
)
         
Extraordinary item
   
 
(29,358
)
                              
 
(29,358
)
    
  
    
  
  
Net income
   
$
44,348
 
   
$
30,196
 
     
$
20,651
   
$
(50,847
)
   
$
44,348
 
    
  
    
  
  
For the six months ended June 30, 2001
                                             
Net operating revenues
   
$
506,064
 
   
$
253,247
 
     
$
89,822
   
$
(62,276
)
   
$
786,857
 
Operating expenses
   
 
424,649
 
   
 
210,732
 
     
 
67,853
   
 
(62,276
)
   
 
640,958
 
    
  
    
  
  
Operating income
   
 
81,415
 
   
 
42,515
 
     
 
21,969
            
 
145,899
 
Other income
   
 
2,511
 
   
 
(43
)
                     
 
2,468
 
Debt expense
   
 
32,369
 
   
 
3,446
 
     
 
2,624
            
 
38,439
 
Minority interests
                              
 
(4,726
)
   
 
(4,726
)
Income taxes
   
 
28,880
 
   
 
16,820
 
                     
 
45,700
 
Equity earnings in consolidated subsidiaries
   
 
36,825
 
                     
 
(36,825
)
         
Extraordinary gain
   
 
977
 
                              
 
977
 
    
  
    
  
  
Net income
   
$
60,479
 
   
$
22,206
 
     
$
19,345
   
$
(41,551
)
   
$
60,479
 
    
  
    
  
  

12

DAVITA INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(continued)
(unaudited)
(dollars in thousands, except per share data)

 
Condensed Consolidating Statements of Cash Flows
 
    
DaVita Inc.
     
RTC
     
Non-
guarantor subsidiaries
     
Consolidating adjustments
     
Consolidated total
  
For the six months ended June 30, 2002
                                             
Cash flows from operating activities:
                                             
Net income
   
$
44,348
 
   
$
30,196
 
   
$
20,651
 
   
$
(50,847
)
   
$
44,348
 
Changes in operating and intercompany assets and liabilities and non cash items included in net income
   
 
81,837
 
   
 
(17,460
)
   
 
(13,517
)
   
 
50,847
 
   
 
101,707
 
    
  
  
  
  
Net cash provided by operating activities
   
 
126,185
 
   
 
12,736
 
   
 
7,134
 
   
 
—  
 
   
 
146,055
 
    
  
  
  
  
Cash flows from investing activities:
                                             
Purchases of property and equipment, net
   
 
(25,793
)
   
 
(14,840
)
   
 
(3,058
)
            
 
(43,691
)
Acquisitions and divestitures, net
   
 
(47
)
   
 
(1,379
)
                     
 
(1,426
)
Other items
   
 
1,827
 
                              
 
1,827
 
    
  
  
  
  
Net cash used in investing activities
   
 
(24,013
)
   
 
(16,219
)
   
 
(3,058
)
            
 
(43,290
)
    
  
  
  
  
Cash flows from financing activities:
                                             
Long-term debt, net
   
 
502,434
 
   
 
1,732
 
   
 
62
 
            
 
504,228
 
Other items
   
 
(502,546
)
            
 
(4,138
)
            
 
(506,684
)
    
  
  
  
  
Net cash provided (used in) financing activities
   
 
(112
)
   
 
1,732
 
   
 
(4,076
)
            
 
(2,456
)
    
  
  
  
  
Net increase (decrease) in cash
   
 
102,060
 
   
 
(1,751
)
   
 
—  
 
            
 
100,309
 
Cash at the beginning of the period
   
 
34,949
 
   
 
1,762
 
   
 
—  
 
            
 
36,711
 
    
  
  
  
  
Cash at the end of the period
   
$
137,009
 
   
$
11
 
   
$
—  
 
   
$
—  
 
   
$
137,020
 
    
  
  
  
  
For the six months ended June 30, 2001
                                             
Cash flows from operating activities:
                                             
Net income
   
$
60,479
 
   
$
22,206
 
   
$
19,345
 
   
$
(41,551
)
   
$
60,479
 
Changes in operating and intercompany assets and liabilities and non cash items included in net income
   
 
66,215
 
   
 
