UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 

For the Fiscal Year Ended

December 31, 20062007

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number: 1-14106

 

DAVITA INC.

 

601 Hawaii Street

El Segundo, California 90245

Telephone number (310) 536-2400

 

Delaware 51-0354549
(State of incorporation) 

(I.R.S. Employer

Identification No.)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Class of Security: Registered on:

Common Stock, $0.001 par value

 New York Stock Exchange

Common Stock Purchase Rights

 New York Stock Exchange

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

 

Indicate by check mark whether the registrant (1) 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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a non-accelerated filer.smaller reporting company. See definitionthe definitions of “large accelerated filer,” “accelerated filerfiler” and large accelerated filer”“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

As of June 30, 2006,2007, the number of shares of the Registrant’s common stock outstanding was approximately 103.6105.6 million shares and the aggregate market value of the common stock outstanding held by non-affiliates based upon the closing price of these shares on the New York Stock Exchange was approximately $5.1$5.7 billion.

 

As of February 1, 2007,2008, the number of shares of the Registrant’s common stock outstanding was approximately 104.9107.4 million shares and the aggregate market value of the common stock outstanding held by non-affiliates based upon the closing price of these shares on the New York Stock Exchange was approximately $5.8 billion.

 

Documents incorporated by reference

 

Portions of the Registrant’s proxy statement for its 20072008 annual meeting of stockholders are incorporated by reference in Part III of this Form 10-K.

 



PART I

 

Item 1.    Business.Business

 

We were incorporated as a Delaware corporation in 1994. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are made available free of charge through our website, located athttp://www.davita.com, as soon as reasonably practicable after the reports are filed with or furnished to the Securities and Exchange Commission, or SEC. The SEC also maintains a website at http://www.sec.gov where these reports and other information about us can be obtained. The contents of our website are not incorporated by reference into this report.

 

Overview

 

DaVita is a leading provider of dialysis services in the United States for patients suffering from chronic kidney failure, also known as end stage renal disease, or ESRD. As of December 31, 2006,2007, we operated or provided administrative services to approximately 1,3001,359 outpatient dialysis centers located in 4243 states and the District of Columbia, serving approximately 103,000107,000 patients. We also provide acute inpatient dialysis services in approximately 770700 hospitals and related laboratory services. Dialysis and dialysis related services account for approximately 97% of total net revenues. All other ancillary services and strategic initiatives, which currently account for approximately 2%3% of our consolidated revenues, relate primarily to our core business of providing renal care services. On October 5, 2005, we completed our acquisition of DVA Renal Healthcare, Inc. (formerly known as Gambro Healthcare, Inc.) from Gambro, Inc. for approximately $3.06 billion. DVA Renal Healthcare was one of the largest dialysis service providers in the United States, operating 566 outpatient dialysis centers, serving approximately 43,000 patients, and generating annual revenues of approximately $2 billion.

 

The dialysis industry

 

The loss of kidney function is normally irreversible. ESRD is the stage of advanced kidney impairment that requires continued dialysis treatments or a kidney transplant to sustain life. Dialysis is the removal of toxins, fluids and salt from the blood of ESRD patients by artificial means. Patients suffering from ESRD generally require dialysis at least three times per week for the rest of their lives.

 

Since 1972, the federal government has provided universal payment coverage for dialysis treatments under the Medicare ESRD program regardless of age or financial circumstances. Under this system, Congress establishes Medicare rates for dialysis treatments, and related supplies, tests and medications. Approximately 87% of our total patients are under government-based programs, with approximately 78%80% of our patients under Medicare and Medicare assignedMedicare-assigned HMO plans.

 

ESRD patient base

 

There are more than 335,000340,000 ESRD dialysis patients in the United States. The recent historical compound annual growth rate in the number of ESRD dialysis patients has been approximately 3%-4%. The growth rate is attributable to the aging of the population, increased incidence rates for diseases that cause kidney failure such as diabetes and hypertension, lower mortality rates for dialysis patients and growth rates of minority populations with higher than average incidence rates of ESRD.

 

Treatment options for ESRD

 

Treatment options for ESRD are dialysis and kidney transplantation.

Dialysis Options

 

  

Hemodialysis

 

Hemodialysis, the most common form of ESRD treatment, is usually performed in outpatient facilities (centers).dialysis centers. It may also be done while a patient is at home or while hospitalized. The hemodialysis machine uses an artificial kidney, called a dialyzer, to remove toxins, fluids and salt from the patient’s blood. The dialysis process

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occurs across a semi-permeable membrane that divides the dialyzer into two distinct chambers. While blood is circulated through one chamber, a pre-mixed fluid is circulated through the other chamber. The toxins, salt and excess fluids from the blood cross the membrane into the fluid, allowing cleansed blood to return into the patient’s body. Each hemodialysis treatment typically lasts approximately three and one-half hours. Hemodialysis is usually performed three times per week.

 

Certain ESRD patients may perform home-based hemodialysis in their home or residence through the use of a hemodialysis machine designed for home therapy. Patients receive training, support and monitoring from registered nurses, in some cases in our outpatient dialysis centers, in order to perform their treatments. Home-based hemodialysis is typically performed with greater frequency than in-center dialysis treatments and on varying schedules.

 

Hospital inpatient hemodialysis services are required for patients with acute kidney failure resulting from trauma, patients in early stages of ESRD and ESRD patients who require hospitalization for other reasons. Hospital inpatient hemodialysis is generally performed at the patient’s bedside or in a dedicated treatment room atin the hospital.

 

  

Peritoneal dialysis

 

A patient generally performsPeritoneal dialysis uses the patient’s peritoneal, dialysis at home.or abdominal, cavity to eliminate fluid and toxins. The most common methods of peritoneal dialysis are continuous ambulatory peritoneal dialysis, or CAPD, and continuous cycling peritoneal dialysis, or CCPD. All forms ofA patient generally performs peritoneal dialysis use the patient’s peritoneal, or abdominal, cavity to eliminate fluid and toxins.at home. Because it does not involve going to a center three times a week for treatment, peritoneal dialysis is an alternative to hemodialysis for patients who desire more freedom in their lifestyle. However, peritoneal dialysis is not a suitable method of treatment for many patients, including patients who are unable to perform the necessary procedures and those at greater risk of peritoneal infection.

 

CAPD introduces dialysis solution into the patient’s peritoneal cavity through a surgically placed catheter. Toxins in the blood continuously cross the peritoneal membrane into the dialysis solution. After several hours, the patient drains the used dialysis solution and replaces it with fresh solution. This procedure is usually repeated four times per day.

 

CCPD is performed in a manner similar to CAPD, but uses a mechanical device to cycle dialysis solution through the patient’s peritoneal cavity while the patient is sleeping or at rest.

 

  

Transplantation

 

Although transplantation, when successful, is generally the most desirable form of therapeutic intervention, the shortage of suitable donors, side effects of immunosuppressive pharmaceuticals given to transplant recipients and dangers associated with transplant surgery for some patient populations limit the use of this treatment option.

 

Services we provide

 

Dialysis Services

 

Outpatient dialysis services

 

As of December 31, 2006,2007, we operated or provided administrative services to approximately 1,3001,359 outpatient dialysis centers in the United States that are designed specifically for outpatient hemodialysis. In 2006,2007, we added 67a net total of 59 centers primarily as a result of acquisitions and the opening of new centers, net of divestures and

center closures. Throughout our network of outpatient dialysis centers, we also provide training, supplies and on-call support services to our peritoneal dialysis patients. With the introduction of smaller, easier to use and portable technologies, we are also providing certain patients the option of home-based hemodialysis, as described above.

 

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As required by law, we contract with a nephrologist or a group of affiliated nephrologists to provide medical director services at each of our centers. In addition, other nephrologists may apply for practice privileges to treat their patients at our centers. Each center has an administrator, typically a registered nurse, who supervises the day-to-day operations of the center and its staff. The staff of each center typically consists of registered nurses, licensed practical or vocational nurses, patient care technicians, a social worker, a registered dietician, biomedical technician support and other administrative and support personnel.

 

Many of our outpatient dialysis centers offer services for home dialysis patients, primarily CAPD and CCPD. Home dialysis services consist of providing equipment and supplies, training, patient monitoring and follow-up assistance to patients who prefer and are able to receive peritoneal dialysis or home-based hemodialysis treatments in their homes. Registered nurses train patients and their families or other caregivers to perform either peritoneal dialysis or hemodialysis at home.

 

We do not enter into contractual or preferential relationships with our patients that obligate either our patients or us for services. Total patient turnover averages more than 25% per year. However, the overall number of patients that we treat increased by approximately 7% as of December 31, 2006 compared to December 31, 2005. Approximately 87% of the treatments we administer for patients are paid for, at least in part, by government-based programs, principally Medicare, and underUnder Medicare regulations, we cannot promote, develop or maintain any kind of contractual relationship with our patients which would directly or indirectly obligate a patient to use or continue to use our services, or which would give us any preferential rights other than those related to collecting payments for our services. Total patient turnover averages more than 30% per year. However, the overall number of patients that we treat increased by approximately 4% as of December 31, 2007 compared to December 31, 2006.

 

Hospital inpatient dialysis services

 

We provide hospital inpatient dialysis services, excluding physician services, to patients in approximately 770700 hospitals. We render these services for a contracted per-treatment fee that is individually negotiated with each hospital. When a hospital requests our services, we typically administer the dialysis treatment at the patient’s bedside or in a dedicated treatment room in the hospital. InpatientHospital inpatient dialysis services are required for patients with acute kidney failure resulting from trauma, patients in the early stages of ESRD and ESRD patients who require hospitalization for other reasons. In 2006, acute2007, hospital inpatient dialysis services accounted for approximately 5% of our total dialysis treatments.

 

ESRD laboratory services

 

We own two separately incorporated, licensed, clinical laboratories, both located in Florida, specializing in ESRD patient testing. These specialized laboratories provide routine laboratory tests covered by the Medicare composite payment rate for dialysis and other physician-prescribed laboratory tests for ESRD patients. Our laboratories provide these tests predominantly for our own ESRD patients throughout the United States. These tests are performed to monitor a patient’s ESRD condition, including the adequacy of dialysis, as well as other diseases a patient may have. Our laboratories utilize information systems which provide information to our dialysis centers regarding critical outcome indicators.

 

Ancillary services and strategic initiatives

 

Ancillary services and strategic initiatives, which currently account for less than 2%approximately 3% of our total revenues, consist of the following:

 

  

Pharmacy.Infusion Therapy Services.    HomeChoice Partners provides personalized infusion therapy services to patients in their own homes as a cost-effective alternative to inpatient hospitalization. Intravenous and nutritional support therapies are typically managed by registered and/or board-certified professionals including pharmacist, nurses and dieticians in collaboration with the patient’s physician in support of the patient’s ongoing healthcare needs. Revenues are recognized in the period when infusion therapy services are provided.

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Pharmacy.    DaVita Rx is a wholly-owned full-service pharmacy whichthat provides oral medications to DaVita’s patients with chronic kidney disease, or CKD, and patients with ESRD. The main objectives of

the pharmacy are to improve clinical outcomes, patient compliance and to provide service excellence by providing our patients a convenient way to fill their prescription needs. Revenues are recognized as prescriptions are filled and shipped to patients.

 

  

Vascular access services.    We provideRMS Lifeline provides management and administrative services to physician-owned vascular access clinics that provide surgical and interventional radiology services for dialysis patients. Management fees generated from these services are included in management fee income.income and are recognized as earned typically based on a percentage of revenues or cash collections generated by the clinics.

 

  

Disease management services.services and Special Needs Plans.    We provideVillage Health provides advanced care management services to employers, health plans and government agencies for employees/members diagnosed with chronic kidney disease, including renal failure.CKD or ESRD. Through a combination of clinical coordination, medical claims analysis and information technology, we endeavor to assist our customers and patients in obtaining superior renal health care and improved clinical outcomes, as well as helping to reduce overall medical costs. Revenues are typically based upon an established contract fee and are recognized as earned over the contract period and can include additional fees for cost savings recognized by certain customers. Village Health also offers full service health care plans for ESRD and CKD patients. The health care business is part of a Medicare Advantage Special Needs Plan that works with the Centers for Medicare and Medicaid Services, or CMS, to provide ESRD patients full service health care. Revenues are recognized as earned and are based on capitated rates as determined by CMS for each patient enrolled in the plan.

 

  

ESRD clinical research programs.    DaVita Clinical Research conducts research trials with dialysis patients and provides administrative support for research conducted by DaVita-affiliated nephrology practices. Revenues are based upon an established fee per study, as determined by contract with drug companies and other sponsors.sponsors and are recognized as earned according to the contract terms.

 

  

Management fee income.    We currently operate or provide management and administrative services to 3823 outpatient dialysis centers, in which we either own a noncontrolling interest, or are wholly-owned or majority-owned by third parties, under management services agreements. Management fees are established by contract and are recognized as earned typically based on a percentage of revenues or cash collections generated by the centers.

 

Quality care

 

We believe our reputation for providing quality care is a key factor in attracting patients and physicians and in securing contracts with healthcare plans. We engage in organized and systematic efforts through our quality management programs to monitor and improve the quality of services we deliver. These efforts include the development and implementation of patient care policies and procedures, clinical education and training programs, education and mentoring related to our clinical guidelines and protocols and audits of the quality of services rendered at each of our centers.

 

We haveDaVita employs over 140 clinical nurses who serve as service specialists who are trained to assistspecialists. The primary focus of this group is assuring and facilitating processes that ensure superior clinical outcomes at our outpatient clinics at a local level with education and quality outcome management. We have also established a Physician Council made up of a panel of physicians who also serve as our medical directors.facilities. The Physician Council actsserves as an advisory panelbody to our Chief Executive Officersenior DaVita management. The council is composed of 17 physicians with extensive experience in clinical practice. It represents both private and academic centers. The Physician Council advises on issues relating to, among other things, quality care practices,clinical priorities and standards of medical appropriateness. We also maintain areviews policies and procedures affecting patient care. The Physician Laboratory Advisory Committee, whichor PLAC, composed of 10 physicians provides clinical reviewphysician input and input to bothoversight in the operations of our laboratories. In addition, we established aDaVita’s laboratory facilities. The DaVita Quality Council, in 2006 underconsisting of the supervisionsenior directors of ourclinical service as well as representatives of operations and the office of the Chief Medical Officer, coordinates certain clinical activities and Director of Quality Management. The Quality Council, composed of teammates specializing in clinical services and operations, coordinates and prioritizes directivesintegrates input from the Physician Councilphysician and management.the PLACs into clinical practice.

 

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Sources of revenue—concentrations and risks

 

Our dialysis revenue represents 98%97% of our total net operating revenues with the balance of our revenues from ancillary services and strategic initiatives. Dialysis revenue is derived from dialysis and dialysis relateddialysis-related services, which includes the administration of pharmaceuticals and related laboratory services.

 

The sources of our dialysis revenue are government-based programs, including Medicare, Medicaid and Medicare assignedMedicare-assigned HMO plans, commercial payors, which consist principally of commercial insurance plans, and direct payments from patients established by single patient agreements with patients not covered by other contracts.

The following table summarizes our dialysis revenue and patient percentages by payor type for the year ended December 31, 2006:2007:

 

  Revenues

 

Patient

Percentages


   Revenues Patient
Percentages
 

Medicare and Medicare assigned HMO plans

  58% 78%

Medicare and Medicare-assigned HMO plans

  58% 80%

Medicaid

  4% 6%  4% 5%

Other government-based programs

  3% 3%  2% 2%
  

 

       

Total government-based programs

  65% 87%  64% 87%

Commercial

  35% 13%  36% 13%
  

 

       

Total dialysis revenue

  100% 100%  100% 100%
  

 

       

 

The following table summarizes our dialysis revenue by source for the year ended December 31, 2006:2007:

 

   

Revenue


Percentages


 

Outpatient hemodialysis centers

  82%

Peritoneal dialysis and home-based hemodialysis

  9%

Hospital inpatient hemodialysis

  6%

Laboratory Servicesservices

  3%
  

Total dialysis revenue

  100%
  

 

Medicare revenue

 

Under the Medicare ESRD program, payment rates for dialysis are established by Congress. The Medicare composite rate set by CMS, pays freestanding dialysis facilities for services provided to Medicare beneficiaries under two methods: (1) the Centerscomposite payment which includes a base payment, adjusted for Medicarecase-mix and Medicaid Services, or CMS, includesgeography, which has no statutory inflation adjustment mechanism, and a drug add-on payment, which is updated annually to account for changes in drug prices and utilization and (2) separately billable drug reimbursement. Thus, facilities receive a composite payment rate per treatment to cover routine dialysis services, certain pharmaceuticals, routine lab work, and other supplies, as well as a separate payment for pharmaceuticals that are not included in the dialysis treatment, supplies used for that treatment, specified laboratory tests and certain pharmaceuticals.composite payment rate. The Medicare composite rate is subject to regional differences based upon several factors, including differences in wage levels.levels and is subject to a case mix adjustment methodology designed to link payments more closely with illness severity. We are paid separately for other services and pharmaceuticals, including Epogen®, or EPO, vitamin D analogs and iron supplements. Pharmaceuticals are generally paid at average sale price, or ASP, plus 6% based upon prices set by Medicare. The Medicare payment rates, including separately billable drugs, are not sufficient to cover the average cost of providing a dialysis treatment.

 

ESRD patients receiving dialysis become eligible for primary Medicare coverage at various times, depending on their age or disability status, as well as whether they are covered by an employer group health plan.

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Generally, for a patient not covered by an employer group health plan, Medicare becomes the primary payor either immediately or after a three-month waiting period. For a patient covered by an employer group health plan, Medicare generally becomes the primary payor after 33 months or earlier if the patient’s employer group health plan coverage terminates. When Medicare becomes the primary payor, the payment rate we receive for that patient shifts from the employer group health plan rate to the Medicare payment rate.

 

For each covered treatment, Medicare pays 80% of the amount set by the Medicare system. The patient is responsible for the remaining 20%, and in. In most cases, a secondary payor, such as Medicare supplemental insurance, a state Medicaid program or a commercial health plan, covers all or part of these balances. Some patients, who do not qualify for Medicaid but otherwise cannot afford secondary insurance, can apply for premium payment assistance from charitable organizations through a program offered by the American Kidney Fund. We and other dialysis providers support the American Kidney Fund and similar programs through voluntary contributions. If a patient does not have secondary insurance coverage, we are generally unsuccessful in our efforts to collect from the patient the 20% portion of the ESRD composite rate that Medicare does not pay.

The Medicare composite payment rates set by Congress for dialysis treatments that were in effect for 20062007 were between $147$149 and $162$165 per treatment, with an average rate of $155$157 per treatment. Unlike Medicare payment rates for most other medical services, Medicare composite payment rates for dialysis have not been routinely increased to compensate for the impact of inflation. Since 1972, the Medicare composite payment rate has declined over 75% in inflation-adjusted dollars.inflation, which negatively impacts our margins as patient care costs continue to rise. Congress and CMS have addressed the impact of inflation more consistently since 2000, with increases of 1.2% in 2000, 2.4% in 2001, 1.6% in each of 2005 and 2006, and a 1.6% increase that will bewas effective on April 1, 2007.

 

However, although the 2005 composite payment rate increased under the Medicare Prescription Drug Improvement and Modernization Act, or MMA, separate payment rates for pharmaceuticals were reduced. While the MMA committed that aggregate payments for dialysis services would not be reduced by the payment changes, the changes resulted in a net reduction of average Medicare payment rates to the Company of 1.3%. CMS also implemented a case-mix adjustment methodology in April 2005 designed to link payments more closely to illness severity.

In 2005, CMS issued revised rules with regard to payment for separately billable pharmaceuticals furnished by ESRD facilities. Effective January 1, 2006, payments for pharmaceuticals furnished by ESRD facilities were set at the average sales price, or ASP, plus 6 percent. CMS adjusted payment amounts quarterly for 2006, based on ASP data reported by the drug manufacturers. Increases in drug prices are generally not reflected in our payment rates for a minimum of at least a quarter after the prices are adjusted. While these rates resulted in lower payments to ESRD providers for pharmaceuticals, the composite rate was concurrently increased, substantially offsetting the impact of the reduction in pharmaceutical payments. Effective January 1, 2006, CMS increased the Medicare composite payment rate by 1.6%, and will further increase the Medicare composite payment rate by 1.6% effective April 1, 2007, as discussed above.

During 2005, the Company contracted with CMS toWe participate in two Medicare demonstration programs—programs through a contract with CMS—an ESRD demonstration project in California’s Riverside and San Bernardino counties; and a CKD demonstration project in New York, including Nassau and Suffolk counties and the Queens Borough of New York City. The CKD project is for three years and became effective November 2005.project. The ESRD demonstration project is for four years and became effective January 2006. The CKD project is a three year program and became effective November 2005. Under the ESRD demonstration project, the Company’sour revenue is capitated for all medical services required by enrollees in the program. The Company isWe are at risk for all medical costs of the program in excess of the capitation payments. Under the CKD demonstration project, the Company iswe are paid a management fee for program enrollees. Management fee revenues are subject to retraction if medical cost savings targets are not met.

 

Medicaid revenue

 

Medicaid programs are state-administered programs partially funded by the federal government. These programs are intended to provide health coverage for patients whose income and assets fall below state-defined levels and who are otherwise uninsured. These programs also serve as supplemental insurance programs for co-insurance payments due from Medicaid-eligible patients with primary coverage under Medicare. Some Medicaid programs also pay for additional services, including some oral medications that are not covered by Medicare. We are an authorized Medicaid provider in the states in which we conduct our business.

 

Commercial revenues

 

Before Medicare becomes the primary payor, a patient’s employer group health plan or private insurance plan, if any, is responsible for payment. Although commercial payment rates vary significantly, average commercial payment rates are moregenerally significantly higher than double Medicare rates. The payments we receive from commercial payors generate nearly all of our profits. Commercial payment rates are the result of negotiations between us, insurers, third-party administrators, and occasionally, individuals. More common paymentWe are continuously in the process of negotiating agreements with our commercial payors and if our negotiations result in overall commercial rate reductions in excess of our commercial rate increases, our revenues and operating results could

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be negatively impacted. Payment methods include a single lump-sum per treatment, (standardized rates)referred to as standardized, or bundled, rates and separate payments for treatments and pharmaceuticals, if used as part of the treatment, (unbundled rates).

referred to as unbundled rates.

Our commercial payors consist principally of commercial insurance plans, including more than 1,2001,100 with whom we have contracted rates. Approximately 13%36% of our dialysis revenue is associated with non-contracted commercial payors for the year ended December 31, 2006. Less then2007. Approximately 1% of our dialysis services and related dialysis services payments are received directly from patients. No single commercial payor accounted for more than 5% of total dialysis revenue for the year ended December 31, 2006.2007.

 

Revenue from EPO and other pharmaceuticals

 

ApproximatelySlightly more than 30% of our total dialysis revenue for the year ended December 31, 20062007 is associated with the administration of physician-prescribed pharmaceuticals that improve clinical outcomes when included with the dialysis treatment. These pharmaceuticals include EPO, vitamin D analogs and iron supplements.

 

EPO is a genetically engineered form of a naturally occurring protein that stimulates the production of red blood cells. EPO is used in connection with all forms of dialysis to treat anemia, a medical complication most ESRD patients experience. The administration of EPO, which is separately billable under the Medicare payment program, accountsaccounted for approximately 25%slightly more than 20% of our dialysis revenue for the year ended December 31, 2006.2007. Changes in the levels of physician-prescribed EPO and commercial and government payment rates related to EPO can significantly influence our revenues and operating earnings.

CMS issued a new payment coverage policy for EPO, which became effective April 1, 2006, and was subsequently revised effective October 1, 2006. This new policy limitslimited payments based on EPO doses for certain patients. Further, effective July 1, 2007, CMS implemented a new reimbursement methodology for EPO. CMS combined the ASP’s, as reported by drug manufacturers, for EPO and a similar pharmaceutical to establish one reimbursement payment rate for EPO. This methodology change, along with a reduction in the ASP’s as reported by the drug manufacturers, resulted in an overall decrease to the EPO reimbursement payment rate by CMS. In addition, effective January 1, 2008, CMS changed the way EPO is billed from a total monthly dosage to the line-item date-of-service approach used for other separately billable drugs.

 

Furthermore, EPO is produced by a single manufacturer, Amgen, and any interruption of supply or product cost increases could adversely affect our operations. We have entered into an agreement with Amgen that provides for EPO pricing for a fixed time period that includes potential discounts depending upon the achievement of certain clinical and other criteria. Our agreement with Amgen also provides for specific rebates, and incentives, which are based on a variety of factors including patient outcomes, process improvement, data submission purchase volume growth and some combination of these factors.

 

Amgen has also developed a new product, darbepoetin alfa, also known asand obtained U.S. Food and Drug Administration, or FDA, approval for Aranesp®, that could potentiallymay replace EPO or reduce its use with dialysis patients. In addition, Roche has developed and is seekingobtained FDA approval for CERA,Mircera®, a pharmaceutical also used to treat anemia. Unlike EPO, which is generally administered in conjunction with each dialysis treatment, Aranesp® and CERAMircera® can be administered less frequently. The FDA has approved Aranesp® forA significant increase in the development and use with dialysis patients. However, we cannot predict when,of these or whether, thesesimilar alternatives to EPO, will be marketedor a change in administration practices, could have a material impact on revenues, earnings and cash flows.

Since late 2006, there has been significant media discussion and government scrutiny regarding anemia management practices for ESRD patients in the United States, largely in response to recent clinical studies identifying risks in certain patient populations related to the dialysis industry, how Medicare or other payors will reimburse dialysis providers for their use, whether physicians will prescribe these alternatives insteadutilization of EPO or how it will impactand similar pharmaceuticals. As a result, the FDA required warning labels for EPO and Aranesp, congressional hearings were held and legislation regarding utilization and reimbursement was proposed. Although we believe our revenuesanemia management practices have been compliant with existing laws and earnings.regulations, as a result of the current high level of scrutiny and

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controversy, we may be subject to increased inquiries from a variety of governmental bodies, as well as additional changes by CMS to its EPO reimbursement policies. For example, changes to the existing EPO monitoring policy went into effect in January 2008 which further limit reimbursement and which have impacted the prescribing habits of our physicians. Commercial payers have also increased scrutiny of their own administration policies for the reimbursement of EPO.

 

Physician relationships

 

An ESRD patient generally seeks treatment at aan outpatient dialysis center near his or her home and at which his or her treating nephrologist has practice privileges. Our relationships with local nephrologists and our ability to meet their needs and the needs of their patients are key factors in the success of a dialysis center. Over 2,8003,000 nephrologists currently refer patients to our centers. As is typical in the dialysis industry, one or a few physicians, including the center’s medical director, usually account for all or a significant portion of a dialysis center’s patient referral base. Our medical directors provide a substantial portion of our patient referrals. If a significant number of physicians were to cease referring patients to our dialysis centers, our business could be adversely affected.

 

Participation in the Medicare ESRD program requires that treatment at aan outpatient dialysis center be under the general supervision of a medical director who is a physician. We have engaged physicians or groups of physicians to serve as medical directors for each of our centers. At some centers, we also separately contract with one or more physicians to serve as assistant or associate medical directors or to direct specific programs, such as home

dialysis training programs. We have contracts with approximately 1,0201,080 individual physicians and physician groups to provide medical director services.

 

Medical directors enter into written contracts with us that specify their duties and fix their compensation generally for periods of ten years. The compensation of our medical directors is the result of arm’s length negotiations and generally depends upon an analysis of various factors such as the physician’s duties, and responsibilities, and the physician’s professional qualifications and experience, among others.

 

Our medical director agreements generally include covenants not to compete. Also, when we acquire a center from one or more physicians or where one or more physicians own interests in centers as co-owners with us, these physicians have agreed to refrain from owning interests in competing centers within a defined geographic area for various time periods. These agreements not to compete restrict the physicians from owning or providing medical director services to other dialysis centers, but do not prohibit the physicians from referring patients to any dialysis center, including competing centers. Many of these agreements not to compete expire at the same time as the corresponding medical director agreements, although some continue for a period of time beyond expiration. WeOccasionally we have from time to time experienced competition from a new dialysis center established by a former medical director following the termination of his or her relationship with us.

 

Government regulation

 

Our dialysis operations are subject to extensive federal, state and local governmental regulations. These regulations require us to meet various standards relating to, among other things, government payment programs, dialysis facilities and equipment, management of centers, personnel qualifications, maintenance of proper records and quality assurance programs and patient care.

 

Our dialysis centers are certified by CMS, as is required for the receipt of Medicare payments. In some states, our dialysis centers also are required to secure additional state licenses and permits. Governmental authorities, primarily state departments of health, periodically inspect our centers to determine if we satisfy applicable federal and state standards and requirements, including the conditions of participation in the Medicare ESRD program.

 

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Because a significant number of dialysis patients are covered for treatment under government-based programs, our business could be adversely impacted by:

 

Loss or suspension of federal certifications;

Loss or suspension of licenses under the laws of any state or governmental authority from which we generate substantial revenues;

Exclusion from government healthcare programs including Medicare and Medicaid;

Significant reductions or lack of inflation-adjusted increases in payment rates or reduction of coverage for dialysis and ancillary services and related pharmaceuticals;

Fines, damages and monetary penalties for anti-kickback law violations, Stark II violations, submission of false claims, civil or criminal liability based on violations of law or other failures to meet regulatory requirements;

Claims for monetary damages from patients who believe their protected health information has been used or disclosed in violation of federal and state patient privacy laws;

Government mandated practice changes that significantly increase operating expenses; or

Refunds of payments received from government payors and government health care program beneficiaries because of any failures to meet applicable requirements.

 

To date, we have not experienced significant difficulty in maintaining our licenses or our Medicare and Medicaid authorizations. However, we have experienced delays in obtaining certifications from CMS. We expect that our industry will continue to be subject to significant government regulation and scrutiny, the scope and

application of which are difficult to predict. This regulation and scrutiny could adversely impact us in a material way.

 

CMS continues to study the regulations applicable to Medicare certification to provide dialysis services. On February 4, 2005, CMS published a proposed rule that would revise the conditions of coverage for ESRD facilities. The revised requirements would, among other things, establish performance expectations for facilities, eliminate many procedural requirements from the current conditions of coverage, and promote continuous quality improvement. The proposed regulations are stillCMS was expected to issue a final rule by February 5, 2008, but has announced that it is delaying the issuance. Accordingly, these proposals remain subject to revision based on public comments in the rulemaking process and would not become effective until issued as final regulation. WeAlthough the new deadline for issuance of the rule is February 4, 2009, we do not know what changes may be made in a final rule or when a final rule might be published, and accordingly, we cannot predict what impact it might have on our operating results.

 

Federal anti-kickback statute

 

The “anti-kickback” statute contained in the Social Security Act imposes criminal and civil sanctions on persons who receive, make, offer or solicit payments in return for:

 

The referral of a Medicare or Medicaid patient for treatment;

The ordering or purchasing of items or services that are paid for in whole or in part by Medicare, Medicaid or similar federal and state programs; or

Arranging for or recommending the ordering or purchasing of such items.

 

Federal criminal penalties for the violation of these laws include imprisonment, fines and exclusion of the provider from future participation in the Medicare and Medicaid programs. Violations of the anti-kickback statute are punishable by imprisonment for up to five years and fines of up to $25,000 or both. Under the U.S. Sentencing Guidelines, an individual may be fined up to $250,000 and an organization may be fined up to $500,000 upon conviction for an offense described in any federal statute. Individuals and entities convicted of violating the anti-kickback statute are subject to mandatory exclusion from participation in Medicare, Medicaid and other federal healthcare programs for a minimum of five years. Civil penalties for violation of these laws include up to $50,000 in monetary penalties per violation, repayments of up to three times the total payments between the parties and suspension from future participation in Medicare and Medicaid. Some state anti-kickback statutes also include criminal penalties. The federal statute expressly prohibits traditionally criminal

10


transactions, such as kickbacks, rebates or bribes for patient referrals. Court decisions have also held that the statute is violated whenever one of the purposes of remuneration is to induce referrals. If any of our practices were to be found to violate the anti-kickback statute, it could have a material adverse impact on our earnings and subject us to any of the penalties described above.

 

The Department of Health and Human Services regulations create exceptions or “safe harbors” for some business transactions and arrangements. Transactions and arrangements structured within these safe harbors do not violate the anti-kickback statute. A business transaction or arrangement must satisfy every element of a safe harbor to be protected by that safe harbor. Transactions and arrangements that do not satisfy all elements of a relevant safe harbor do not necessarily violate the statute, but are subject to greater scrutiny by enforcement agencies.

 

Some medical directors and other referring physicians may own our common stock, which they either purchased in the open market or received from us as consideration in an acquisition of dialysis centers from them.stock. We believe that these interests materially satisfy the requirements of the safe harbor for investments in large publicly traded companies for the anti-kickback statute.

 

While nearly all of our stock option arrangements with referring physicians were terminated in 2000, a few medical directors still hold options to acquire our common stock because we did not have the contractual right to terminate their options. It is possible that CMS could view these interests as prohibited arrangements that must be restructured and which could subject us to possible criminal, civil or administrative sanctions.

Our medical directors refer patients to our centers and these arrangements, by which we pay them for their medical director services, must be in compliance with the federal anti-kickback statute. Among the available safe harbors is one for personal services furnished for fair market value. However, most of our agreements with our medical directors do not satisfy all seven of the requirements of the personal services safe harbor. We believe that, because of the nature of our medical directors’ duties, it is impossible to satisfy the anti-kickback safe-harbor requirement that if the services provided under the agreement are on a part-time basis, as they are with our medical directors, the agreement must specify the schedule of intervals of service, their precise length and the exact charge for such intervals. Accordingly, while we believe that our agreements with our medical directors satisfy as many of the elements of this safe harbor as we believe is reasonably possible, our arrangements do not qualify for safe harbor protection. We believe, however, that our agreements do not violate the federal anti-kickback statute. We also note that there is little guidance available as to what constitutes fair market value for medical director services. Although the final Phase II, Stark II regulations (described below) created a so-called safe harbor method of establishing the fair market value of physician compensation, this methodology, which is not required by the rule, is very restrictive, and has been challenged in court. Regardless of the outcome of the challenge, we do not believe that this method produces a reasonable estimate of the fair market value of dialysis facility medical director services.

 

We own a controlling interest in approximately 85numerous dialysis related joint ventures, representingwhich represented approximately 15% of our dialysis revenue. In addition we also own a noncontrolling interest in several other dialysis related joint ventures. Our relationships with physicians and other referral sources relating to these joint ventures are required to comply with the anti-kickback statute. Although there is a safe harbor for certain investment interests in “small entities,” it is not clear if any of our joint ventures satisfies all of the requirements for protection by this safe harbor. Under current law, physician joint ventures are not prohibited but instead require a case by case evaluation under the anti-kickback statute. We have structured our joint ventures to satisfy as many safe harbor requirements as we believe are reasonably possible and we believe that these investments are offered on a fair market value basis and provide returns to the physician investors only in proportion to their actual investment in the venture. Notwithstanding these efforts, since the arrangements do not satisfy all of the requirements for safe harbor protection, these arrangements could be challenged.

 

We lease space for approximately 330390 of our centers from entities in which physicians hold ownership interests and we sublease space to referring physicians at approximately 160 of our dialysis centers. These arrangements must be in compliance with the anti-kickback statute. We believe that we meet the elements of the safe harbor for space rentals in all material respects.

 

Because we are purchasing and selling items and services in the operation of our centers that may be paid for, in whole or in part, by Medicare or a state healthcare program and because we acquire certain items and services at a discount, we must structure these arrangements in compliance with the federal anti-kickback statute. Subject to certain requirements and limitations, discounts representing reductions in the amounts we are charged for items or services based on arms-length transactions can qualify for safe harbor protection if we fully and accurately report the discounts in the applicable Medicare cost reports. While some of the safe harbor criteria are subject to interpretation, we believe that our vendor contracts with discount provisions do not violate the anti-kickback statute.

 

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If any of our business transactions or arrangements including those described above were found to violate the federal “anti-kickback” statute, we could face criminal, civil and administrative sanctions, including possible exclusion from participation in Medicare, Medicaid and other state and federal healthcare programs.

 

Stark II

 

Another federal law (known as the “Stark Law”) prohibits a physician who has a financial relationship, or who has an immediate family member who has a financial relationship, with entities (including hospitals) providing “designated health services”, from referring Medicare patients to such entities for the furnishing of such services, with limited exceptions. Stark Law designated health services include equipment and supplies, home health services, outpatient prescription drugs, inpatient and outpatient hospital services and clinical

laboratory services. The Stark Law also prohibits the entity receiving a prohibited referral from filing a claim or billing for the services arising out of the prohibited referral. The prohibition applies regardless of the reasons for the financial relationship and the referral; and therefore, unlike the federal anti-kickback statute, intent to violate the law is not required. Sanctions for violation of the Stark Law include denial of payment for the services provided in violation of the prohibition, refunds of amounts collected in violation, a civil penalty of up to $15,000 for each service arising out of the prohibited referral, exclusion from the federal healthcare programs, including Medicare and Medicaid and a civil penalty of up to $100,000 against parties that enter into a scheme to circumvent the Stark Law prohibition. Knowing violations of the Stark Law may also serve as the basis for liability under the False Claims Act. The types of financial arrangements between a physician and an entity that trigger the self-referral prohibitions of the Stark Law are broad and include ownership and investment interests and compensation arrangements.

 

CMS has adopted regulations under the Stark Law applicable to clinical laboratory services (“Stark I”) and implementing the Stark Law’s application to all designated health services (sometimes referred to as “Stark II” or the “Stark II Regulations”). The Stark II Regulations include additional guidance regarding CMS’s interpretation of the Stark Law. CMS anticipates issuing additional regulations regarding Medicaid enforcement.