(21,340
)
   
 
(12,147
)
   
 
41,551
 
   
 
74,279
 
    
  
  
  
  
Net cash provided by operating activities
   
 
126,694
 
   
 
866
 
   
 
7,198
 
   
 
—  
 
   
 
134,758
 
    
  
  
  
  
Cash flows from investing activities:
                                             
Purchases of property and equipment, net
   
 
(11,748
)
   
 
(2,881
)
   
 
(3,954
)
            
 
(18,583
)
Acquisitions and divestitures, net
   
 
(51,124
)
                              
 
(51,124
)
Other items
   
 
20,611
 
            
 
25
 
            
 
20,636
 
    
  
  
  
  
Net cash used in investing activities
   
 
(42,261
)
   
 
(2,881
)
   
 
(3,929
)
            
 
(49,071
)
    
  
  
  
  
Cash flows from financing activities:
                                             
Long-term debt, net
   
 
(26,347
)
   
 
151
 
   
 
403
 
            
 
(25,793
)
Other items
   
 
(2,171
)
            
 
(3,672
)
            
 
(5,843
)
    
  
  
  
  
Net cash provided (used in) financing activities
   
 
(28,518
)
   
 
151
 
   
 
(3,269
)
            
 
(31,636
)
    
  
  
  
  
Net increase (decrease) in cash
   
 
55,915
 
   
 
(1,864
)
   
 
—  
 
            
 
54,051
 
Cash at the beginning of the period
   
 
29,336
 
   
 
1,871
 
   
 
—  
 
            
 
31,207
 
    
  
  
  
  
Cash at the end of the period
   
$
85,251
 
   
$
7
 
   
$
—  
 
   
$
—  
 
   
$
85,258
 
    
  
  
  
  

13

Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
Forward-looking statements
 
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These statements involve known and unknown risks and uncertainties, including risks resulting from the regulatory environment in which we operate, economic and market conditions, competitive activities, other business conditions, accounting estimates, and the risk factors set forth in this Form 10-Q. These risks, among others, include those relating to possible reductions in private and government reimbursement rates, the concentration of profits generated from PPO and private and indemnity patients and from ancillary services including the administration of pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, the ongoing review of the Company’s Florida laboratory subsidiary by its Medicare carrier and the Department of Justice, the ongoing review by the US Attorney’s Office and the HHS Office of Inspector General in Philadelphia and the Company’s ability to maintain contracts with physician medical directors. Our actual results may differ materially from results anticipated in our forward-looking statements. We base our forward-looking statements on information currently available to us, and we have no current intention to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.
 
Results of operations
 
Continental U.S. and non-continental U.S. operating revenues and operating expenses were as follows (dollars in millions):
 
    
Quarter ended
  
    
June 30,
2002
     
March 31,
2002
     
June 30,
2001
  
Revenues:
                                          
Continental U.S.
   
$
441
   
99
%
   
$
424
   
99
%
   
$
397
   
99
%
Non-continental U.S. 
   
 
2
   
1
%
   
 
4
   
1
%
   
 
4
   
1
%
    
  
  
  
  
  
    
$
443
   
100
%
   
$
428
   
100
%
   
$
401
   
100
%
    
  
  
  
  
  
Operating expenses:
                                          
Continental U.S.
   
$
362
   
99
%
   
$
345
   
99
%
   
$
316
   
99
%
Non-continental U.S. 
   
 
2
   
1
%
   
 
4
   
1
%
   
 
4
   
1
%
    
  
  
  
  
  
    
$
364
   
100
%
   
$
349
   
100
%
   
$
320
   
100
%
    
  
  
  
  
  
Consolidated operating income
   
$
79
          
$
79
          
$
81
       
    
         
         
      
 
The Company’s divestiture of its dialysis operations outside the continental United States was substantially completed during 2000, reducing the number of dialysis centers that we operated outside the continental United States from 84 to two. On June 1, 2002, we completed the divestiture of our remaining non-continental U.S. operations, all of which were located in Puerto Rico.

14

 
Continental U.S. operations
(dollars in millions)
 
    
Quarter ended
  
    
June 30,
2002
     
March 31,
2002
     
June 30,
2001
  
Revenues
   
$
441
 
   
100
%
   
$
424
   
100
%
   
$
397
 
   
100
%
    
  
  
  
  
  
Operating expenses:
                                              
Dialysis centers and labs
   
 
298
 
   
68
%
   
 
288
   
68
%
   
 
269
 
   
68
%
General and administrative
   
 
42
 
   
10
%
   
 
36
   
8
%
   
 
32
 
   
8
%
Depreciation and amortization for identified intangibles
   
 
16
 
   
4
%
   
 
16
   
4
%
   
 
16
 
   
4
%
Provision for uncollectible accounts (excluding recoveries of $2, $2 and $9 associated with amounts reserved in 1999)
   
 
8
 
   
2
%
   
 
7
   
2
%
   
 
8
 
   
2
%
    
         
         
      
    
 
364
 
   
82
%
   
 
347
   
82
%
   
 
325
 
   
82
%
    
         
         
      
Operating income (excluding recoveries and impairments and valuation adjustments and before goodwill amortization in 2001)
   
$
77
 
   
18
%
   
$
77
   
18
%
   
$
72
 
   
18
%
    
         
                      
Goodwill amortization (effective prior to 2002)
                                 
 
(10
)
       
                                  
      
Operating income (excluding recoveries)
                                 
$
62
 
   
15
%
                                  
      
Impairments and valuation gains:
                                              
Continental U.S. operations
   
$
(1
)
                                     
Non-continental U.S. operations
   
 
(1
)
                                     
    
                                    
    
$
(2
)
                                     
    
                                    
Dialysis treatments (000’s)
   
 
1,487
 
          
 
1,434
          
 
1,409
 
       
Average dialysis treatments per treatment day
   
 
19,062
 
          
 
18,767
          
 
18,068
 
       
Average dialysis revenue per dialysis treatment
   
$
291
 
          
$
290
          
$
276
 
       
 
Net operating revenues for the continental U.S. operations were $441 million for the second quarter of 2002, an increase of 11% from the second quarter of 2001. Approximately one-half of the increase in revenue was due to higher average revenue per treatment and approximately one-half was due to the increase in the number of treatments. The average dialysis revenue per treatment (excluding lab and clinical research revenues and management fee income) was $291 for the second quarter of 2002, compared to $276 for the same period of 2001. The increase in average revenue per treatment was principally due to increases in our standard fee schedules (impacting non-contract commercial revenue), changes in mix and intensity of physician-prescribed pharmaceuticals, and continued improvements in revenue capture, billing and collecting operations, and payor contracting. The increase in the number of treatments was principally attributable to same center growth, which was 4.5% in the second quarter of 2002 compared to 2.8% in the second quarter of 2001. We expect the same center growth rate to remain in the range of 3.0% to 5.0% for the remainder of 2002 and into 2003. Other operating revenues were approximately $9 million in the second quarter of 2002, an increase of approximately $1 million from the second quarter of 2001.
 
Second quarter 2002 net operating revenues increased approximately 4% from the first quarter of 2002. The increase was largely attributable to additional treatment days in the second quarter, which resulted in an increase in the overall number of dialysis treatments. The average dialysis treatments per day increased approximately 1.6% from the first quarter of 2002.
 
Center operating expenses remained at approximately 68% of net operating revenues for continental U.S. operations for all three periods presented. On a per-treatment basis, center operating expenses for the second

15

quarter of 2002 were approximately $1 lower than the first quarter of 2002, and were approximately $10 higher than the second quarter of 2001. The decrease from the first quarter of 2002 was principally due to improvements in labor productivity more than offsetting labor rate increases in the second quarter of 2002. The increase from the second quarter of 2001 was attributable to higher labor and drug costs.
 
General and administrative expenses were approximately 10% of net operating revenues for continental U.S. operations for the second quarter of 2002 as compared to approximately 8% in the first quarter of 2002 and the second quarter of 2001. In absolute dollars, general and administrative expenses for the second quarter of 2002 were approximately 17% higher than in the first quarter of 2002. The increase in the dollar amount of general and administrative expenses was due primarily to higher labor costs, continued investments in infrastructure to develop new operating and billing systems, and higher legal costs relating to the laboratory and U.S. Attorney’s reviews and other compliance initiatives.
 