 

Under Stark II, “financial relationship” is defined as an ownership or investment interest in, or a compensation arrangement with, an entity providing designated health services and includes certain indirect financial relationships. We have entered into several types of financial relationships with referring physicians, including compensation arrangements. We believe that the compensation arrangements under our medical director agreements materially satisfy the personal services compensation arrangement exception to the Stark II prohibition. The Stark II regulations provide a safe harbor method of establishing the fair market value of physician compensation. CMS recognizes that compensation to medical directors which exceeds amounts determined by the Stark II safe harbor method does not necessarily exceed fair market value, but that such compensation is not assured of a favorable finding upon review. None of our medical director agreements establishes compensation using the Stark II safe harbor method. While we believe that compensation under our medical director agreements, which is the result of arm’s length negotiations, results in fair market value payments for medical director services, even though these amounts exceed amounts determined using the Stark II safe harbor method, an enforcement agency could potentially challenge the level of compensation that we pay our medical directors. Accordingly, we could in the future be required to change our practices, face criminal or civil penalties, pay substantial fines, return certain payments received from governmental payors and beneficiaries or otherwise experience a material adverse effect as a result of a challenge to these arrangements. For example, DVA Renal Healthcare’s relationships with itsthe medical directors of the centers we acquired from Gambro Healthcare, were reviewed in connection with the investigation of Gambro Healthcare by the United States Attorney’s office for the Eastern District of Missouri that was resolved in December 2004 and may be subject to ongoing review by the Office of Inspector General, or OIG, under a corporate integrity agreement (see description on page 16).

 

Some of our dialysis centers are leased from entities in which referring physicians hold interests and we sublease space to referring physicians at some of our dialysis centers. The Stark law provides an exception for lease arrangements if specific requirements are met. We believe that our leases and subleases with referring physicians materially satisfy the requirements for this exception.

 

Some medical directors and other referring physicians may own our common stock, which they either purchased instock. We believe that these interests materially satisfy the open market or received from us as consideration in an acquisitionrequirements of dialysis centers from them. There is a Stark II exceptionthe safe harbor for investments in large publicly traded companies which we believe covers these investment interests.for the anti-kickback statute.

 

While nearly all of our stock option arrangements with referring physicians were terminated in 2000, a few medical directors still hold options to acquire our common stock because we did not have the contractual right to terminate their options. Under the Stark II regulations, these stock options constitute financial relationships that12

must meet an applicable exception if the physician makes referrals to DaVita for designated health services. It is possible that CMS could view these interests as prohibited arrangements that must be restructured or for which we could be subject to other significant penalties or prohibited from accepting referrals from those medical directors.


Some of our medical directors also own equity interests in entities that operate our dialysis centers. The Stark II exception applicable to physician ownership interests in entities to which they make referrals does not encompass the kinds of ownership arrangements that referring physicians hold in several of our subsidiaries that operate dialysis centers. Accordingly, it is possible that CMS could require us to restructure some of these arrangements or could seek to impose substantial fines or additional penalties on us, prohibit us from accepting referrals from those physician owners and/or force us to return certain amounts paid by CMS and program beneficiaries. We believe that the language and legislative history of Stark II and the Stark II regulations indicate that Congress did not intend to include dialysis services and the services and items provided incident to dialysis services as a part of designated health services. The final Stark II regulations exempt from the referral prohibition referrals for clinical laboratory services that are included in the ESRD composite rate. The final Stark II regulations also exempt EPO and certain other dialysis-related outpatient prescription drugs furnished in (or by, in the case of EPO) an ESRD facility. The Final Phase II regulations also confirmed that home dialysis supplies are not considered designated health services. Accordingly, referrals for composite rate laboratory tests, and these dialysis related medications and home dialysis supplies do not violate the Stark II prohibition.

 

While the Stark II “designated health services” include inpatient and outpatient hospital services, our arrangements with hospitals for the provision of dialysis services to hospital inpatients and outpatients do not involve prohibited referrals to DaVita and do not create material indirect financial relationships between the hospitals and the physicians providing services for DaVita. This is because under the final Stark II regulations in situations involving such services furnished “under arrangements” it is the hospital, rather than DaVita, that is considered to be receiving referrals for furnishing and billing for the designated health services.

 

Because the Stark II regulations do not expressly address all of our operations, it is possible that CMS could interpret Stark II to apply to parts of our operations. Consequently, it is possible that CMS could determine that Stark II requires us to restructure existing compensation agreements with our medical directors and to repurchase or to request the sale of ownership interests in subsidiaries and partnerships held by referring physicians or, alternatively, to refuse to accept referrals for designated health services from these physicians. If CMS were to interpret Stark II to apply to aspects of our operations and we could not achieve compliance with Stark II, it would have a material adverse effect on our operations. We could be subject to monetary penalties and serious administrative sanctions for non-compliance and be forced not to accept referrals from important referral sources. While the rules and interpretations surrounding the Stark II and various state self-referral prohibitions are complicated and while refunds for billing errors may be necessary from time to time, we do not believe that the Company haswe have presented or caused to be presented any claims for a designated health service furnished pursuant to prohibited referrals for which there was no applicable exception that would have a material adverse effect on us.

 

Fraud and abuse under state law

 

Many states in which we operate dialysis centers, have statutes prohibiting physicians from holding financial interests in various types of medical facilities to which they refer patients. Some of these statutes could be interpreted as prohibiting physicians who hold shares of our publicly traded stock from referring patients to our dialysis centers if the centers use our laboratory subsidiary to perform laboratory services for their patients. Some states also have laws similar to the federal anti-kickback statute that may affect our ability to receive referrals from physicians with whom we have financial relationships, such as our medical directors. Some of these statutes include exemptions applicable to our medical directors and other physician relationships or for financial interests limited to shares of publicly traded stock. Some, however, include no explicit exemption for

medical director services or other services for which we contract with and compensate referring physicians or for joint ownership interests of the type held by some of our referring physicians or for financial interests limited to shares of publicly traded stock. If these statutes are interpreted to apply to referring physicians with whom we contract for medical director and similar services, or to referring physicians with whom we hold joint ownership interests or to physicians who hold interests in DaVita limited solely to publicly traded stock, we may be required to terminate or restructure some or all of our relationships with or refuse referrals from these referring physicians and could be subject to civil and administrative sanctions, refund requirements and exclusions from government

13


healthcare programs, including Medicare and Medicaid. Such events could negatively affect the decision of referring physicians to refer patients to our centers.

 

The False Claims Act

 

The federal False Claims Act, or FCA, is a means of policing false bills or false requests for payment in the healthcare delivery system. In part, the FCA authorizes the imposition of civil penalties on any person who:

 

Knowingly presents or causes to be presented to the federal government, a false or fraudulent claim for payment or approval;

Knowingly makes, uses or causes to be made or used, a false record or statement to get a false or fraudulent claim paid or approved by the federal government;

Conspires to defraud the federal government by getting a false or fraudulent claim allowed or paid; or

Knowingly makes, uses or causes to be made or used, a false record or statement to conceal, avoid or decrease an obligation to pay or transmit money or property to the federal government.

 

The penalties for a violation of the FCA range from $5,500 to $11,000 for each false claim plus three times the amount of damages caused by each such claim. The federal government has used the FCA to prosecute a wide variety of alleged false claims and fraud allegedly perpetrated against Medicare and state healthcare programs, including coding errors, billing for services not rendered, the submission of false cost reports, billing for services at a higher payment rate than appropriate, billing under a comprehensive code as well as under one or more component codes included in the comprehensive code and billing for care that is not considered medically necessary. Although still subject to dispute, at least two federal district courts have also determined that an alleged violation of the federal anti-kickback statute or the Stark I self-referral prohibition areis sufficient to state a claim for relief under the FCA. In addition to the provisions of the FCA, which provide for civil enforcement, the federal government can use several criminal statutes to prosecute persons who are alleged to have submitted false or fraudulent claims for payment to the federal government.

 

The Health Insurance Portability and Accountability Act of 1996

 

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, among other things, allows individuals who lose or change jobs to transfer their insurance, limits exclusions for preexisting conditions and establishes a pilot program for medical savings accounts. In addition, HIPAA also expanded federal attempts to combat healthcare fraud and abuse by making amendments toamending the Social Security Act and the federal criminal code. Among other things, HIPAA created a “Health Care Fraud Abuse Control Account,” under which advisory opinions are issued by the OIG regarding the application of the anti-kickback statute; criminal penalties for Medicare and Medicaid fraud were extended to other federal healthcare programs; the exclusion authority of the OIG was expanded; Medicare and Medicaid civil monetary penalty provisions were extended to other federal healthcare programs; the amounts of civil monetary penalties were increased; and a criminal healthcare fraud statute was established.

 

HIPAA also includes provisions relating to the privacy of medical information. These provisions require us to maintain extensive policies and procedures, and to implement administrative safeguards with respect to private health information in our possession. HIPAA also includes provisions relating to standards for security of electronic protected health information, electronic transactions and electronic signatures. We believe we are in substantial compliance with these requirements.

Other regulations

 

Our operations are subject to various state hazardous waste and non-hazardous medical waste disposal laws. These laws do not classify as hazardous most of the waste produced from dialysis services. Occupational Safety and Health Administration regulations require employers to provide workers who are occupationally subject to

14


blood or other potentially infectious materials with prescribed protections. These regulatory requirements apply to all healthcare facilities, including dialysis centers, and require employers to make a determination as to which employees may be exposed to blood or other potentially infectious materials and to have in effect a written exposure control plan. In addition, employers are required to provide or employ hepatitis B vaccinations, personal protective equipment and other safety devices, infection control training, post-exposure evaluation and follow-up, waste disposal techniques and procedures and work practice controls. Employers are also required to comply with various record-keeping requirements. We believe that we are in material compliance with these laws and regulations.

 

A New York statute prohibits publicly-held companies from owning the health facility license required to operate a dialysis center in New York. Although weWe currently own substantially all of the assets, including the fixed assets, of our affiliated New York dialysis centers, but, because of the requirements of New York law, the operating licenses for these centers are currently held by privately-owned companies with which we have agreements to provide a broad range of administrative services, including billing and collecting. TheIn 2007, changes to the New York Statelaw were adopted that will permit us to hold these licenses directly and the New York Department of Health has approvedis currently in the process of adopting implementing regulations. We intend to transfer these typesoperating licenses to us as soon as approval of arrangements; however, we cannot guarantee that they will notsuch transfers can be challenged as prohibited underobtained from the relevant statute. We are currently working closely with other industry representatives to effectuate a change in New York law that would allow for direct ownershipDepartment of dialysis centers by publicly held companies.Health.

 

We have a similar management relationship with physician practices in several states which prohibit the corporate practice of medicine, and with a privately-owned company in New Jersey for several New Jersey dialysis centers. We have had difficulty securing licenses for new centers in New Jersey in our own name because the New Jersey Department of AgingHealth and Senior Services refuses to grant new licenses to companies that have more than a small number of outstanding adverse survey issues throughout all of their centers in the entire United States, regardless of the respective size of the companies’ operations.

 

A few states have certificate of need programs regulating the establishment or expansion of healthcare facilities, including dialysis centers. We believe that we are in material compliance with all applicable state certificate of need laws.

 

Although we have implemented a company-wide corporate compliance program, as discussed below, and believe we are in material compliance with current applicable laws and regulations, our industry will continue to be subject to substantial regulation, the scope and effect of which are difficult to predict. Our activities could be reviewed or challenged by regulatory authorities at any time in the future.

 

Corporate compliance program

 

We have implemented a company-wide corporate compliance program as part of our commitment to comply with all applicable laws, regulations and DVA Renal Healthcare’sthe corporate integrity agreement (discussed below)applicable to the dialysis centers acquired from Gambro Healthcare and assumed in connection with such acquisition, which is discussed below, and to maintain the high standards of conduct we expect from all of our teammates. We continuously review this program and enhance it as necessary. The primary purposes of the program include:

 

Increasing, through training and education, the awareness of our teammates and affiliated professionals of the necessity of complying with all applicable laws and regulations in an increasingly complicated regulatory environment;

Auditing and monitoring the activities of our dialysis centers, laboratories and billing offices on a regular basis to identify potential instances of noncompliance in a timely manner; and

Ensuring that we take steps to resolve instances of noncompliance or to address areas of potential noncompliance as promptly as we become aware of them.

When evaluating the effectiveness of our corporate compliance program, we take into consideration a number of factors, including favorable results under various government inquiries and adherence to the requirements of our CIA measured in part by the favorable outcome of audits by the independent review organization.

15


We have a code of conduct that each of our teammates and affiliated professionals must follow and we have a confidential toll-free hotline (888-458-5848) for teammates to report potential instances of noncompliance. Our Chief Compliance Officer administers the compliance program. The Chief Compliance Officer reports directly to our Chief Executive Officer, our President-West and to the Compliance Committee of our Board of Directors.

 

Corporate Integrity Agreement

 

On December 1, 2004, DVA RenalGambro Healthcare, Inc, which we acquired in October 2005, entered into a settlement agreement with the Department of Justice and other agencies of the United States government relating to the Department of Justice’s investigation of DVA RenalGambro Healthcare’s Medicare and Medicaid billing practices and its relationships with physicians and pharmaceutical manufacturers. In connection with the settlement agreement, DVA RenalGambro Healthcare, without admitting liability, made a one timeone-time payment of approximately $310 million and entered into a five year corporate integrity agreement with OIG. DVA RenalThe centers we acquired from Gambro Healthcare and its subsidiaries continue to be subject to the corporate integrity agreement. The corporate integrity agreement requires, among other things, that DVA Renal Healthcare designate a compliance liaison be designated for each dialysis center owned or operated by the entity acquired from Gambro Healthcare, now known as DVA Renal Healthcare, or any of its subsidiaries and provide compliance training for each of its employees and credentialed physicians. DVA Renal Healthcare has a compliance officer and a separate compliance committee made up of members of senior management, consistent with the requirements of the corporate integrity agreement. Certain types of employees are also required to complete additional specialized training in areas such as billing and reimbursement issues. Furthermore, DVA Renal Healthcare is required to review all of its arrangements or transactions with any actual or potential source of healthcare business to ensure compliance with federal anti-kickback statute. It has also engaged an independent review organization to conduct an annual review of a sample of DVA Renal Healthcare’s claims for reimbursement from federal healthcare programs to verify compliance with applicable laws and regulations. DVA Renal Healthcare must submit to the OIG an annual report with respect to the status of, and findings regarding, its compliance activities, including a copy of all reports prepared by the independent review organization. In addition, DVA Renal Healthcare must notify the OIG of any ongoing government investigations or legal proceedings and report to the OIG any substantial overpayment or any probable violations of the laws applicable to any federal healthcare program.

 

Insurance

 

We maintain insurance for property and general liability, professional liability, directors’ and officers’ liability, workers compensation and other coverage in amounts and on terms deemed adequate by management based on our claims experience and expectations for future claims. Future claims could, however, exceed our applicable insurance coverage. Physicians practicing at our dialysis centers are required to maintain their own malpractice insurance and our medical directors are required to maintain coverage for their individual private medical practices. Our liability policies cover our medical directors for the performance of their duties as medical directors.

 

Capacity and location of our centers

 

We are able to increase our capacity by extending hours at our existing centers, expanding our existing centers, relocating our centers, developing new centers and by acquiring centers. The development of a typical outpatient center by us generally requires approximately $1.6 million for leasehold improvements, equipment and first-year working capital. Based on our experience, a new center typically opens within a year after the property lease is signed, normally achieves operating profitability in the second year of operation and normally reaches maturity within three to five years. Acquiring an existing center requires a substantially greater initial investment, but profitability and cash flow are initially more predictable. To a limited extent, we enter into agreements to provide administrative services to third-party-owned or noncontrolling-owned dialysis centers in return for management fees, which are typically based on a percentage of revenues.revenues or cash collections of the managed operations, or upon a percentage of operating income.

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The table below shows the growth of our Company by number of dialysis centers.

 

   2006

      2005    

      2004    

      2003    

      2002    

 

Number of centers at beginning of year

  1,233  658  566  515  495 

Acquired centers

  26  609(1) 51  27  11 

Developed centers

  55  46  44  30  19 

Net change in third-party centers with management services agreements

  —    4(1) 5  (1) (2)

Divested, closed or sold

  (14)(2) (84)(1) (8) (5) (8)
   

 

 

 

 

Number of centers at end of year

  1,300  1,233  658  566  515 
   

 

 

 

 


   2007  2006  2005  2004  2003 

Number of centers at beginning of year

  1,300  1,233  658  566  515 

Acquired centers

  16  26  609(1) 51  27 

Developed centers

  64  55  46  44  30 

Net change in centers with management services agreements *

  (15)(3) —    4(1) 5  (1)

Divested, closed or sold

  (6) (14)(2) (84)(1) (8) (5)
                

Number of centers at end of year

  1,359  1,300  1,233  658  566 
                

(1)566 centers were added, including 11 centers under management services agreements, as a result of the DVA Renal Healthcare acquisition and 74 centers were divested in connection with this acquisition, including three centers under management services agreements.
(2)Three centers were divested in connection with the acquisition of DVA Renal Healthcare.

(3)

In November 2007, one of our management and administration service agreements was terminated, in which we provided management and administrative services to 20 dialysis centers.

*Represents dialysis centers in which we either own a noncontrolling interest, or are wholly-owned by third parties.

 

As of December 31, 2006,2007, we operated or provided administrative services to 1,3001,359 outpatient dialysis centers, of which 1,2621,336 are consolidated in our financial statements. Of the remaining 3823 centers, we own minoritynoncontrolling interests in fourten centers, which are accounted for as equity investments and provide administrative services to 3413 centers in which we have no ownership interest. The locations of the 1,2621,336 centers included in our consolidated financial statements at December 31, 20062007 were as follows:

 

State


  Centers

  

State


  Centers

  

State


  Centers

  Centers  

State

  Centers  

State

  Centers

California

  153  Louisiana  29  Washington  11  169  

Missouri

  30  Oregon  12

Florida

  116  

Tennessee

  30  Iowa  11

Texas

  111  Missouri  29  Iowa  11  112  

Louisiana

  28  Wisconsin  11

Florida

  107  Tennessee  28  Wisconsin  11

Georgia

  85  South Carolina  25  Oregon  9  88  

Colorado

  25  District of Columbia  8

Pennsylvania

  56  Colorado  25  District of Columbia  8  58  

South Carolina

  25  Idaho  6

North Carolina

  52  New Jersey  21  Idaho  6  54  

New Jersey

  22  Arkansas  3

Virginia

  50  Arizona  20  Mississippi  3  54  

Indiana

  21  Mississippi  3

Michigan

  50  

Arizona

  20  South Dakota  3

Maryland

  47  Indiana  20  South Dakota  3  48  

Kentucky

  20  West Virginia  3

Michigan

  45  Connecticut  17  West Virginia  3

Illinois

  42  Kansas  16  Delaware  2  43  

Connecticut

  18  Delaware  2

Ohio

  35  Kentucky  16  New Mexico  2  40  

Kansas

  16  New Mexico  2

Minnesota

  32  Nebraska  13  Utah  2  35  

Nevada

  14  Utah  2

New York

  31  Massachusetts  12  Arkansas  1  32  

Nebraska

  13  New Hampshire  1

Alabama

  30  Nevada  12  New Hampshire  1  31  

Washington

  13  North Dakota  1

Oklahoma

  30              31  

Massachusetts

  12    

 

Competition

 

The dialysis industry is highly competitive, particularly in terms of acquiring existing dialysis centers. We are facing increased competition in the dialysis industry from large and medium-sized providers which compete directly with us for acquisition targets as well as for individual patients. Acquisitions and patient retention are an important part of our growth strategy and our business could be adversely affected if we are not able to continue to make acquisitions on reasonable terms or if we face significant patient attrition to our competitors. Competition for qualified physicians to act as medical directors and for inpatient dialysis services agreements with hospitals is intense. WeOccasionally we have also experienced competition from former medical directors or

17


referring physicians who have opened their own dialysis centers. In addition, we experience competitive pressures in connection with negotiating contracts with commercial healthcare payors.

 

The two largest dialysis companies, Fresenius Medical Care (Fresenius) and our company, account for more thanapproximately 65% of outpatient dialysis patients in the United States. Approximately half45% of the centers not owned by us or Fresenius are owned or controlled by hospitals or non-profit organizations. Hospital-based and non-profit dialysis units typically are more difficult to acquire than physician-owned centers. Because of the ease of entry into the dialysis business and the ability of physicians to be medical directors for their own center or centers, competition for growth in existing and expanding markets is not limited to large competitors with substantial financial resources.

Fresenius also manufactures a full line of dialysis supplies and equipment in addition to owning and operating dialysis centers. This may give them cost advantages over us because of their ability to manufacture their own products. Fresenius historically has been one of our largest suppliersuppliers of dialysis products. However, in connection with our acquisition of DVA Renal Healthcare, we entered into an alliance and product supply agreement thatwith Gambro Renal Products, or GRP, which was subsequently amended on August 25, 2006, which obligatesin 2006. The amended product supply agreement still requires us to purchase a significant amountmajority of our hemodialysis non-equipment product supply and equipment requirements from Gambro Renal Productssupplies, such as dialyzers, at fixed prices for ten years, subject to certain terms and conditions.through 2015. Our purchases of products in the categories generally offered by Fresenius and Gambro Renal Products represent approximately 8%4% of our total operating expense.expenses. During 2006,2007, we purchased hemodialysis products supplies and equipmentsupplies from Gambro Renal Products representing approximately 4%2% of our total operating expenses.

 

A portion of our business also consists of monitoring and providing supplies for ESRD treatments in patients’ homes. Other companies provide similar services. NxStage, Renal Solutions and Fresenius have developed home-based hemodialysis systems designed to enable patients to perform hemodialysis on a daily basis in their homes. On February 7, 2007 we entered into a National Provider Agreement with NxStage, Inc. The agreement provides us the ability to purchase NxStage home-based hemodialysis products at a potential discount depending upon the achievement of certain volume targets. The agreement has an initial term of three years, terminating on December 31, 2009, and may be extended in six monthsix-month increments for up to two additional years if certain volume targets are met. As part of the agreement, we purchased all of our NxStage System One equipment currentlythen in use for approximately $5.1 million and will purchase a majority of our future home-based hemodialysis equipment and supplies from NxStage. To date, there has not been significant adoption of these home-based hemodialysis systems by our patients or physicians. We cannot predict whether home-based hemodialysis will be widely adopted by patients or physicians or what impact these services will have on our business over the longer term.

 

Teammates

 

As of December 31, 2006,2007, we had approximately 28,90031,000 teammates:

 

•     Licensed professional staff (nurses, dieticians and social workers)

  11,90012,800

•     Other patient care and center support staff and laboratory personnel

  13,40014,500

•     Corporate, billing and regional administrative staff

  3,6003,700

 

Our dialysis business requires nurses with specialized training for patients with complex care needs. Recruitment and retention of nurses are continuing concerns for health carehealthcare providers generally because of the disparity between the supply and demand for nurses, which has led to a nursing shortage. We have an active program of investing in our professional healthcare teammates to help ensure we meet our recruitment and retention targets, including expanded training opportunities, tuition reimbursements and other incentives.

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Item 1A.    Risk Factors.

 

This Annual Report on Form 10-K contains statements that are forward-looking statements within the meaning of the federal securities laws. These statements involve known and unknown risks and uncertainties including the risks discussed below. The risks discussed below are not the only ones facing our business. Please read the cautionary notice regarding forward-looking statements in Item 7 under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation”.

 

If the average rates that commercial payors pay us decline significantly, it would have a material adverse effect on our revenues, earnings and cash flows.

 

Approximately 35%36% of our dialysis revenue for the year ended December 31, 20062007 was generated from patients who have commercial payors as the primary payor. The majority of these patients have insurance policies that pay us on terms and at rates materiallythat are generally significantly higher than Medicare rates. The payments we receive from commercial payors generate nearly all of our profit. We expect thatare experiencing a decrease in some of our commercial reimbursementpayment rates willand it is possible that commercial payment rates could be materially lower in the future asfuture. The downward pressure on commercial payment rates is a result of general conditions in the market, recent and future consolidations among commercial payors, downward trends in health insurance premiums, increased focus on dialysis services our acquisition of DVA Renal Healthcare, including the reconciliation of existing contracts with differing rates, and other factors.

We are continuously in the process of negotiating agreements with our commercial payors.payors and certain payors have become increasingly aggressive in their negotiations with us. In the fourth quarter of 2007, our overall commercial rate reductions were in excess of our overall commercial rate increases. In the event that our negotiations continue to result in overall commercial rate reductions in excess of overall commercial rate increases, the cumulative effect could have a material adverse effect on our financial results. Consolidations have significantly increased the negotiating leverage of commercial payors. We expect that some of our contracted rates with commercial payors will decrease as our negotiations with commercial payors continue. In addition we believe thatto increasing downward pressure on contracted commercial payor rates, payors have been attempting to impose restrictions and employers continue to encourage members to obtainlimitations on non-contracted or out-of-network providers. We, along with others in the kidney care community, are resisting such activity through regulatory, legislative and legal means. Decreases in out-of-network rates and restrictions on out-of-network access combined with in-network providers and networkdecreases in contracted rates are typically lower than out-of-network rates.could result in a significant decrease in our overall revenue derived from commercial payors. If the average rates that commercial payors pay us decline significantly, it would have a material adverse effect on our revenues, earnings and cash flows.

 

If the number of patients with higher-paying commercial insurance declines, then our revenues, earnings and cash flows would be substantially reduced.

 

Our revenue levels are sensitive to the percentage of our patients with higher-paying commercial insurance coverage. A patient’s insurance coverage may change for a number of reasons, including as a result of changes in the patient’s or a family member’s employment status. ForCurrently, for a patient covered by an employer group health plan, Medicare generally becomes the primary payor after 33 months, or earlier, if the patient’s employer group health plan coverage terminates. When Medicare becomes the primary payor, the payment rate we receive for that patient shifts from the employer group health plan rate to the lower Medicare payment rate. If there is a significant reduction in the number of patients under higher-paying commercial plans relative to government-based programs that pay at lower rates, it would have a material adverse effect on our revenues, earnings and cash flows.

 

Future declines, or the lack of further increases, in Medicare payment rates would reduce our revenues, earnings and cash flows.

Approximately one-half of our dialysis revenue for the year ended December 31, 2006 was generated from patients who have Medicare as their primary payor. The Medicare End Stage Renal Disease (ESRD) program pays us for dialysis treatment services at fixed rates. Unlike most other services covered by Medicare, the Medicare ESRD program has not provided for regular inflation increases in payment rates. Increases in operating costs that are subject to inflation, such as labor and supply costs, have occurred and are expected to continue to occur regardless of whether there is a compensating increase in payment rates. We cannot predict with certainty the nature or extent of future rate changes, if any. To the extent these rates decline or are not adjusted to keep pace with inflation, our revenues, earnings and cash flows would be adversely affected.

Changes in the structure of, and payment rates under the Medicare ESRD program could substantially reduce our revenues, earnings and cash flows.

 

Approximately one-half of our dialysis revenue for the year ended December 31, 2007 was generated from patients who have Medicare as their primary payor. Currently, the Medicare End Stage Renal Disease, or ESRD, program pays us for dialysis treatment services at fixed rates. The Medicare composite rate is the payment rate

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for a dialysis treatment including the supplies used in those treatments, specified laboratory tests and certain pharmaceuticals. Other services and pharmaceuticals, including EPO (a pharmaceutical used to treat anemia, a common complication associated with ESRD), vitamin D analogs and iron supplements, are separately billed. ChangesUnlike most other services covered by Medicare, the Medicare ESRD program has not provided for regular inflation increases in payment rates. We experience increases in operating costs that are subject to inflation, such as labor and supply costs, regardless of whether there is a compensating inflation-based increase in Medicare payment rates. To the extent Medicare rates decline or are not adjusted to keep pace with inflation, our revenues, earnings and cash flows would be adversely affected.

In addition, changes to the structure of the composite rate and separately billable payment rates went into effect January 1, 2006, as Medicare moved to payment rates for pharmaceuticalsmay occur which would reduce our overall payments from average acquisition cost to average sale price plus 6%. Future changes in the structure of, and payment rates under, the Medicare ESRD program could substantially reduce our revenues, earningsprogram. CMS and cash flows.

Pharmaceuticals are approximately 30% of our total Medicare revenue for the year ended December 31, 2006. ESRD pharmaceutical payment rates and utilizationCongress continue to receive attention fromexamine and propose changes to the government,payment structure for dialysis services including the addition of services into the composite rate that are currently separately billed, also referred to as bundling. CMS recently released a report to Congress titled “A Design for a Bundled End Stage Renal Disease Prospective Payment System” which may lead to reimbursement changesproposes a framework for bundling which could result in the future.lower payment rates. If Medicare begins to bundle other services for payment by including in its composite payment rate the pharmaceuticals, laboratory services or other ancillary services that it currently pays separately at rates that would result in lower overall reimbursement, or if there are further changes to or decreases in the payment rate for these separately billed items without a corresponding increase in the composite rate, it could have a material adverse effect on our revenues, earnings and cash flows.

 

Changes in state Medicaid programs or payment rates could reduce our revenues, earnings and cash flows.

 

Approximately 5%4% of our dialysis revenue for the year ended December 31, 20062007 was generated from patients who have Medicaid as their primary coverage. As state governments face increasing budgetary pressure, they may propose reductions in payment rates, limitations on eligibility or other changes to Medicaid programs. Currently, Medicaid eligibility requirements mandate that citizen enrollees in Medicaid programs provide documented proof of citizenship. Our revenues, earnings and cash flows could be negatively impacted to the extent that we are not paid by Medicaid or other state programs for services provided to patients that are unable to satisfy the revised eligibility requirements, including undocumented patients living in the U.S. If state governments reduce the rates paid by thoseMedicaid programs for dialysis and related services, further limit eligibility for Medicaid coverage or adopt changes similar to those adopted by Medicare,the Medicaid payment structure which reduces our overall payments from Medicaid, then our revenues, earnings and cash flows could be adversely affected.

Delays in state Medicare and Medicaid certification of our dialysis centers could adversely affect our revenues, earnings and cash flows.

Before we can begin billing for patients that may be enrolled in government-based programs and are treated in our outpatient dialysis centers, we are required to obtain state and federal certification for participation in the Medicare and Medicaid programs. As state governments face increasing budgetary pressure, certain states may have difficulty certifying dialysis centers in the normal course and significant delays may result. If state governments are unable to certify new centers in the normal course and we experience significant delays in our ability to treat and bill for services provided to patients covered under government programs, our revenues, earnings and cash flows could be adversely affected.

 

Changes in clinical practices and payment rates or rules for EPO and other pharmaceuticals could substantially reduce our revenues, earnings and cash flows.

 

The administration of EPO and other pharmaceuticals accountsaccounted for approximatelyslightly more than 30% of our total dialysis revenue for the year ended December 31, 2006. In2007, with EPO accounting for slightly more than 20% of our dialysis revenue. Since late 2006, there washas been significant media discussion and government scrutiny regarding anemia management practices in the United States additionally a hearing was held bywhich has created confusion and concern in the nephrology community. In late 2006, the House Ways and Means Committee held a hearing on the issue of EPO utilization and in December 2006. Further,2007, the FDA has been examiningrequired changes to the labeling of EpogenEPO and Aranesp® to include a black box warning, the FDA’s strongest form of warning label. The FDA has held additional hearings to revisit these label changes as they apply to ESRD and continues to examine the issue. CMS also reviewed its EPO reimbursement policies and in responseJanuary 2008, changes to the increased scrutiny. This increased scrutinyEPO monitoring policy went into effect which further limit reimbursement and which have impacted the prescribing habits of our physicians. Commercial payors have also increasingly examined their administration policies for EPO and, in some cases have modified those policies. Beginning in the second quarter of 2007, EPO utilization by prescribing physicians declined and could have an

impact on physician practice patterns and accepted clinical practices. Changescontinue to decline further. Further changes in physician practice patterns and accepted clinical practices, changes in labeling of other pharmaceuticals in a manner that alters physician practice patterns or accepted clinical practices, changes in

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private and governmental payment criteria, including the introduction of EPO administration policies, by private payors, the introduction of new pharmaceuticals or the conversion to alternate types of administration of EPO or other pharmaceuticals that result in further decreases in utilization or reimbursement for EPO could have a material adverse effect on our revenues, earnings and cash flows. Such changes could also have a negative impact on our patient clinical outcomes.

 

Changes in EPO pricing and the use and marketing of alternatives to EPO could materially reduce our revenues, earnings and cash flows and affect our ability to care for our patients.

 

Amgen Inc. is the sole supplier of EPO and may unilaterally decide to increase its price for EPO, subject to certain contractual limitations. Future changes in the cost of EPO could have a material adverse effect on our earnings and cash flows and ultimately reducesreduce our income. Although our agreement with Amgen for EPO continues for a fixed time period and includes potential pricing discounts dependingwhich depend upon the achievement of certain clinical and other criteria, we cannot predict whether we will continue to receive the 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, our contractOur agreement with Amgen also provides for specific rebates and incentives that areoff of list price based on patient outcomes, process improvement and data submission purchase volume growth and some combination of these factors. Factors that could impact our ability to qualify for the discounts rebates and incentivesrebates provided for in our agreement with Amgen includein the future include: our ability to achievedevelop and implement certain clinical outcomes, changes in pharmaceutical intensitiesprocess improvements and our growth. We have and may from time to time accelerate our EPO purchase volume in a given period to take advantage oftrack certain incentives provided for in the agreement, which could result in an increase in our inventory levels.data elements. Failure to qualify for discounts or meet or exceed thecertain targets and earn the specified rebates and incentives could have a material adverse effect on our earnings and cash flows.

 

Amgen has developed and obtained FDA approval for Aranesp®, a pharmaceutical used to treat anemia that may replace EPO or reduce its use with dialysis patients. In addition, Roche has developed and is seekingobtained FDA approval for CERA,Mircera®, a pharmaceutical also used to treat anemia. Unlike EPO, which is generally administered in conjunction with each dialysis treatment, these pharmaceuticals are administered less frequently. In the event that these similar alternatives to EPO are marketed for the treatment of dialysis patients, we may realize lower margins on the administration of such pharmaceuticals than are currently realized with EPO. In addition, to the extent that changes in administration practices occur as a result of changes in labeling of these pharmaceuticals in a manner that alters physician practice patterns or accepted clinical practices or such pharmaceuticals begin to be administered to patients through channels other than DaVita, we would realize a significant reduction in revenue or profit from such administration. A significant increase in the development and use of similar alternatives to EPO, or a change in administration practices, could have a material adverse effectimpact on our revenues, earnings and cash flows.

 

Continued inquiries from various governmental bodies with respect to our utilization of EPO will require management’s attention, cause us to incur significant legal expense and could result in substantial financial penalties against us, exclusion from future participation in the Medicare and Medicaid programs and could substantially reduce our revenues, earnings and cash flows.

In response to recent clinical studies identifying risks in certain patient populations related to the utilization of EPO and other erythropoiesis-stimulating agents, i.e., Aranesp®, and in response to changes in the labeling of EPO and Aranesp®, there has been substantial media attention and government scrutiny resulting in hearings and proposed legislation regarding utilization and reimbursement. Although we believe our anemia management practices have been compliant with existing laws and regulations, as a result of the current high level of scrutiny and controversy, we may be subject to increased inquiries from a variety of governmental bodies and claims by third parties. For example, the subpoena from the U.S. Attorney’s office in the Eastern District of Missouri includes requests for documents regarding the administration of, and billing for, EPO. In August 2007, we received a subpoena from the Office of Inspector General in Houston, Texas for records relating to EPO claims submitted to Medicare. In addition, in August 2007 a complaint was filed against us, Amgen and Fresenius Medical Care Holdings by Sheet Metal Workers Health Fund and Glenn Randle alleging claims related to the administration and use of EPO and in February 2008 the Attorney General’s Office for the State of Nevada notified us that they intend to conduct audits of ESRD providers in Nevada relating to the billing of pharmaceuticals, including EPO. Additional inquiries from various agencies and claims by third parties with respect to this issue would continue to require management’s attention and significant legal expense and any negative findings could result in substantial financial penalties against us, exclusion from future participation in the Medicare and Medicaid programs and could substantially reduce our revenues, earnings and cash flows.

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The investigation related to the subpoena we received on March 4, 2005 from the U.S. Attorney’s Office for the Eastern District of Missouri could result in substantial penalties against us.

 

We are voluntarily cooperating with the U.S. Attorney’s Office for the Eastern District of Missouri with respect to the subpoena we received on March 4, 2005, which requested a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies and financial relationships with physicians and joint ventures and theventures. We received a related request for additional documents related toregarding specific medical director and joint venture arrangements we received in October 2005, and the additionala related subpoena we received in February 2006 requesting documents related to certain patient records relating toregarding the administration and billing of EPO.EPO and a request for additional documents related to durable medical equipment and supply companies owned and operated by us in May 2007. It is possible that criminal proceedings may be initiated against us in connection with this inquiry.these inquiries. Any negative findings could result in substantial financial penalties against us, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To our knowledge, no proceedings have been initiated against us at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may

be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

 

The investigation related to the subpoena we received on October 25, 2004 from the U.S. Attorney’s Office for the Eastern District of New York could result in substantial penalties against us.

 

We are voluntarily cooperating with the U.S. Attorney’s Office for the Eastern District of New York and the OIG with respect to the subpoena we received on October 25, 2004, which requires production of a wide range of documents relating to our operations, including DaVita Laboratory Services. The subpoena also includes specific requests for documents relating to testing for PTH and to products relating to vitamin D therapies. DVA Renal Healthcare (formerly Gambro Healthcare) received a similar subpoena in November 2004. It is possible that criminal proceedings may be initiated against us and DVA Renal Healthcare in connection with this inquiry. Any negative findings could result in substantial financial penalties against us, and DVA Renal Healthcare, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To our knowledge, no proceedings have been initiated against us or DVA Renal Healthcare at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas may require management’s attention and significant legal expense.