The provisions for uncollectible accounts receivable before considering cash recoveries were approximately 1.8% in the second and first quarters of 2002, as compared to 2% in the second quarter of 2001. During each of the second quarter and first quarters of 2002, we realized cash recoveries of $2 million as compared to $9 million in the second quarter of 2001. The recoveries continue to be the result of improved collection processes and are associated with aged accounts receivables reserved in 1999.
 
The impairments and valuation adjustments net gain of approximately $1 million recognized in the second quarter of 2002 for continental U.S. operations consisted of a realized gain of approximately $2 million on a previously impaired investment offset by certain operating asset impairment losses. On June 1, 2002, we completed the divestiture of our remaining non-continental U.S. operations, all of which were located in Puerto Rico. As a result, we also recognized a recovery gain of approximately $1 million on assets previously impaired in contemplation of the closing of this sale.
 
Debt expense of $17 million for the second quarter of 2002 was approximately $2 million lower than the second quarter of 2001 due to lower effective interest rates and a lower average debt balance during the second quarter of 2002. Debt expense in future quarters will be higher due to the additional borrowings in conjunction with our recapitalization.
 
Projections for 2002 and 2003
 
Based on current conditions and recent experience, our current projections for 2002 are for normal operating earnings before depreciation and amortization, debt expense and taxes, or EBITDA, to be in the range of $360 million to $380 million. Our current projections for 2003 are for EBITDA to be in the same range as for 2002. See Note 6 of the condensed consolidated financial statements in this report regarding the laboratory contingencies and recent developments, which could potentially result in an increase to the projected earnings.
 
These projections and the underlying assumptions involve significant risks and uncertainties, and actual results may vary significantly from these current projections. These risks, among others, include those relating to possible reductions in private and government reimbursement rates, the concentration of profits generated from non-governmental payors and from the administration of pharmaceuticals, changes in pharmaceutical practice patterns or reimbursement policies, and the ongoing review by the United States Attorney’s Office and the OIG. Additionally, the termination or restructuring of managed care contracts, medical director agreements or other arrangements may result in future impairments or otherwise negatively affect our operating results. We undertake no duty to update these projections, whether due to changes in current or expected trends, underlying market conditions, decisions of the United States Attorney’s Office, the DOJ or the OIG in any pending or future review of our business, or otherwise.

16

 
Significant new accounting standards
 
We have adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Under SFAS No. 142, goodwill is not amortized effective January 1, 2002. SFAS No. 142 also requires that the goodwill balance be regularly assessed for possible valuation impairment and that there be an impairment charge against current earnings if the recorded goodwill balance exceeds fair value. If this standard had been implemented as of January 1, 2001, amortization expense would have been reduced by approximately $6.3 million and $12.6 million net of tax, for the three and six months ended June 30, 2001. Income before extraordinary item and diluted income before extraordinary item per share would have been approximately $35 million and $72 million and $0.38 and $0.80 per share for the same periods.
 
Liquidity and capital resources
 
Cash flow from operations during the first six months of 2002 amounted to approximately $146 million. The non-operating cash outflows were primarily associated with the recapitalization transaction, as discussed below, and investments of approximately $44 million in center development, systems infrastructure and equipment.
 
In March 2002, we initiated a recapitalization plan consisting of debt restructuring and repurchases of common stock. On April 26, 2002 we completed the initial phase of the recapitalization plan by repurchasing all of our $225 million outstanding 9¼% Senior Subordinated Notes due 2011 at a total cost of approximately $266 million. The difference between the reacquisition price and the net carrying amount of the Senior Subordinated Notes together with the write-off of deferred financing costs associated with extinguishing the existing senior credit facilities and notes resulted in a net extraordinary loss of $29.3 million. On June 6, 2002, we completed the next phase of the recapitalization plan with the repurchase of 16,682,337 shares of our common stock for approximately $402 million, or $24 per share, through a modified dutch auction tender offer. On May 30, 2002, our Board of Directors authorized management to repurchase up to an additional $225 million of common stock over the next eighteen months. As of June 30, 2002, 199,700 shares had been purchased for approximately $4.7 million. As of July 31, 2002, approximately 3.7 million shares at a cost of approximately $79 million have been repurchased under this authorization. For the six months ended June 30, 2002, stock repurchases totaled 19,827,737 shares for a total cost of approximately $474 million, or a composite average of $23.93 per share.
 