 

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, earnings and cash flows.

 

Our dialysis operations are subject to extensive federal, state and local government regulations, including Medicare and Medicaid payment rules and regulations, federal and state anti-kickback laws, the Stark II physician self-referral prohibition and analogous state referral statutes, and federal and state laws regarding the collection, use and disclosure of patient health information. The Medicare and Medicaid reimbursement rules related to claims submission, cost reporting, and payment processes impose complex and extensive requirements upon dialysis providers, and a violation or departure from such requirements may result in government audits, reimbursement recoupment,lower reimbursements, recoupments or voluntary repayments, and the potential loss of certification.

 

The regulatory scrutiny of healthcare providers, including dialysis providers, has increased significantly in recent years. Medicare has increased the frequency and intensity of its certification inspections of dialysis centers. For example, we are required to provide substantial documentation related to the administration of pharmaceuticals, including EPO, and, to the extent that any such documentation is found insufficient, we may be required to refund any amounts received from such administration by government or private payors, and be subject to substantial penalties under applicable laws or regulations. In addition, fiscal intermediaries have increased their prepayment and post-payment reviews.

 

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We endeavor to comply with all of the requirements for receiving Medicare and Medicaid payments and to structure all of our relationships with referring physicians to comply with state and federal anti-kickback laws and the Stark II physician self-referral law. However, the laws and regulations in this area are complex and subject to varying interpretations. For example, none of our medical director agreements establishes compensation using the Stark II safe harbor method; rather, compensation under our medical director agreements is the result of individual negotiation and, we believe, exceeds amounts determined under the safe harbor method. If an enforcement agency were to challenge the level of compensation that we pay our medical directors, we could be required to change our practices, face criminal or civil penalties, pay substantial fines or otherwise experience a material adverse effect as a result of a challenge to these arrangements.

 

Because of regulatory considerations unique to each of these states, all of our dialysis operations in New York and some of our dialysis operations in New Jersey are conducted by privately-owned companies to which we provide a broad range of administrative services. These operations accounted for approximately 6% of our 2006 dialysis revenue. We believerevenue for the year ended December 31, 2007. In 2007, changes to New York law were adopted that will permit us to hold licenses to conduct dialysis business directly, but until these changes are implemented and we have structuredtransfer these operations to comply with the laws and regulations of these states, butoperating licenses, we can give no assurances that theythese arrangements will not be challenged.

If any of our

operations are found to violate these or other government regulations, we could suffer severe consequences that would have a material adverse effect on our revenues, earnings and cash flows including:

 

Suspension or termination of our participation in government payment programs;

Refunds of amounts received in violation of law or applicable payment program requirements;

Loss of required government certifications or exclusion from government payment programs;

Loss of licenses required to operate healthcare facilities in some of the states in which we operate, including the loss of revenues from operations in New York and New Jersey conducted by privately-owned companies as described above;operate;

Reductions in payment rates or coverage for dialysis and ancillary services and related pharmaceuticals;

Fines, damages or monetary penalties for anti-kickback law violations, Stark II violations, submission of false claims, civil or criminal liability based on violations of law, or other failures to meet regulatory requirements;

Claims for monetary damages from patients who believe their protected health information has been used or disclosed in violation of federal or state patient privacy laws;

Mandated practice changes that significantly increase operating expenses; and

Termination of relationships with medical directors.

 

If our joint ventures were found to violate the law, we could suffer severe consequences that would have a material adverse effect on our revenues, earnings and cash flows.

 

As of December 31, 20062007 we owned a controlling interest in approximately 85numerous dialysis related joint ventures, representingwhich represented approximately 15% of our dialysis revenue. In addition, we also owned a noncontrolling interest in several other dialysis related joint ventures. We anticipate that we will continue to increase the number of our joint ventures during 2007.2008. Many of our joint ventures with physicians or physician groups also have the physician owners providing medical director services to those centers or other centers we own and operate. Because our relationships with physicians are governed by the “anti-kickback”anti-kickback statute contained in the Social Security Act, we have sought to structure our joint venture arrangements to satisfy as many safe harbor requirements as we believe are reasonably possible. However, our joint venture arrangements do not satisfy all elements of any safe harbor under the federal anti-kickback statute. Based on the exceptions applicable to ESRD services, we believe that our joint venture arrangements and operations materially comply with the Stark II law. The subpoena we received from the United States Attorney’s Office for the Eastern District of Missouri on March 4, 2005, and the related request for additional documents received in October 2005, includes a requestinclude requests for documents related to our joint ventures.

 

If our joint ventures are found to be in violation of the anti-kickback statute or the Stark provisions, we could be required to restructure the joint ventures or refuse to accept referrals for designated health services from the physicians with whom the joint venture centers have a financial relationship. We also could be required to

23


repay amounts received from Medicare and certain other payors by the joint ventures pursuant to prohibited referrals, and we could be subject to monetary penalties and exclusion from government healthcare programs. If our joint venture centers are subject to any of these penalties, we could suffer severe consequences that would have a material adverse effect on our revenues, earnings and cash flows.

 

There are significant estimating risks associated with the amount of dialysis revenue that we recognize and if we are unable to accurately estimate our revenue, it could impact the timing of our revenue recognition or have a significant impact on our operating results.

 

There are significant estimating risks associated with the amount of dialysis revenue that we recognize for a reporting period. Ongoing insurance coverage changes, geographic coverage differences, differing interpretations of contract coverage, and other payor issues complicate the billing and collection process. Determining applicable primary and secondary coverage for our more than 103,000107,000 patients at any point in time, together with the changes in patient coveragescoverage that occur each month, requires complex, resource-intensive processes and errors in determining the correct coordination of benefits may result in refunds to payors. Revenues associated with Medicare and Medicaid programs are also subject to estimating risk related to the amounts not paid by the

primary government payor that will ultimately be collectible from other government programs paying secondary coverage, the patient’s commercial health plan secondary coverage or the patient. Collections, refunds and payor retractions typically continue to occur for up to three years and longer after services are provided. If our estimates of dialysis revenue are materially inaccurate, it could impact the timing of our revenue recognition and have a significant impact on our operating results.

 

We may be subject to liability claims for damages and other expenses not covered by insurance that could reduce our earnings and cash flows.

The administration of dialysis and related services to patients may subject us to litigation and liability for damages. Our business, profitability and growth prospects could suffer if we face negative publicity or we pay damages or defense costs in connection with a claim that is outside the scope of any applicable insurance coverage, including claims related to contractual disputes and professional and general liability claims. In addition, we have received several notices of claims from commercial payors and other third parties related to our historical billing practices and the historical billing practices of DVA Renal Healthcare and other matters related to their settlement agreement with the Department of Justice. Although the ultimate outcome of these claims cannot be predicted, an adverse result with respect to one or more of these claims could have a material adverse effect on our financial condition, results of operations, and cash flows. We currently maintain programs of general and professional liability insurance. However, a successful claim, including a professional liability, malpractice or negligence claim which is in excess of our insurance coverage could have a material adverse effect on our earnings and cash flows.

In addition, if our costs of insurance and claims increase, then our earnings could decline. Market rates for insurance premiums and deductibles have been steadily increasing. Our earnings and cash flows could be materially and adversely affected by any of the following:

further increases in premiums and deductibles;

increases in the number of liability claims against us or the cost of settling or trying cases related to those claims; and

an inability to obtain one or more types of insurance on acceptable terms.

If businesses we acquire have liabilities that we are not aware of, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.

Our business strategy includes the acquisition of dialysis centers and businesses that own and operate dialysis centers, as well as other ancillary businesses. Businesses we acquire may have unknown or contingent liabilities or liabilities that are in excess of the amounts that we estimated. Although we generally seek indemnification from the sellers of businesses we acquire for matters that are not properly disclosed to us, we are not always successful. In addition, even in cases where we are able to obtain indemnification, we may discover liabilities greater than the contractual limits or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.

If the ancillary services we provide or the strategic initiatives we invest in are ultimately unsuccessful, we may have to write off our investment and incur other exit costs in one or more of these activities.

 

Our ancillary services and strategic initiatives include pharmacy services, vascular access services, disease management services, ESRD clinical research programs, ESRD full capitation demonstration projects, ESRD special needs plans, and administrative services provided to minority-ownednoncontrolling owned and third-party owned centers and clinics, each of which is related to our core business of providing dialysis services.services, as well as the provision of home infusion therapy services which is related to our core competencies. If any of our ancillary services or strategic initiatives do not perform at the level that we anticipate, we may be required to write off our investment in one or more of these activities. As an example, our fixedexisting investment in pharmacy services of approximately $13$17 million at the end of 2006,2007 may be subject to future write-offs.

If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, our revenues, earnings and cash flows would be substantially reduced.

 

Many physicians prefer to have their patients treated at dialysis centers where they or other members of their practice supervise the overall care provided as medical director of the center. As a result, the primary referral source for most of our centers is often the physician or physician group providing medical director services to the center. Neither our current nor former medical directors have an obligation to refer their patients to our centers. 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 center. If we are unable to enforce noncompetition provisions contained in the terminated medical director agreements, former medical directors may choose to provide medical director services for competing providers or establish their own dialysis centers in competition with ours. Also, if the quality of service levels at our centers deteriorates, it may negatively impact patient referrals and treatment volumes.

 

Our medical director contracts are for fixed periods, generally three to ten years. Medical directors have no obligation to extend their agreements with us. We may take actions to restructure existing relationships or take positions in negotiating extensions of relationships to assure compliance with the safe harbor provisions of the anti-kickback statute, Stark II law and other similar laws. These actions could negatively impact the decision of physicians to extend their medical director agreements with us or to refer their patients to us. If the terms of any

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existing agreement are 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 cause the physician to stop referring patients to our centers. If a significant number of physicians were to cease referring patients to our dialysis centers, whether due to regulatory or other reasons, then our revenues, earnings and cash flows would be substantially reduced.

 

Delays in state Medicare and Medicaid certification of our dialysis centers could adversely affect our revenues, earnings and cash flows.

Before we can begin billing for patients treated in our outpatient dialysis centers who are enrolled in government-based programs, we are required to obtain state and federal certification for participation in the Medicare and Medicaid programs. As state governments face increasing budgetary pressure, certain states may have difficulty certifying dialysis centers in the normal course and significant delays may result. If state governments are unable to certify new centers in the normal course and we experience significant delays in our ability to treat and bill for services provided to patients covered under government programs, it could have an adverse effect on our revenues, earnings, and cash flows.

If we are not able to continue to make acquisitions on reasonable terms or if we face significant patient attrition to our competitors, it could adversely affect our business.

We are facing increased competition in the dialysis industry from large and medium-sized providers which compete directly with us for acquisition targets as well as for individual patients. Acquisitions and patient retention are an important part of our growth strategy. If we are not able to continue to make acquisitions on reasonable terms or if we face significant patient attrition to our competitors, it could adversely affect our business.

The level of our current and future debt could have an adverse impact on our business.

 

We have substantial debt outstanding including debt we incurred to finance the DVA Renal Healthcare acquisition. In addition,and we may incur additional indebtedness in the future. The high level of our indebtedness, among other things, could:

 

make it difficult for us to make payments on our debt securities;

increase our vulnerability to general adverse economic and industry conditions;

require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and investments and other general corporate purposes;

expose us to interest rate fluctuations to the extent we have variable rate debt;

limit our flexibility in planning for, or reacting to, changes in our business and the markets in which we operate;

place us at a competitive disadvantage compared to our competitors that have less debt; and

limit our ability to borrow additional funds.

 

If additional debt financing is not available when required or is not available on acceptable terms, we may be unable to grow our business, take advantage of business opportunities, respond to competitive pressures or refinance maturing debt, any of which could have a material adverse effect on our operating results and financial condition.

We will require a significant amount of cash to service our indebtedness. Our ability to generate cash depends on many factors beyond our control.

 

Our ability to make payments on our indebtedness and to fund planned capital expenditures and expansion efforts, including any strategic acquisitions we may make in the future, will depend on our ability to generate cash. This, to a certain extent, is subject to general economic, financial, competitive, regulatory and other factors that are beyond our control.

 

25


We cannot assure you that our business will generate sufficient cash flow from operations in the future, that our currently anticipated growth in revenue and cash flow will be realized on schedule or that future borrowings will be available to us in an amount sufficient to enable us to service our indebtedness, including the senior and senior subordinated notes, or to fund other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before maturity. Our senior secured credit facilitiesSenior Secured Credit Facilities are secured by substantially all of our and our subsidiaries’ assets. As such, our ability to refinance our debt or seek additional financing could be limited by such security interest. We cannot assure you that we will be able to refinance our indebtedness on commercially reasonable terms or at all.

 

If the current shortage of skilled clinical personnel continues or if we experience a higher than normal turnover rate, 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. We compete for nurses with hospitals and other health care providers. This nursing shortage may limit our ability to expand our operations. If we are unable to hire skilled clinical personnel when needed, or if we experience a higher than normal turnover rate for our skilled clinical personnel, our operations and treatment growth will be negatively impacted, which would result in reduced revenues, earnings and cash flows.

 

The integration of DVA Renal Healthcare’s clinical, billing and collection systems into our operations is significant and the failure to successfully integrate the systems could have a material adverse effect on our revenues, cash flows and operating results.

The integration of DVA Renal Healthcare requires the successful implementation of uniform information technology systems, including clinical, billing and collections systems. We may experience difficulties in our ability to successfully bill and collect for services rendered as a result of our upgrade and integration of the billing and collection systems. Complications associated with the integration of our clinical, billing and collections systems could cause increased risk of retractions from and refunds to commercial and government payors, noncompliance with reimbursement regulations and could have an adverse impact on the claims review required by DVA Renal Healthcare’s corporate integrity agreement. We may experience difficulties in effectively implementing these and other systems across our operations, including DVA Renal Healthcare. The failure to successfully integrate these and other systems could have a material adverse effect on our revenues, cash flows and operating results.

If DVA Renal Healthcare does not comply with its corporate integrity agreement, or DVA Renal Healthcare otherwise has failed or fails to comply with government regulations applicable to its operations, we could be subject to additional penalties and otherwise may be materially harmed.

DVA Renal Healthcare entered into a settlement agreement with the Department of Justice and certain agencies of the United States government relating to the Department of Justice’s investigation of DVA Renal Healthcare’s Medicare and Medicaid billing practices and its relationships with physicians and pharmaceutical manufacturers. If DVA Renal Healthcare does not comply with the terms of the corporate integrity agreement or otherwise has failed or fails to comply with the extensive federal, state and local government regulations applicable to its operations, we could be subject to additional penalties, including monetary penalties or

exclusion from participation in government programs, and otherwise may be materially harmed. The costs associated with compliance with the corporate integrity agreement and cooperation with the government are substantial and may be greater than we currently experience. In addition, as a result of the settlement agreement, commercial payors and other third parties may initiate legal proceedings against DVA Renal Healthcare related to the billing practices and other matters covered by the settlement agreement.

Our alliance and product supply agreement with Gambro Renal Products Inc. may limit our ability to achieve cost savings with respect to products and equipment we are required to purchase under this agreement.

 

On August 25, 2006, we amended ourWe entered into an alliance and product supply agreement with Gambro Renal Products Inc., a subsidiaryin October 2005 to supply dialysis equipment, machines, dialyzers and certain other products, which was subsequently amended in 2006, in part to permit the termination of Gambro AB, pursuant to which we are required to purchase from Gambro Renal Products specified percentages of hemodialysis products, supplies and equipment at fixed prices. The amended supply agreement, among other things, reduces our purchase obligations with respect to our requirements for such products, supplies and equipment and permits the termination of our obligations with respect to certain productsdialysis machines under certain circumstances. TheWe are no longer obligated under the amended supply agreement continues to require us to purchase a significant majority of our hemodialysis product supplies and equipment at fixed pricesdialysis machines from Gambro Renal Products. In addition, all other purchase obligations under the amended supply agreement remain the same and may limit our ability to realize future cost savings in regard to certain products and equipment for which we remain obligated to make purchases under the agreement. For the year ended December 31, 2006,2007, our total spending on hemodialysis products, supplies and equipment with Gambro Renal Products was approximately 4%2% of our total operating costs.

Planned upgrades to our billing and collections systems and complications associated with the integration of our billing and collections systems could have a material adverse effect on our revenues, cash flows and operating results.

In 2007, we completed the integration of our billing systems into one system and system upgrades will continue in 2008. We may experience difficulties in our ability to successfully bill and collect for services rendered as a result of the integration of our billing and collection systems and as we complete planned upgrades to our billing and collection systems. Complications related to the integration of our billing and collections systems and associated with the upgrade of our billing and collections systems could result in a slow-down of collections, a reduction in the amounts we expect to collect, increased risk of retractions from and refunds to commercial and government payors and noncompliance with reimbursement regulations, could have an adverse impact on the claims review required by the corporate integrity agreement applicable to the centers acquired from Gambro Healthcare, described above. The failure to successfully complete the upgrades to the billing and collection systems could have a material adverse effect on our revenues, cash flows and operating results.

26


If DVA Renal Healthcare does not comply with the corporate integrity agreement applicable to the centers acquired from Gambro Healthcare, or DVA Renal Healthcare otherwise has failed or fails to comply with government regulations applicable to its operations, we could be subject to additional penalties and otherwise may be materially harmed.

In 2004, Gambro Healthcare entered into a settlement agreement with the Department of Justice and certain agencies of the United States government relating to the Department of Justice’s investigation of Gambro Healthcare’s Medicare and Medicaid billing practices and its relationships with physicians and pharmaceutical manufacturers. If DVA Renal Healthcare (formerly Gambro Healthcare) does not comply with the terms of the corporate integrity agreement applicable to the centers acquired from Gambro Healthcare, or otherwise has failed or fails to comply with the extensive federal, state and local government regulations applicable to its operations, we could be subject to additional penalties, including monetary penalties or exclusion from participation in government programs, and otherwise may be materially harmed. The costs associated with compliance with the corporate integrity agreement and cooperation with the government are substantial and may increase. In addition, as a result of the settlement agreement, some commercial payors and other third parties have initiated legal proceedings against DVA Renal Healthcare related to the billing practices and other matters covered by the settlement agreement and we could receive similar claims in the future.

 

Our ability to effectively provide the services we offer could be negatively impacted if certain of our suppliers are unable to meet our needs or if we are unable to effectively access new technology, which could substantially reduce our revenues, earnings and cash flows.

 

We have significant suppliers that are either the sole or primary source of products critical to the services we provide or to which we have committed obligations to make purchases, including Amgen, Fresenius Medical Care, Gambro Renal Products, Baxter Healthcare Corporation, as well as others. If any of these suppliers are unable to meet our needs for the products they supply and we are not able to find adequate alternative sources, our revenues, earnings and cash flows could be substantially reduced. For example, in July 2007, we notified Gambro Renal Products that we were electing to be permanently relieved of our obligation to purchase dialysis machines which remained subject to an import ban by the FDA. In addition, the technology related to the products critical to the services we provide is subject to new developments and may result in superior products. If we are not able to access superior products on a cost-effective basis or if suppliers are not able to fulfill our requirements for such products, we could face patient attrition which could substantially reduce our revenues, earnings and cash flows.

We may be subject to liability claims for damages and other expenses not covered by insurance that could reduce our earnings and cash flows.

The administration of dialysis and related services to patients may subject us to litigation and liability for damages. Our business, profitability and growth prospects could suffer if we face negative publicity or we pay damages or defense costs in connection with a claim that is outside the scope of any applicable insurance coverage, including claims related to contractual disputes and professional and general liability claims. In addition, we have received several notices of claims from commercial payors and other third parties related to our historical billing practices and the historical billing practices of the centers acquired from Gambro Healthcare and other matters related to their settlement agreement with the Department of Justice. Although the ultimate outcome of these claims cannot be predicted, an adverse result with respect to one or more of these claims could have a material adverse effect on our financial condition, results of operations, and cash flows. We currently maintain programs of general and professional liability insurance. However, a successful claim, including a professional liability, malpractice or negligence claim which is in excess of our insurance coverage could have a material adverse effect on our earnings and cash flows.

27


In addition, if our costs of insurance and claims increase, then our earnings could decline. Market rates for insurance premiums and deductibles have been steadily increasing. Our earnings and cash flows could be materially and adversely affected by any of the following:

further increases in premiums and deductibles;

increases in the number of liability claims against us or the cost of settling or trying cases related to those claims; and

an inability to obtain one or more types of insurance on acceptable terms.

If businesses we acquire have liabilities that we are not aware of, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.

Our business strategy includes the acquisition of dialysis centers and businesses that own and operate dialysis centers, as well as other ancillary businesses. Businesses we acquire may have unknown or contingent liabilities or liabilities that are in excess of the amounts that we estimated. Although we generally seek indemnification from the sellers of businesses we acquire for matters that are not properly disclosed to us, we are not always successful. In addition, even in cases where we are able to obtain indemnification, we may discover liabilities greater than the contractual limits or the financial resources of the indemnifying party. In the event that we are responsible for liabilities substantially in excess of any amounts recovered through rights to indemnification, we could suffer severe consequences that would substantially reduce our revenues, earnings and cash flows.

 

Provisions in our charter documents, compensation programs and Delaware law 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 90 days advance notice of stockholder proposals or nominations to our Board of Directors and granting our Board of Directors the authority to issue preferred stock and to determine the rights and preferences of the preferred stock without the need for further stockholder approval. In addition, on November 14, 2002, the Board of Directors approved a shareholder rights plan that would substantially dilute the interest sought by an acquirer that our Board of Directors does not approve.

 

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 also maintain a change of control protection program for our employees who do not have a significant number of stock awards, which provides for cash bonuses to the employees in the event of a change of control which has been in place since September 2001. Based on the shares of our common stock outstanding and the market price of our stock on December 31, 2006,2007, these cash bonuses would total approximately $231$234 million if a change of control transaction occurred at that price and our Board of Directors did not modify this program. These compensation programs may affect the price an acquirer would be willing to pay for theour Company.

We are also subject to Section 203 of the Delaware General Corporation Law that, subject to exceptions, would prohibit us from engaging in any business combinations with any interested stockholder, as defined in that section, for a period of three years following the date on which that stockholder became an interested stockholder.

 

These provisions may discourage, delay or prevent an acquisition of our Company at a price that our stockholders may find attractive. These provisions could also make it more difficult for our stockholders to elect directors and take other corporate actions and could limit the price that investors might be willing to pay for shares of our common stock.

 

28


Item 1B.    Unresolved Staff Comments.

 

None.

 

Item 2.    Properties.

 

We own the land and buildings for 2625 of our dialysis centers. We also own the buildings for six other dialysis centers and the building at one of our Florida labs and we own one separate land parcel and sublease a total of tennine properties to third party tenants. Our remaining dialysis centers are located on premises that we lease. Our leases generally cover periods from five to ten years and typically contain renewal options of five to ten years at the fair rental value at the time of renewal, or at rates subject to periodic consumer price index increases, or contain fixed escalation clauses. Our outpatient dialysis centers range in size from approximately 500 to 30,00044,000 square feet, with an average size of approximately 6,5006,800 square feet.

 

The following is a summary of our business, administrative offices, laboratories and pharmacies:

 

Office


  

Location


  Square Feet

  Expiration

  

Location

  

Square Feet

  

Expiration

Corporate Headquarters

  El Segundo, CA  51,000  2013  El Segundo, CA  61,000  2013

Business Office

  Tacoma, WA  140,000  2009 through 2011  Tacoma, WA  140,000  2009 through 2011

Business Office

  Berwyn, PA  57,000  2012  Berwyn, PA  57,000  2012

Administrative Office

  Exton, PA  8,000  2008

Administrative Office

  Exton, PA  8,000  2008  Vernon Hills, IL  18,000  2011

Administrative Office

  Vernon Hills, IL  18,000  2011  Burlingame, CA  7,000  2009

Administrative Office

  Burlingame, CA  7,000  2009  Norfolk, VA  11,000  2010

Former Corporate Headquarters**

  Torrance, CA  28,000  2008  Torrance, CA  28,000  2008

Business Office

  Lakewood, CO  82,000  2010  Lakewood, CO  82,000  2010

Business Office

  Brentwood, TN  95,000  2011  Brentwood, TN  95,000  2011

Business Office

  Irvine, CA  65,000  2015  Irvine, CA  65,000  2015

Laboratory

  DeLand, FL  40,000  owned  DeLand, FL  40,000  owned

Laboratory

  DeLand, FL  14,000  2007  DeLand, FL  20,000  2013

Laboratory Administrative Office

  DeLand, FL  23,000  2011  DeLand, FL  23,000  2011

Laboratory

  Ft. Lauderdale, FL  43,000  2008  Ft. Lauderdale, FL  43,000  2008

DaVita Rx

  San Mateo, CA  3,000  2008  San Mateo, CA  3,000  2008

DaVita Rx

  Orlando, FL  17,000  2013  Orlando, FL  17,000  2013

DaVita Rx

  Coppell, TX  53,000  2013  Coppell, TX  53,000  2013

** Subleased portion–16,000; unused portion–12,000


** Subleased portion–16,000; unused portion–12,000

   

** Subleased portion–16,000; unused portion–12,000

  

 

Some of our dialysis centers are operating at or near capacity. However, we believe that we have adequate capacity within most of our existing dialysis centers to accommodate additional patient volume through increased hours and/or days of operation, or, if additional space is available within an existing facility, by adding dialysis stations. We can usually relocate existing centers to larger facilities or open new centers if existing centers reach capacity. With respect to relocating centers or building new centers, we believe that we can generally lease space

at economically reasonable rates in the areas planned for each of these centers. Expansion of existing centers or relocation of our dialysis centers is subject to review for compliance with conditions relating to participation in the Medicare ESRD program. In states that require a certificate of need or center license, additional approvals would generally be necessary for expansion or relocation.

 

29


Item 3.    Legal Proceedings.

 

United States Attorney inquiries

 

In February 2007, we received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services, or OIG, for records relating to Epogen,® or EPO, claims submitted to Medicare. In August 2007, we received a subpoena from the OIG seeking similar documents. The requested documents relate to services provided from 2001 to 2004 by a number of our centers. The request and subpoena were sent from the OIG’s offices in Houston and Dallas, Texas. We are cooperating with the inquiry and are producing the requested records. We have been in contact with the United States Attorney’s Office, or U.S. Attorney’s Office, for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. There appears to be substantial overlap between this issue and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office, for the Eastern District of Missouri in St. Louis, described below. To our knowledge, no proceedings have been initiated against us at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena will continue to require management’s attention and significant legal expense. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.

On March 4, 2005, we received a subpoena from the United States Attorney’s Office, or U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. The subpoena requires production of a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies, and financial relationships with physicians and joint ventures. The subpoena covers the period from December 1, 1996 through the present. In October 2005, we received a follow-up request for additional documents related to specific medical director and joint venture arrangements. In February 2006, we received an additional subpoena for documents, including certain patient records relating to the administration and billing of EPO. In May 2007, we received a request for documents related to durable medical equipment (DME) and supply companies owned and operated by us. We are producing documents and providing information to the government. We are also cooperating, and intend to continue to cooperate, with the government’s investigation, including by participating in discussions and meetings with the government. The subpoenas have been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against us in connection with this inquiry. Any negative findings could result in substantial financial penalties against us, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To our knowledge, no proceedings have been initiated against us at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

 

On October 25, 2004, we received a subpoena from the U.S. Attorney’s Office for the Eastern District of New York in Brooklyn. The subpoena covers the period from 1996 to present and requires the production of a wide range of documents relating to our operations, including DaVita Laboratory Services. Gambro Healthcare received a similar subpoena in November 2004. The subpoena also includes specific requests for documents relating to testing for parathyroid hormone levels, (PTH),or PTH, and to products relating to vitamin D therapies. The subpoena has been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against us in connection with this inquiry. Any negative findings could result in substantial financial penalties against us, and DVA Renal Healthcare, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. Other participants in the dialysis industry received a similar subpoena, including Fresenius Medical Group, Renal Care Group and DVA Renal Healthcare, which was acquired by us in October of 2005.Group. To our knowledge, no proceedings have been initiated against us or DVA Renal Healthcare at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena may continue to require management’s attention and significant legal expense.

 

In February 2001, the Civil Division of the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted us and requested our cooperation in a review of some of our historical practices, including billing and other operating procedures and our financial relationships with physicians. We cooperated in this review and provided the requested records to the U.S. Attorney’s Office. In May 2002, we received a subpoena from the U.S. Attorney’s Office and the Philadelphia Office of the Office of Inspector General of the Department of Health and Human Services (OIG). The subpoena required an update to the information we provided in our response to the February 2001 request, and also sought 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 our financial relationships with physicians and pharmaceutical companies. The subpoena covered the period from May 1996 to May 2002. We provided the documents requested and cooperated with the United States Attorney’s Office and the OIG in its investigation. In January30

2007, the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia informed us that it has decided to close its investigation of DaVita. No charges were made against us, no fines were assessed and no mandatory policy changes were required in connection with this investigation.

In February 2007, we received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services for records relating to EPO claims submitted to Medicare. The claims relate to services provided from 2002 to 2004 by a number of our centers. The request was sent from the OIG’s office in Houston, Texas. We have been in contact with the U.S. Attorney’s Office for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. We are cooperating with the inquiry and will be producing the requested records. There appears to be substantial overlap between this issue, and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. EPO utilization was also one of the subjects of the multi-year investigation by the U.S. Attorney’s Office for the Eastern District of Pennsylvania, which was recently closed as described herein. To the best of our knowledge, the government has not initiated any proceeding against us in connection with this request although we cannot predict whether we will receive further inquiries or whether or when a proceeding might be initiated.


Other

 

We have received several notices of claims from commercial payors and other third parties related to our historical billing practices and claims against DVA Renal Healthcare (formerly known as Gambro Healthcare) related to historical DVA RenalGambro Healthcare billing practices and other matters covered by their settlement agreement with the Department of Justice. At least one commercial payor has filed an arbitration demand against us, as described below, and additional commercial payors have threatened litigation. We intend to defend against these claims vigorously; however, we may not be successful and these claims may lead to litigation and any such litigation may be resolved unfavorably. Although the ultimate outcome of these claims cannot be predicted at this time, an adverse result in excess of our established reserves, with respect to one or more of these claims could have a material adverse effect on our business, financial condition, and results of operations.operations and liquidity.

 

We have received several informal inquiries from representativesIn December 2007, we entered into a Settlement Agreement with the State of New York to resolve certain billing issues that had been the subject of inquiry by the New York Attorney General’s Medicaid Fraud Control Unit, (MFCU) regarding certain aspectsor MFCU. We had received several informal inquiries from representatives of the EPO and otherMFCU regarding billing practices taking place atfor facilities managed by us in New York. The Settlement Agreement covers numerous dialysis facilities in New York for which we, through our subsidiaries, provide administrative services. We are cooperating withpaid approximately $1.5 million in settlement, which included the MFCU’s informal inquiriesamount of the overpayments by the New York Medicaid program plus interest; no fines or penalties were assessed.

In October 2007, we were contacted by the Attorney General’s Office for the State of Nevada. The Attorney General’s Office informed us that it was conducting a criminal investigation of our operations in Nevada and have provided documents and informationthat the investigation related to the MFCU.billing of pharmaceuticals, including EPO. On February 8, 2008, the Attorney General’s Office informed us that the criminal investigation has been discontinued. The Attorney General’s Office further advised us that Nevada Medicaid intends to conduct audits of ESRD providers in Nevada, including us, and that such audits will relate to the issues that were the subjects of the criminal investigation. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs. To the best of our knowledge, no proceedings have been initiated against us and the MFCU has not indicated an intention to do so, although we cannot predict whether we will receive further inquiries or whether or when proceedings might be initiated.at this time.

 

In June 2004, DVA Renal Healthcare was served withOn August 28, 2007, Sheet Metal Workers National Health Fund and Glenn Randle filed a complaint filed in the SuperiorUnited States District Court for the Central District of California by one of its former employees who worked for its California acute services program.against us. The complaint whichalso names as defendants Amgen, Inc. and Fresenius Medical Care Holdings, Inc. The complaint is styled as a class action and alleges among other things,four claims against us, including violations of the federal RICO statute, California’s unfair competition law, California’s false advertising law and for unjust enrichment. The complaint’s principal allegations against us are that DVA Renal Healthcare failedthe defendants engaged in a scheme to provide overtime wages, defined rest periodsunlawfully promote the administration of EPO to hemodialysis patients intravenously, as opposed to subcutaneously, and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements.over-utilize EPO. We are evaluating the claims and intend to vigorously defend ourselves in the matter.against these claims. We also intend to vigorously oppose the certification of this matter as a class action. AlthoughAt this time, we cannot predict the ultimate outcome of these claims cannot be predicted, we do not expect that an unfavorable result,this matter or the potential range of damages, if any, would have a material adverse effect on our business, financial condition, liquidity or results of operations.any.

 

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the Western District of Louisiana against Gambro AB, DVA Renal Healthcare (formerly Gambro Healthcare) and related entities. The plaintiff sought to bring its claims as a class action on behalf of itself and all entities that paid any of the defendants for health care goods and services from on or about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying DVA RenalGambro Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek

arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against us and DVA Renal Healthcare. We intend to vigorously defend against these claims. We also intend to vigorously oppose the certification of this matter as a class action. At this time, we cannot estimatepredict the ultimate outcome of this matter or the potential range of damages, if any.

31


In June 2004, Gambro Healthcare was served with a complaint filed in the Superior Court of California by one of its former employees who worked for its California acute services program. The complaint, which is styled as a class action, alleges, among other things, that DVA Renal Healthcare (formerly Gambro Healthcare) failed to provide overtime wages, defined rest periods and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements. We are investigating these claims and continueintend to vigorously defend ourselves inagainst this claim. We also intend to vigorously oppose the matter.certification of this matter as a class action. Although the ultimate outcome of these claims cannot be predicted, we do not expect that an unfavorable result, if any, would have a material adverse effect on our business, financial condition, liquidity or results of operations.

 

In addition to the foregoing, we are subject to claims and suits, in the ordinary course of business, including from time to time, contractual disputes and professional and general liability claims.claims, as well as audits and investigations by various government entities, in the ordinary course of business. We believe that the ultimate resolution of any such pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on our financial condition, results of operations or cash flows.

 

Item 4.    Submission of Matters to a Vote of Securities Holders.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2006.2007.

32


PART II

 

Item 5.    Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Our common stock is traded on the New York Stock Exchange under the symbol “DVA”. The following table sets forth, for the periods indicated, the high and low closing prices for our common stock as reported by the New York Stock Exchange.

 

  High

  Low

  High  Low

Year ended December 31, 2007:

    

1st quarter

  $58.54  $51.54

2nd quarter

   57.48   52.56

3rd quarter

   63.18   52.78

4th quarter

   66.53   55.63

Year ended December 31, 2006:

          

1st quarter

  $60.27  $51.52  $60.27  $51.52

2nd quarter

   58.75   47.59   58.75   47.59

3rd quarter

   58.79   48.32   58.79   48.32

4th quarter

   59.36   51.89   59.36   51.89

Year ended December 31, 2005:

      

1st quarter

  $44.10  $39.26

2nd quarter

   46.72   40.01

3rd quarter

   47.78   43.28

4th quarter

   53.59   47.88

 

The closing price of our common stock on February 1, 20072008 was $54.89$54.27 per share. According to The Bank of New York, our registrar and transfer agent, as of February 1, 2007,2008, there were 3,6665,521 holders of record of our common stock. We have not declared or paid cash dividends to holders of our common stock since 1994. We have no current plans to pay cash dividends and we are restricted from paying dividends under the terms of our credit facilitiesSenior Secured Credit Facilities and the indentures governing our senior and senior subordinated notes. Also, see the heading “Liquidity and capital resources” under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the notes to our consolidated financial statements.

 

On September 11, 2003, the Company announced that the BoardStock Repurchases

The following table summarizes our repurchases of Directors authorized the Company to repurchase up to $200 million of the Company’sour common stock with no expiration date. On November 2, 2004, the Company announced that the Board of Directors approved an increase in the Company’s authorization to repurchase shares of its common stock by an additional $200 million. The Company is authorized to make purchases from time to time in the open market or in privately negotiated transactions, depending upon market conditions and other considerations. However, under the terms of our credit facilities and our senior and senior subordinated notes, we have share repurchase limitations.during 2007:

 

There were no repurchases of our common stock during 2006 and 2005. We had approximately $249 million available from Board authorizations2007 prior to repurchase sharesthe third quarter of our common stock as of December 31, 2006.2007.

Period

  Total Number
of
Shares
Purchased
  Average
Price Paid
per Share
  Total Number
of Shares Purchased as
Part of Publicly
Announced Plans or
Programs(1)
  Approximate Dollar Value
of Shares that May Yet Be
Purchased Under the
Plans or Programs
(in millions)

July 1—31, 2007

  —    $—    —    $249.1

August 1—31, 2007

  111,300   57.05  111,300   242.8

September 1—December 31, 2007

  —     —    —     242.8
              

Total

  111,300  $—    111,300  $—  
              

(1)On September 11, 2003, we announced that the Board of Directors authorized the repurchase of up to $200 million of our common stock, with no expiration date. On November 2, 2004, we announced that the Board of Directors approved an increase in our authorization to repurchase shares of our common stock by an additional $200 million. We are authorized to make purchases from time to time in the open market or in privately negotiated transactions, depending upon market conditions and other considerations. However, we are subject to share repurchase limitations under the terms of the Senior Secured Credit Facilities and the indentures governing our senior and senior subordinated notes.

33


Item 6.    Selected Financial Data.