We have secured a new senior credit facility agreement in the amount of $1,115 million to finance these transactions and to pay down all outstanding amounts under the previously existing senior credit facilities. The new senior credit facility consists of a Term Loan A for $150 million, a Term Loan B for $850 million and a $115 million undrawn revolving credit facility, which includes up to $50 million available for letters of credit. The Term Loan A and the revolving credit facility will bear interest at a rate equal to LIBOR plus a margin ranging from 1.5% to 2.75% based on our leverage ratio. The Term Loan B bears interest at LIBOR plus 3.00%. As of June 30, 2002, $850 million of the Term Loan B had been drawn. We are currently evaluating our current and future liquidity requirements for potential borrowings under the Term Loan A but have no obligation to draw the loan. The lenders’ commitment to fund the undrawn portion of the Term Loan A will expire in January 2003. If the entire $1,000 million term credit facility is drawn, the aggregate annual principal reduction will range from $16 million to $51 million in years one through five, and will be $403 million in each of years six and seven, with the balance due not later than 2009. The new senior credit facility is secured by all our personal property and that of all our wholly-owned subsidiaries, along with the stock of our subsidiaries. The new senior credit facility also contains certain financial and operating covenants and limits our investments. As of June 30, 2002, we were in compliance with the financial and operating covenants of the credit facility in all material respects.
 
Continental U.S. accounts receivable at June 30, 2002 amounted to $347 million, an increase of approximately $10 million during the quarter. In both the second quarter of 2002 and first quarter of 2002, the continental U.S. accounts receivable balance represented approximately 73 days of revenue.

17

 
Our current plans continue to call for increases in capital expenditures, including significant investment expenditures for information technology projects and for new dialysis centers, relocations and expansions.
 
We believe that we will have sufficient liquidity and operating cash flows to fund our capital investments, scheduled debt service and planned stock repurchases over the next twelve months.
 
Item 3.     Quantitative and Qualitative Disclosures About Market Risk.
 
Interest rate sensitivity
 
The table below provides information about our financial instruments that are sensitive to changes in interest rates.
 
    
Expected maturity date
   
Thereafter
   
Total
   
Fair value
   
Average interest Rate
  
    
2002
   
2003
   
2004
   
2005
   
2006
   
2007
            
Long-term debt
                                                                      
Fixed rate
                               
$
125
          
$
345
   
$
470
   
$
463
   
6.63
%
Variable rate
   
$
4
   
$
8
   
$
9
   
$
9
   
$
9
   
$
307
   
$
508
   
$
854
   
$
854
   
5.41
%
 

18

RISK FACTORS
 
This Form 10-Q contains statements that are forward-looking statements within the meaning of the federal securities laws, including statements about our expectations, beliefs, intentions or strategies for the future. These forward-looking statements include statements regarding our expectations for treatment growth rates, revenue per treatment, expense growth, levels of the provision for uncollectible accounts receivable, earnings before depreciation and amortization, debt expense and taxes, and capital expenditures. We base our forward-looking statements on information currently available to us, and we do not currently intend to update these statements, whether as a result of changes in underlying factors, new information, future events or other developments.
 
These statements involve known and unknown risks and uncertainties, including risks resulting from economic and market conditions, the regulatory environment in which we operate, competitive activities and other business conditions. Our actual results may differ materially from results anticipated in these forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include those set forth below. The risks discussed below are not the only ones facing our business.
 
If the percentage of our patients paying at or near our list prices declines, then our revenues, cash flows and earnings would be substantially reduced.
 
Approximately 44% of our continental U.S. dialysis revenues are generated from patients who have private payors as the primary payor. A minority of these patients have insurance policies that reimburse us at or near our list prices, which are significantly higher than Medicare rates. The majority of these patients have insurance policies that reimburse us at rates that are below our list prices but, in most cases, higher than Medicare rates. We believe that pressure from private payors to decrease the rates they pay us may increase. If the percentage of patients who have insurance that pays us at or near our list prices decreases significantly, it would have a material adverse effect on our revenues, cash flows and earnings.
 