 

The following financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation” and our consolidated financial statements filed as part of this report. The following table presents selected consolidated financial and operating data for the periods indicated. In October 2005, we acquired DVA Renal Healthcare for approximately $3.06 billion. DVA Renal Healthcare was one of the largest dialysis services providers in the United States operating 566 outpatient dialysis centers and generating annual revenues of approximately $2 billion. In conjunction with a consent order issued by the Federal Trade Commission, on October 4, 2005, we divested a total of 71 centers and terminated two management service agreements. In addition, effective January 1, 2006, we divested three additional centers that were previously pending state regulatory approval in order to complete the acquisition of DVA Renal Healthcare. See footnote (6) below. The operating results of DVA Renal Healthcare are included in our operating results from October 1, 2005, and the operating results of the historical DaVita divested centers are reflected as discontinued operations in our consolidated statements of income for 2005 and prior. The following financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation” and our consolidated financial statements filed as part of this report.

 

  Year ended December 31,

 
  2006

  2005

  2004

  2003

  2002

 
  (in thousands, except share data) 

Income statement data:

                    

Net operating revenues(1)

 $4,880,662  $2,973,918  $2,177,330  $1,919,278  $1,766,564 

Operating expenses and charges(2)

  4,141,230   2,508,547   1,796,204   1,559,347   1,400,897 
  


 


 


 


 


Operating income

  739,432   465,371   381,126   359,931   365,667 

Debt expense(3)

  (276,706)  (139,586)  (52,411)  (66,821)  (71,612)

Swap valuations gain, net(4)

  —     4,548   —     —     —   

Refinancing charges(5)

  —     (8,170)  —     (26,501)  (48,930)

Other income, net

  13,033   8,934   4,125   3,042   3,980 
  


 


 


 


 


Income from continuing operations before income taxes

  475,759   331,097   332,840   269,651   249,105 

Income tax expense

  186,430   123,675   128,332   105,173   102,749 
  


 


 


 


 


Income from continuing operations

  289,329   207,422   204,508   164,478   146,356 

Income from discontinued operations, net of tax (6)

  —     13,157   17,746   11,313   10,973 

Gain on disposal of discontinued operations, net of tax (6)

  362   8,064   —     —     —   
  


 


 


 


 


Net income

 $289,691  $228,643  $222,254  $175,791  $157,329 
  


 


 


 


 


Basic earnings per common share from continuing operations(6)(7)

 $2.79  $2.06  $2.07  $1.74  $1.36 
  


 


 


 


 


Diluted earnings per common share from continuing operations (6)(7)

 $2.73  $1.99  $1.99  $1.56  $1.22 
  


 


 


 


 


Weighted average shares outstanding:(7)(9)

                    

Basic

  103,520,000   100,762,000   98,727,000   94,346,000   107,747,000 
  


 


 


 


 


Diluted

  105,793,000   104,068,000   102,861,000   113,760,000   135,720,000 
  


 


 


 


 


Ratio of earnings to fixed charges(8)

  2.38:1   2.86:1   5.26:1   3.98:1   3.67:1 

Balance sheet data:

                    

Working capital

 $597,324  $664,675  $426,985  $242,238  $251,925 

Total assets

  6,491,816   6,279,762   2,511,959   1,945,530   1,775,693 

Long-term debt

  3,730,380   4,085,435   1,322,468   1,117,002   1,311,252 

Shareholders’ equity(9)

  1,245,924   850,609   523,134   306,871   70,264 

   Year ended December 31, 
   2007  2006  2005  2004  2003 
   (in thousands, except share data) 

Income statement data:

      

Net operating revenues(1)

  $5,264,151  $4,880,662  $2,973,918  $2,177,330  $1,919,278 

Operating expenses and charges

   4,401,942   4,141,230   2,508,547   1,796,204   1,559,347 
                     

Operating income

   862,209   739,432   465,371   381,126   359,931 

Debt expense(2)

   (257,147)  (276,706)  (139,586)  (52,411)  (66,821)

Swap valuations gain, net(3)

   —     —     4,548   —     —   

Refinancing charges(4)

   —     —     (8,170)  —     (26,501)

Other income, net

   22,460   13,033   8,934   4,125   3,042 
                     

Income from continuing operations before income taxes

   627,522   475,759   331,097   332,840   269,651 

Income tax expense

   245,744   186,430   123,675   128,332   105,173 
                     

Income from continuing operations

   381,778   289,329   207,422   204,508   164,478 

Income from discontinued operations, net of tax (5)

   —     —     13,157   17,746   11,313 

Gain on disposal of discontinued operations, net of tax (5)

   —     362   8,064   —     —   
                     

Net income

  $381,778  $289,691  $228,643  $222,254  $175,791 
                     

Basic earnings per common share from continuing operations(5)(6)

  $3.61  $2.79  $2.06  $2.07  $1.74 
                     

Diluted earnings per common share from continuing operations(5)(6)

  $3.55  $2.73  $1.99  $1.99  $1.56 
                     

Weighted average shares outstanding:(6)(8)

      

Basic

   105,893,000   103,520,000   100,762,000   98,727,000   94,346,000 
                     

Diluted

   107,418,000   105,793,000   104,068,000   102,861,000   113,760,000 
                     

Ratio of earnings to fixed charges(7)

   2.92:1   2.38:1   2.86:1   5.26:1   3.98:1 

Balance sheet data:

      

Working capital

  $889,754  $597,324  $664,675  $426,985  $242,238 

Total assets

   6,943,960   6,491,816   6,279,762   2,511,959   1,945,530 

Long-term debt

   3,683,887   3,730,380   4,085,435   1,322,468   1,117,002 

Shareholders’ equity(8)

   1,732,250   1,245,924   850,609   523,134   306,871 

(1)Net operating revenues include $3,771 in 2005, $8,293 in 2004, and $24,000 in 2003 and $58,778 in 2002 of Medicare lab recoveries relating to prior years’ services.
(2)Total operating expenses include recoveries of $5,192 in 2002 of accounts receivable reserved in 1999.

(3)Debt expense in 2007 and 2006 includes the write-off of approximately $4.4 million and $3.3 million of deferred financing costs associated with our principal prepayments on the Term loans.
(4)(3)

The swap valuation net gains of $4,548 in 2005 represented the accumulated fair value on several swap instruments that were ineffective as cash flow hedges, as a result of the repayment of our credit facilities,Senior Secured

34


Credit Facilities, as well as changes in the fair values of these swaps until they were redesignated as hedges, and represent changes in the fair value of the swaps during periods in which there was no matching variable rate LIBOR-based interest payments.

(5)(4)

Refinancing charges of $8,170 in 2005 represented the write-off of deferred financing costs associated with the extinguishment of our prior credit facility.Senior Secured Credit Facilities. Refinancing charges of $26,501 in 2003 represented the consideration paid to redeem the $125,000 5 5/8% Convertible Subordinated Notes due 2006 and the $345,000 7% Convertible Subordinated Notes due 2009 in excess of book value, the write-off of related deferred financing costs and other financing fees associated with the amendment of the prior credit facility. Refinancing charges of $48,930 in 2002 represented the write-off of deferred financing costs associated with the retirement of the $225,000 outstanding 9 1/4% Senior Subordinated Notes due 2011.Secured Credit Facilities.

(6)(5)During 2005, we divested a total of 71 outpatient dialysis centers in conjunction with a consent order issued by the Federal Trade Commission on October 4, 2005 in order for us to complete the acquisition of DVA Renal Healthcare. In addition, we completed the sale of three additional centers that were previously pending state regulatory approval in January 2006. The operating results of the historical DaVita divested and held for sale centers were reflected as discontinued operations in our consolidated financial statements for 2005 and prior.
(7)(6)All share and per-share data for all periods presented prior to 2005 have been adjusted to retroactively reflect the effects of a 3-for-2 stock split that occurred in the second quarter of 2004.
(8)(7)The ratio of earnings to fixed charges was computed by dividing earnings by fixed charges. Earnings for this purpose is defined as pretax income from continuing operations adjusted by adding back fixed charges expensed during the period. Fixed charges include debt expense (interest expense and the write off and amortization of deferred financing costs), the estimated interest component of rental expense on operating leases, and capitalized interest.
(9)(8)Share repurchases consisted of 111,300 shares of common stock for $6,350 in 2007, 3,350,100 shares of common stock for $96,540 in 2004 and 5,162,850 shares of common stock for $107,162 in 2003, 40,991,216 shares of common stock for $642,171 in 2002.2003. Debt of $124,700 and $526 was converted into 7,302,528 and 24,045 shares of common stock in 2003. Shares issued in connection with stock awards amounted to 2,480,899 in 2007, 2,620,125 in 2006, 3,303,451 in 2005, 5,106,783 in 2004, and 3,539,919 in 2003, and 5,131,425 in 2002.2003.

35


Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operation.

 

Forward looking statements

 

This Annual Report on Form 10-K contains statements that are forward-looking statements within the meaning of the federal securities laws. All statements that do not concern historical facts are forward-looking statements and include, among other things, statements about our expectations, beliefs, intentions and/or strategies for the future. These forward-looking statements include statements regarding our future operations, financial condition and prospects, expectations for treatment growth rates, revenue per treatment, expense growth, levels of the provision for uncollectible accounts receivable, operating income, cash flow, operating cash flow, estimated tax rates, capital expenditures, the development of new centers and center acquisitions, the impact of the DVA Renal Healthcare acquisitionrevenue estimating risk and our related level of indebtedness on our financial performance, including earnings per share, and anticipated integration costs.share. These statements involve substantial known and unknown risks and uncertainties that could cause our actual results to differ materially from those described in the forward-looking statements, including, but not limited to, risks resulting from the regulatory environment in which we operate, economic and market conditions, competitive activities, other business conditions, accounting estimates, the concentration of profits generated from commercial payor plans, continued downward pressure on average realized payment rates from commercial payors and possible reductions in private and government payment rates, changes in the structure of and payment rates under the Medicare ESRD program which may further reduce Medicare payment rates, changes in pharmaceutical or anemia management practice patterns, payment policies or pharmaceutical pricing, our ability to maintain contracts with physician medical directors, legal compliance risks, including our continued compliance with complex government regulations and the subpoena from the U.S. Attorney’s Office for the Eastern District of New York, the subpoenas from the U.S. Attorney’s Office for the Eastern District of Missouri and DVA Renal Healthcare’s compliance with itsthe corporate integrity agreement our abilityapplicable to completethe dialysis centers acquired from Gambro Healthcare and integrate acquisitionsassumed in connection with such acquisition, the resolution of businesses, the successful integration of DVA Renal Healthcare, including its billingongoing investigations by various federal and collection operationsstate government agencies, and the risk factors set forth in this Annual Report on Form 10-K. We base our forward-looking statements on information currently available to us, and we undertake no obligation to update or revise these statements, whether as a result of changes in underlying factors, new information, future events or otherwise.

 

The following should be read in conjunction with our consolidated financial statements and “Item 1. Business”.

 

Overview

 

We are a leading provider of dialysis services in the United States through a network of approximately 1,3001,359 outpatient dialysis centers and 770700 hospitals, serving approximately 103,000 patients.107,000 patients in 43 states. In October 2005, we acquired DVA Renal Healthcare, Inc., then one2007, our overall network of the largest dialysis service providers in the United States, for approximately $3.06 billion. At the time of the acquisition, DVA Renal Healthcare was operating 566 outpatient dialysis centers and generating annual revenuesincreased by 59 centers primarily as a result of approximately $2 billion. The operating results of DVA Renal Healthcare are included in our operating results effective October 1, 2005.

In accordance with a consent order issued by the Federal Trade Commission on October 4, 2005, we were required to divest a total of 69 outpatient dialysisopening new centers and to terminate two management services agreements in order for us to completeacquisitions and the DVA Renal Healthcare acquisition. In 2005,overall number of patients that we divested a total of 71 centers and terminated the two management services agreements. In addition, effective January 1, 2006, we completed the sale of three additional centers that were previously pending state regulatory approval. We received total cash consideration ofserve increased by approximately $330 million for all of the centers divested and used approximately $13 million to purchase the minority interest ownership of a joint venture, to distribute a minority owners’ share of the sale proceeds, and to pay related transaction costs. We also paid approximately $85 million in related income taxes in the first quarter of 2006. The operating results of the historical DaVita divested centers and its one management services agreement are reflected as discontinued operations in our consolidated financial statements for 2005 and prior.4%.

 

Our stated mission is to be the provider, partner and employer of choice. We believe our attention to these three areas, our patients, our teammates,business partners, and our business partners, representteammates, represents the major drivers of our long-term

potential long term success, aside fromalthough we are subject to the impact of external factors such as government policy and physician practice patterns. Accordingly, two principal non-financial metrics we track are quality clinical outcomes and teammate turnover. We have developed our own composite index for measuring improvements in our clinical outcomes, which we refer to as the DaVita Quality Index, or DQI. Our clinical outcomes as measured by DQI have improved over each of the past three years, and in 2006 we achieved another year of excellentare pleased with our 2007 clinical outcomes. Although it is difficult to reliably measure clinical performance across our industry, we believe our clinical outcomes compare favorably with other dialysis providers in the United States. OverIn addition, over the past severalcouple of years we have achieved significant reductions in teammate turnover, which hashave been a major contributor to our clinical performance improvements. We will continue to focus on these fundamental long-term value drivers.

 

Our operations are presented as a single reporting segment, with approximately 98%Approximately 97% of our revenues currently derived directly from providing dialysis and dialysis related services, such as laboratory services (collectively dialysis revenue). Eighty-two percent of our dialysis revenue is derived from outpatient hemodialysis services in 1,2621,336 centers that we consolidate that are either wholly-owned

36


or majority-owned. Other dialysis services, which are operationally integrated with our dialysis operations, are peritoneal dialysis, home-based hemodialysis, and hospital inpatient hemodialysis services, which combined accounted for approximately 15% of our dialysis revenue, and the remaining 3% of our dialysis revenue was from laboratory services.

 

Our other operations include various ancillary services and strategic initiatives consisting primarily of infusion therapy services, oral pharmacy services, vascular access services, disease management services and special needs plans, ESRD clinical research programs, oral pharmacy servicesand management and administration services to minority-ownednoncontrolling owned and third-party owned centers and clinics, as further described in Item 1 in this Form 10-K. These ancillary services and strategic initiatives are primarily aligned with our core business of providing dialysis services to our 103,000 patients. These services generated less than 2%approximately 3% of our total net revenues in 2006.2007. We currently expect to continue to invest in our ancillary services and strategic initiatives and anticipate that these initiatives willas we work to develop into strategically successful new business operations. However, significant changes in market conditions, business performance or in the regulatory environment may ultimately impact or continue to impact the economic viability of these strategic initiatives. Any unfavorable changes could result in a write-off of some or all of our investments in these strategic initiatives.

 

The principal drivers of our dialysis revenue are a)are: (a) the number of treatments, which is primarily a function of the number of chronic patients requiring three treatments per week, b)as well as the number of treatments for peritoneal dialysis services and home-based dialysis and hospital inpatient dialysis services, (b) average dialysis revenue per treatment revenue and c) laboratory patient testing. The total patient base is a relatively stable factor, influenced by a demographically growing need for dialysis services, our relationships with referring physicians together with the quality of our clinical care, and our pace of openingability to open and acquiringacquire new centers.

Our year-over-year treatment volume growth was as follows:5.7% in 2007.

   2006

  2005

 

Treatment growth related to:

       

Existing and newly opened centers

  4.8% 5.4%

Other center acquisitions

  4.0% 7.5%

DVA Renal Healthcare acquisition effective 10/1/05

    51.5%   23.0%
   

 

Total treatment growth

  60.3% 35.9%
   

 

 

Average dialysis revenue per treatment is principally driven by our mix of commercial and government (principally Medicare and Medicaid) patients, the mix and intensity of physician-prescribed pharmaceuticals, commercial and government payment rates, dialysis services charge-capture, and our billing and collecting operations performance.

 

On average, payment rates from commercial payors are moregenerally significantly higher than double Medicare and Medicaid payment rates, and therefore the percentage of commercial patients to total patients represents a major driver of our total

average revenue per treatment. The acquisition of DVA Renal Healthcare did not materially affect our overall patient mix percentage.

 

The following tablestable summarizes our dialysis revenue and patient percentages by payor type for the year ended December 31, 2006:2007:

 

  Revenues

 

Patient

Percentages


   Revenues Patient
Percentages
 

Medicare and Medicare assigned HMO plans

  58% 78%

Medicare and Medicare-assigned HMO plans

  58% 80%

Medicaid

  4% 6%  4% 5%

Other government-based programs

  3% 3%  2% 2%
  

 

       

Total government-based programs

  65% 87%  64% 87%

Commercial

      35%     13%      36%     13%
  

 

       

Total dialysis revenue

  100% 100%  100% 100%
  

 

       

 

Government payment rates are principally determined by federal (Medicare) and state (Medicaid) policy. These payment rates have limited potential for rate increases and are sometimes at risk of being reduced. Cumulative net increases in Medicare payment rates from 1990 through 20062007 totaled approximately 9%10%. There were no Medicare payment rate increases for 2003 and 2004. CMS implemented increases of 1.6% on April 1, 2007, January 1, 2006 and January 1, 2005, however the 2005 increase was more than offset by other structural

37


changes to Medicare dialysis payment rates that also became effective January 1, 2005. In addition, CMS recently approved a 1.6% increase that will be effective on April 1, 2007. Medicaid rates in some states have been under severe budget pressures. Commercial rates can vary significantly and a major portion of our commercial rates are at contracted amounts with major payors and are subject to intense negotiation pressure. Over the past threeseveral years we have beenwere successful in maintaining relatively stable average payment rates in the aggregate for patients with commercial plans, in addition to obtaining periodic fee schedule increases, althoughincreases. However, we are continuously in the process of negotiating agreements with our commercial payors which may resultand certain payors have become increasingly aggressive in their negotiations. In the fourth quarter of 2007, our overall commercial rate reductions were in excess of our overall commercial rate increases in the future.increases. We continue to expect downward pressure from payors on our contracted commercial payment rates as a result of general market conditions, recent and future consolidations among commercial payors, increased focus on dialysis services and other factors. In addition, payors have been attempting to impose restrictions and limitations on non-contracted or out-of-network providers, which could further decrease our commercial rate revenues.

 

ApproximatelySlightly more than 30% of our dialysis revenue for the year ended December 31, 2006,2007, has been associated with physician-prescribed pharmaceuticals, with EPO accounting for approximately 25%slightly more than 20% of our dialysis revenue. Therefore, changes in physician practice patterns, pharmaceutical protocols, pharmaceutical intensities and changes in private and governmental payment rates for EPO significantly influence our revenue levels. For example, in July 2007, CMS implemented a new reimbursement methodology for EPO which decreased our dialysis revenue per treatment and effective January 2008, changes to the EPO monitoring policy went into effect which further limit reimbursement and which have impacted the prescribing habits of our physicians. Such changes, driven by physician practice patterns and protocols focused on improving clinical outcomes, accounted for a significant portionas well as the reduction in some of the increase inour contracted commercial payment rates negatively impacted our average dialysis revenue per treatment in 2006.2007.