If we are unable to renegotiate material contracts with managed care plans on acceptable terms, we may experience a decline in same center growth and earnings.
 
We have contracts with some large managed care plans that include unfavorable terms. Although we are attempting to renegotiate the terms of these contracts, we cannot predict whether we will reach agreement on new terms or whether we will renew these contracts. As a result, we may lose numerous patients of these managed care plans and experience a decline in our same center growth, which would negatively impact our revenues and near-term earnings.
 
Changes in clinical practices and reimbursement rates or rules for EPO and other drugs could substantially reduce our revenue and earnings.
 
The administration of EPO and other drugs accounts for approximately 40% of our net operating revenue. Changes in physician practice patterns and accepted clinical practices, changes in private and governmental reimbursement rates and rules, the introduction of new drugs and the conversion to alternate types of administration, for example from intravenous administration to subcutaneous or oral administration, that may also result in lower or less frequent dosages, could reduce our revenues and earnings from the administration of EPO and other drugs. For example, some Medicare fiscal intermediaries are seeking to implement local medical review policies for EPO and vitamin D analogs that would, effectively, limit utilization of and reimbursement for these drugs.
 
Future declines, or the lack of further increases, in Medicare reimbursement rates would reduce our net income and cash flows.
 
Approximately 51% of our continental U.S. dialysis revenues were generated from patients who had Medicare as their primary payor.

19

 
The Medicare ESRD program reimburses us for dialysis and ancillary services at fixed rates. Unlike many other Medicare programs, the Medicare ESRD program does not provide for periodic inflation increases in reimbursement rates. These rates have declined over 70% in real dollars since 1972. Increases of 1.2% in 2000 and 2.4% in 2001 were the first increases in the composite rate since 1991, and were significantly less than the cumulative rate of inflation since 1991. There was no increase to the composite rate for 2002. Increases in operating costs that are subject to inflation, such as labor and supply costs, have occurred and are expected to continue to occur without a compensating increase in reimbursement rates. We cannot predict the nature or extent of future rate changes, if any. To the extent these rates are not adjusted to keep pace with inflation, our net income and cash flows would be adversely affected.
 
Future changes in the structure of, and reimbursement rates under, the Medicare ESRD program could substantially reduce our operating earnings and cash flows.
 
In legislation enacted in December 2000, Congress mandated government studies on whether:
 
 
•
 
The Medicare composite rate for dialysis should be modified to include an annual inflation increase—this study was due July 2002, but has not yet been delivered to Congress;
 
 
•
 
The Medicare composite rate for dialysis should be modified to include additional services, such as laboratory and other diagnostic tests and the administration of EPO and other pharmaceuticals, in the composite rate—this study was due July 2002, but has not yet been delivered to Congress; and
 
 
•
 
Reimbursement for many outpatient prescription drugs that we administer to dialysis patients should be reduced from the current rate of 95% of the average wholesale price. This study was completed; the resulting recommendations exclude most drugs administered during dialysis, but Congress has yet to act on these recommendations.
 
If Medicare began to include in its composite reimbursement rate any ancillary services that it currently reimburses separately, our revenue would decrease to the extent there was not a corresponding increase in the composite rate. In particular, Medicare revenue from EPO and other pharmaceuticals is approximately 42% of our total Medicare revenue. If these pharmaceuticals were included in the composite rate, and if the composite rate were not increased sufficiently, our operating earnings and cash flows could decrease substantially. Reductions in current reimbursement rates for EPO or other pharmaceuticals would also reduce our net earnings and cash flows.
 
If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, our revenue and earnings would decline.
 
If a significant number of physicians stop referring patients to our centers, it could have a material adverse effect on our revenue and earnings. Many physicians prefer to have their patients treated at centers where they or other members of their practice supervise the overall care provided as medical directors of the centers. As a result, the primary referral source for our centers is often the physician or physician group providing medical director services to the center. If a medical director agreement terminates, whether before or at the end of its term, and a new medical director is appointed, it may negatively impact the former medical director’s decision to treat his or her patients at our centers.
 
Our medical director contracts are for fixed periods, generally five to ten years. Medical directors have no obligation to extend their agreements with us. In the twelve months ended June 30, 2002, we renewed the agreements with medical directors at 14 centers, and were unable to renew agreements covering six centers. In addition, as of June 30, 2002, there were 36 additional centers at which the medical director agreements required renewal on or before June 30, 2003.

20

 
We also may take actions to restructure existing relationships or take positions in negotiating extensions of relationships in order to assure compliance with anti-kickback and similar laws. These actions could negatively impact physicians’ decisions to extend their medical director agreements with us. In addition, if the terms of an existing agreement were found to violate applicable laws, we may not be successful in restructuring the relationship, which could lead to the early termination of the agreement, or force the physician to stop referring patients to the centers.
 
If the current shortage of skilled clinical personnel or our high level of personnel turnover continues, we may experience disruptions in our business operations and increases in operating expenses.
 
We are experiencing increased labor costs and difficulties in hiring nurses due to a nationwide shortage of skilled clinical personnel. This shortage limits our ability to expand our operations. We also have a high personnel turnover rate in our dialysis centers. Turnover has been the highest among our technicians, nurses and unit secretaries. Recent efforts to reduce this turnover may not succeed. If we are not successful, or if we are unable to hire skilled clinical personnel when needed, our operations and our same center growth will be negatively impacted.
 
Adverse developments with respect to EPO could materially reduce our net income and cash flows and affect our ability to care for our patients.
 
Amgen is the sole supplier of EPO and may unilaterally decide to increase its price for EPO at any time. For example, Amgen unilaterally increased its base price for EPO by 3.9% in each of 2002, 2001 and 2000. Also, we cannot predict whether we will continue to receive the same discount structure for EPO that we currently receive, or whether we will continue to achieve the same levels of discounts within that structure as we have historically achieved. In addition, Amgen has developed a new product, Aranesp®, that may replace EPO or reduce its use with dialysis patients. We cannot predict if or when Aranesp® will be introduced to the U.S. dialysis market, what its cost and reimbursement structure will be, or how it may impact our revenues from EPO. Increases in the cost of EPO and the introduction of Aranesp® could have a material adverse effect on our net income and cash flows.
 
The pending federal review of some of our practices and third-party carrier review of our laboratory subsidiary could result in substantial penalties against us.
 
We are voluntarily cooperating with the United States Attorney’s Office and OIG in Philadelphia in a review of some of our practices, including billing and other operating procedures, financial relationships with physicians and pharmaceutical companies, and the provision of pharmaceutical and other ancillary services. In addition, our Florida-based laboratory subsidiary is the subject of a third-party carrier review of claims it has submitted for Medicare reimbursement. The DOJ has also requested and received information regarding the laboratory. We are unable to determine when these matters will be resolved, whether any additional areas of inquiry will be opened or any outcome of these matters, financial or otherwise. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.
 
If we fail to adhere to all of the complex government regulations that apply to our business, we could suffer severe consequences that would substantially reduce our revenues and earnings.
 
Our dialysis operations are subject to extensive federal, state and local government regulations, including Medicare and Medicaid reimbursement rules and regulations, patient privacy laws, and federal and state anti-kickback laws. The regulatory scrutiny of healthcare providers, including dialysis providers, has increased significantly in recent years. In addition, the frequency and intensity of Medicare certification surveys and inspections of dialysis centers has increased markedly since 2000.

21

 
We endeavor to comply with all of the requirements for receiving Medicare and Medicaid reimbursement and to structure all of our relationships with referring physicians to comply with the anti-kickback laws; however, the laws and regulations in this area are complex and subject to varying interpretations. In addition, our historic dependence on manual processes that vary widely across our network of dialysis centers exposes us to greater risk of errors in billing and other business processes.
 
If any of our operations are found to violate these or other government regulations, we could suffer severe consequences, including:
 
 
•
 
Mandated practice changes that significantly increase operating expenses;
 
 
•
 
Suspension of payments from government reimbursement programs;
 
 
•
 
Refunds of amounts received in violation of law or applicable reimbursement program requirements;
 
 
•
 
Loss of required government certifications or exclusion from government reimbursement programs;
 
 
•
 
Loss of licenses required to operate healthcare facilities in some of the states in which we operate; and
 
 
•
 
Fines or monetary penalties for anti-kickback law violations, submission of false claims or other failures to meet reimbursement program requirements.
 
Our rollout of new information technology systems may significantly disrupt our billing and collection activity, may not work as planned and could have a negative impact on our results of operations and financial condition.
 
We are rolling out new information technology systems and new processes in each of our dialysis centers over the next few years. It is likely that this rollout will disrupt our billing and collection activity and may cause other disruptions to our business operations, which may negatively impact our cash flows. Also, the new information systems may not work as planned or improve our billing and collection processes. If they do not, we may have to spend substantial amounts to enhance or replace these systems.
 
Provisions in our charter documents and compensation programs we have adopted may deter a change of control that our stockholders would otherwise determine to be in their best interests.
 
Our charter documents include provisions that may deter hostile takeovers, delay or prevent changes of control or changes in our management, or limit the ability of our stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting our stockholders from acting by written consent, requiring 60 days advance notice of stockholder proposals or nominations to our Board of Directors and granting our Board of Directors the authority to issue up to five million shares of preferred stock and to determine the rights and preferences of the preferred stock without the need for further stockholder approval.
 
In addition, most of our outstanding employee stock options include a provision accelerating the vesting of the options in the event of a change of control. We have also adopted a change of control protection program for our employees who do not have a significant number of stock options, which provides for cash bonuses to the employees in the event of a change of control. Based on the shares of our common stock outstanding and the market price of our stock on June 30, 2002, these cash bonuses would total approximately $57 million. These compensation programs may affect the price an acquirer would be willing to pay.
 
We may, in the future, adopt other measures that may have the effect of delaying, deferring or preventing an unsolicited takeover, even if such a change of control were at a premium price or favored by a majority of unaffiliated stockholders. Furthermore, we may adopt some of these measures without any further vote or action by our stockholders.

22

 
PART II
 
OTHER INFORMATION
 
Item 1.     Legal Proceedings
 
The information in Note 6 of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this report is incorporated by this reference in response to this item.
 
Item 2.     Changes in Securities and Use of Proceeds
 
In connection with the tender offer for all of our $225 million outstanding 9¼% Senior Subordinated Notes due 2011, the holders of the notes consented to the elimination of the restrictive covenants in the notes. In April 2002, the Company completed the repurchase of the notes, all of which were tendered. Accordingly, none of the notes remain outstanding.
 
Item 3 is not applicable.
 
Item 4.     Submission of Matters to a Vote of Security Holders
 
Our annual meeting of stockholders was held on April 11, 2002. Please refer to Item 4 in our 10-Q for the quarter ended March 31, 2002, which was filed on May 14, 2002, and which contains the information called for by this item.
 
Item 5 is not applicable.
 

23

 
Item 6.     Exhibits and Reports on Form 8-K
 
(a)  Exhibits
 
Exhibit Number
   
Description
12.1
   
Ratio of earnings to fixed charges.ü
99.1
   
Certification of the Chief Executive Officer, dated August 7, 2002, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
99.2
   
Certification of the Chief Financial Officer, dated August 7, 2002, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
ü
 
Filed herewith.
 
(b)  Reports on Form 8-K
 
None.

24

 
SIGNATURE
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
DAVITA INC.
By:
  
/s/    GARY W. BEIL        
   
Gary W. Beil
Vice President and Controller*
 
 
Date: August 7, 2002
 
*
 
Mr. Beil has signed both on behalf of the registrant as a duly authorized officer and as the Registrant’s chief accounting officer.

25

INDEX TO EXHIBITS
 
 
Exhibit Number
   
Description
12.1
   
Ratio of earnings to fixed charges.ü
99.1
   
Certification of the Chief Executive Officer, dated August 7, 2002, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
99.2
   
Certification of the Chief Financial Officer, dated August 7, 2002, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
ü
 
Filed herewith.

26