 

Our operating performance with respect to dialysis services charge-capture and billing and collection can also be a significant factor in how much average dialysis revenue per treatment we actually realize. Over the past threeseveral years we have invested heavily in new systems and processes that we believe have helped improve our operating performance and reduced our regulatory compliance risks and we expect to continue to improve these systems. We are currently in the process of upgradingIn 2007, we began integrating our billing systems into one system. Systems upgrades will continue in 2008 and collections systems as part of the integration of DVA Renal Healthcare’s systems, which could adversely affectimpact our collection performance during the transition period.as well as our dialysis revenue per treatment.

 

Our revenue recognition involves significant estimation risks. Our estimates are developed based on the best information available to us and our best judgment as to the reasonably assured collectibility of our billings as of the reporting date. Changes in estimates are reflected in the then-current period financial statements based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies.

 

Our annual average dialysis revenue per treatment including lab services for continuing operations was approximately $334, $330 and $323 for 2007, 2006, and $322 for 2006, 2005, and 2004, respectively. Principal factors affectingThe increase in our average dialysis revenue per

treatment in 2007 was primarily due to an increase in our standard fee schedules (principally impacting non-contracted commercial revenue) and an increase in the Medicare composite rate, partially offset by a decrease in the government reimbursement for pharmaceuticals associated with the new CMS reimbursement rates for EPO, and a decrease in intensities of physician-prescribed pharmaceuticals. In 2006, wereaverage dialysis revenue per treatment was impacted by increases in our standard fee schedules (principally impacting non-contracted commercial revenue) and changes in our commercial and government payor mix, as well as changes in the intensity of physician-prescribed pharmaceuticals. In 2005, the average revenue per treatment was impacted by the lower average revenue per treatment attributable to the DVA Renal Healthcare acquisition that became effective on October 1, 2005, and an overall decline in the intensities of physician-prescribed pharmaceuticals, offset by increases in our commercial standard fee schedules. The average revenue per treatment for the fourth quarter 2005 following the acquisition was $320 per treatment. Our ability to negotiate acceptable payment rates with contracted and non-contracted commercial payors, changes in the mix and intensities of physician-prescribed pharmaceuticals, government payment policies regarding reimbursement amounts for dialysis treatments and pharmaceuticals, and changes in the mix of government and non-government payments may materially impact our average dialysis revenue per treatment in the future. Additionally, the continuing integration process for the DVA Renal Healthcare billing system could adversely affect our collection performance during the transition period.

 

The principal drivers for our patient care costs are clinical hours per treatment, labor rates, vendor pricing of pharmaceuticals, and business infrastructure and compliance costs. However, other cost categories can also represent significant cost changes, such as increasedemployee benefit costs and insurance costs experienced in 2004.costs. Our average clinical hours

38


per treatment have improvedremained stable over the past threecouple of years primarily because of improved efficiencies driven by reduced teammate turnover and improved training and processes. We believe there is limited opportunity for productivity improvements beyond the levels previously achieved, in 2004 and 2005, andchanges in federal and state policies can adversely impact our ability to achieve optimal productivity levels. In 2006,2007, our clinical hours per treatment remained stable compared to 2005,2006, however, we did experience an increase in our labor rates per treatment of approximately 3%, as labor rates have increased consistent with general industry trends, mainly due to the demand for skilled clinical personnel, along with general inflation increases. For the past threeseveral years we have been able to negotiate relatively stable pharmaceutical pricing with our vendors. In addition, our agreement with Amgen for the purchase of EPO includes volumeprovides for specific rebates off of list price and discount pricing based on process improvement and other thresholdsdata submission and some combination of these factors, which could negatively impact our earnings if we are unable to meet those thresholds. Our acquisitionqualify for these rebates and discounts. In 2007, we experienced an increase in our infrastructure and operating costs of DVA Renal Healthcare did not have a significant impact on our overall patient costs on a per treatment basis.dialysis centers, primarily due to general increases in rent and repairs and maintenance.

 

General and administrative expenses have remained relatively constant as a percent of total revenues over the past three years. However, this reflects a substantial increasesincrease in the dollar amount of spending related to strengthening our business and regulatory compliance processes andas well as legal and other professional fees. We expect that these higher levelsthe level of general and administrative expenses will be sustained or possibly increased in 2008, in order to continue to support our long-term initiatives, including further investments in our ancillary services and strategic initiatives, and to support our efforts to achieve the highest levels of regulatory compliance.

 

Successful resolutions of disputed Medicare billings at our Florida lab resulted in recoveries related to prior years’ services being recognized as current period revenue and operating income of approximately $4 million, and $8 million in 2005, and 2004, respectively. We have received all expected recoveries and will not receive any additional recoveries in the future.

Outlook for 2007.2008.    We currently estimate ourOur operating income in 2007guidance for 2008, excluding the impact of any potential Medicare legislation, is still projected to be in the range of $700—$790-$760 million.850 million; however, we continue to believe that operating income is more likely to be in the lower end of the range for 2008. We are entering into a period of unusual earnings uncertainty. Therefore, the guidance range for 2008 does not capture as high a percentage of the potential outcomes as usual. 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,and uncertainties include those relating to the concentration of profits generated from commercial payor plans, continued downward pressure on average realized payment rates from commercial payors and possible reductions in private and government payment rates, changes in the structure of and payment rates under Medicare ESRD program which may further reduce Medicare payment rates, changes in pharmaceutical or anemia management practice patterns, payment policies or pharmaceutical pricing, our ability to maintain contracts with our physician medical directors, legal compliance risks, including our continued compliance with complex government regulations and the subpoena from the U.S. Attorney’s Office for the Eastern District of New York and the subpoenas from the U.S. Attorney’s Office for the Eastern District of Missouri and DVA Renal Healthcare’s compliance with itsthe corporate integrity agreement our abilityapplicable to completethe dialysis centers acquired from Gambro Healthcare and integrate acquisitions of businesses,assumed in connection with such acquisition, and the successful integrationresolution of DVA Renal Healthcare, including its billingongoing investigations by various federal and collection operations.state government agencies. You should read “Risk Factors” in Item 1A of this Annual Report on Form 10-K and the cautionary language contained in the forward looking statements and associated risks as discussed on page 1936 for more

information about these and other potential risks. We undertake no obligation to update or revise these projections, whether as a result of changes in underlying factors, new information, future events or otherwise.

 

39


Results of operations

 

Following is a summary of operating results for reference in the discussion that follows.

 

  Year ended December 31,

   Year ended December 31, 

Continuing Operations


  2006

 2005

 2004

   2007 2006 2005 
  (dollar amounts rounded to nearest million, except per treatment data)   (dollar amounts rounded to nearest million, except per treatment data) 

Net operating revenues:

                 

Current period services

  $4,881  100% $2,970  100% $2,169  100%  $5,264  100% $4,881  100% $2,970  100%

Prior years’ services—laboratory

   —     4    8      —      —      4  
  


 

   

                
   4,881   2,974    2,177      5,264    4,881    2,974  

Operating expenses and charges:

                 

Patient care costs

   3,390  70%  2,036  69%  1,470  68%   3,590  68%  3,390  70%  2,036  69%

General and administrative

   454  9%  272  9%  192  9%   491  9%  454  9%  272  9%

Depreciation and amortization

   173  4%  117  4%  83  4%   193  4%  173  4%  117  4%

Provision for uncollectible accounts

   126  2%  62  2%  39  2%   137  3%  126  2%  62  2%

Minority interests and equity income, net

   36  1%  22    12      45  1%  36  1%  22  1%

Valuation gain on Product Supply Agreement

   (38)       

Valuation gain on alliance and product supply agreement

   (55) (1)%  (38) (1)%  —    
  


 

   

                

Total operating expenses and charges

   4,141  85%  2,509  85%  1,796  83%   4,402  84%  4,141  85%  2,509  85%
  


 

   

                

Operating income

  $739  15% $465  16% $381  17%  $862  16% $739  15% $465  16%
  


 

   

                

Dialysis treatments

   14,495,796   9,044,966    6,654,069      15,318,995    14,495,796    9,044,966  

Average dialysis treatments per treatment day

   46,372   28,898    21,225      48,942    46,372    28,898  

Average dialysis revenue per treatment

  $320  $313   $313     $324   $320   $313  

Average dialysis revenue per treatment (including the lab)

  $330  $323   $322     $334   $330   $323  

 

The operating results of DVA Renal Healthcare are included in our operating results from October 1, 2005. Our operating income margins, excluding recoveries for prior years’ lab services andincreased to 16.4% in 2007 from 15.2% in 2006, primarily due to increases in revenue, an increase in the valuation gain on the Product Supply Agreement declined from 15.5% in 2005 to 14.4% in 2006, primarily due to higher laboralliance and product supply agreement, along with lower benefit costs, additionallower self-insurance costs, as well as a reduction in integration costs and SFAS No. 123(R) stock-based compensation expense.expenditures.

 

Net operating revenues

 

OperatingNet operating revenues for current period services increased by approximately 8% in 2007, as compared to 2006 and increased by approximately 64% in 2006, as compared to 2005 and increased 37%2005. The increase in 2005 comparednet operating revenues in 2007 was primarily due to 2004. Thean increase of approximately 5% in the number of dialysis treatments, and an increase of approximately 3% in the average dialysis revenue per treatment, additional lab revenue and an increase in revenue from our ancillary services and strategic initiatives. The increase in the number of dialysis treatments in 2007 was primarily due to non-acquired growth from existing and new centers and from acquisitions. Our average dialysis revenue per treatment of approximately $334 increased by approximately $4 in 2007 as compared to 2006.

The increase in net operating revenues in 2006 was primarily due to the number of dialysis treatments, which accounted for approximately 57% of the increase in revenues, in 2006, with approximately 49% primarily due to the acquisition of DVA Renal Healthcare effective on October 1, 2005 and the balance from acquisitions and growth in existing and new centers. The remaining 7% increase in total net operating revenuerevenues in 2006 was due to increases in the average dialysis revenue per treatment and additional management fees and revenuerevenues from ancillary services and strategic initiatives. The acquisition of DVA Renal Healthcare in the fourth quarter of 2005 accounted for approximately 22% of the increase in 2005, approximately 12% was due to increases in the number of dialysis treatments with the balance of approximately 3% due to additional increases in the average dialysis revenue per treatment and additional lab, management fees and ancillary revenue.

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Dialysis revenue, which includes dialysis services and related laboratory services, represented approximately 98%97%, 98% and 99%98% of net operating revenues in 2007, 2006, 2005, and 2004,2005, respectively. Ancillary services and strategic initiatives, including management fee income, accounted for the balance of our total revenues.

 

Dialysis Services

 

Dialysis revenuerevenue..    We generate approximately 82%, 9% and 6% of

The following table summarizes our total dialysis revenue from outpatient hemodialysis, peritoneal dialysis and home-based dialysis, and hospital inpatient hemodialysis, respectively, and 3% of our total dialysis revenue from laboratory services. by source for the year ended December 31, 2007.

Revenue
Percentages

Outpatient hemodialysis centers

82%

Peritoneal dialysis and home-based hemodialysis

9%

Hospital inpatient hemodialysis

6%

Laboratory services

3%

Total dialysis revenue

100%

Major components of dialysis revenue include both the administration of EPO and other pharmaceuticals as part of the dialysis treatment, which represents approximatelyslightly more than 30% of total dialysis revenue, and related laboratory services, as described below.revenue.

 

Approximately 65%64% of our total dialysis revenue for the year ended December 31, 20062007 is from government-based programs, principally Medicare, Medicaid, and Medicare Advantage Plans, representing approximately 87% of our total patients. Our commercial payors consist principally of commercial insurance plans, including more than 1,2001,100 with whom we have contracted rates. Approximately 13%36% of our dialysis revenue is associated with non-contracted commercial payors. Less thanApproximately 1% of our dialysis services and related dialysis services payments are received directly from patients. No single commercial payor accounted for more than 5% of total dialysis revenue for the year ended December 31, 2006.2007.

 

On average we are generally paid atsignificantly more than double Medicare or Medicaid rates for services provided to patients covered by commercial healthcare plans.plans than we are for patients covered by Medicare or Medicaid. Patients covered by employer group health plans transition to Medicare coverage after a maximum of 33 months. As of December 31, 2006,2007, the Medicare ESRD dialysis treatment rates for our patients were between $147$149 and $162$165 per treatment, or an overall average of $155$157 per treatment, excluding the administration of separately billed pharmaceuticals. Medicare payment rates are insufficient to cover our patient care costs associated with providing dialysis treatments, and therefore we lose money on each Medicare treatment.

 

Our net earnings from dialysis services are derived from commercial payors, some of which pay at negotiated payment rates and others of which pay based on our usual and customary fee schedule. While ourOur contracted commercial payment rates are under downward pressure as we negotiate contract rates with large HMOs and insurance carriers and we expect this trend to continue into 2008. In the fourth quarter of 2007, we have been successfulour overall commercial rate reductions were in offsetting these pressures through successful negotiating and price increases.excess of our overall commercial rate increases,. Additionally, as a patient transitions from commercial coverage to Medicare or Medicaid coverage, the payment rates normally decline substantially.

 

Our year-over-year treatment volume growth was as follows:

 

  2006

 2005

   2007 2006 

Treatment growth related to:

      

Existing and newly opened centers

  4.8% 5.4%  4.6% 4.8%

Other center acquisitions

  4.0% 7.5%  1.1% 4.0%

DVA Renal Healthcare acquisition effective 10/1/05

  51.5% 23.0%  —  % 51.5%
  

 

       

Total treatment growth

  60.3% 35.9%  5.7% 60.3%
  

 

       

 

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The annual average dialysis revenue per treatment, including lab services, for continuing operations was approximately $334, $330 and $323 for 2007, 2006, and $3222005, respectively. The increase in our average dialysis revenue per treatment in 2007 was primarily due to an increase in our standard fee schedules (principally impacting non-contracted commercial revenue) and an increase in the Medicare composite rate, partially offset by a decrease in the government reimbursement for pharmaceuticals associated with the new CMS reimbursement rates for EPO, and a decrease in intensities of physician-prescribed pharmaceuticals. In 2006, 2005, and 2004, respectively. Principal factors affecting ourthe average revenue per treatment in 2006 werewas impacted by increases in our standard fee schedules (principally impacting non-contracted commercial revenue), and changes in our commercial and government payor mix, as well as changes in the intensity of physician-prescribed pharmaceuticals. In 2005, the average revenue per treatment was impacted by the lower

average revenue per treatment attributable to the DVA Renal Healthcare acquisition that became effective October 1, 2005, and an overall decline in the intensities of physician-prescribed pharmaceuticals, offset by increases in our commercial standard fee schedules. The average revenue per treatment for the fourth quarter of 2005 following the acquisition was $320 per treatment. Our ability to negotiate acceptable payment rates with contracted and non-contracted commercial payors, changes in the mix and intensities of physician-prescribed pharmaceuticals, government payment policies regarding reimbursement amounts for dialysis treatments and pharmaceuticals, and changes in the mix of government and non-government payments may materially impact our average revenue per treatment in the future. Additionally, the continuing integration process for the DVA Renal Healthcare billing and collections operations could adversely affect our collections through the two to three year transition period.

 

Lab revenues.    Lab revenues represented approximately 3% of our total net operating revenues for 20062007 and 2005.2006.

 

A third-party carrier review of Medicare claims associated with our Florida-based laboratory was initiated in 1998. No Medicare payments were received for our lab services from the second quarter of 1998 until the third quarter of 2002 while we were appealing the Medicare payment withholds. Following a favorable administrative law judge ruling in 2002, we began receiving prior year Medicare payments in the third quarter of 2002, and received a total of approximately $83$91 million prior to 2004, $8 million in 2004,2005, and $4 million in 2005. There are no further significant unresolved Medicare lab billing issues.

 

Ancillary services and strategic initiatives

 

Ancillary services and strategic initiatives, including management fees, represented less than 2%approximately 3% of our total net operating revenues for both 2006in 2007 and 2005.approximately 2% in 2006. The increase in ancillary services and strategic initiative revenues were the result of the acquisition of HomeChoice Partners, an infusion therapy company, as well as growth in our pharmacy, vascular access and disease management businesses.

 

Management fee income.    Management fee income is included as part of our revenue from ancillary services and strategic initiatives, and represented less than 1% of net operating revenues for 20062007 and 2005.2006. We operated or provided administrative services to 23 and 38 third-party or minority-ownednon-controlled dialysis centers as of December 31, 2007 and 2006, and 2005.respectively. We also provided management and administrative services to 48 and 30 physician-owned vascular access clinics at December 31, 2006.2007 and 2006, respectively. Our management fees are principally based on a percentage of the revenue or cash collections of the managed operations, cash collections, or based upon a percentage of operating income. In JanuaryNovember 2007, we received notice that one of our management and administrative services agreements will bewas terminated, on November 30, 2007. As of December 31, 2006pursuant to which we provided management and administrative services to 1920 dialysis centers under this agreement.centers.

 

Operating expenses and charges

 

Patient care costs.    Patient care costs are those costs directly associated with operating and supporting our dialysis centers and ancillary operations, and consist principally of labor, pharmaceuticals, medical supplies and facility costs. As a percentage of current period operating revenues, patient care costs were approximately 68.2% for 2007, 69.5% for 2006 and 68.5% for 2005 and 67.8% for 2004.2005. On a per-treatment basis, patient care costs were flat in 2007 as compared to 2006 and increased year-over-yearby approximately $9 in 2006. The 2007 patient care costs were impacted by an increase in labor costs, higher operating costs of our dialysis centers, as well as an increase in our stock-based compensation expense, offset by a decrease in employee benefit costs and $4workers compensation, lower intensities of physician-prescribed pharmaceuticals and a reduction in 2006our professional and 2005, respectively.general liability insurance costs. The increase in 2006 was principally due to higher labor and benefit costs, increases in expenses

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related to our strategic initiatives and an increase in the intensities of physician-prescribed pharmaceuticals. The increase in 2005 was principally due to higher labor and benefit costs, and to a lesser extent medical supply costs. The higher labor costs in 2007 and 2006 reflect rising labor rates mainly due to the demand for skilled clinical personnel and the effect of the increase in the number of newly opened centers, which are not yet at normal productivity levels.

 

General and administrative expenses.    General and administrative expenses consist of those costs not specifically attributable to the dialysis centers, or the direct costs associated with our ancillary services and strategic initiatives, and include expenses for corporate and divisional administration, including centralized accounting, billing and cash collection functions, and regulatory compliance oversight. General and

administrative expenses as a percentage of current period operating revenues were 9.3%, 9.2%9.3%, and 8.9%9.2% in 2007, 2006, and 2005, respectively. The absolute dollar increase in general and 2004, respectively.administrative expense for 2007 was primarily due to higher labor costs, professional fees for legal and compliance initiatives and government investigations, stock-based compensation expense under SFAS No. 123(R), and the timing of certain expenditures, partially offset by lower integration costs related to the DVA Renal Healthcare acquisition. The absolute dollar increase in general and administrative expense for 2006 was primarily due to higher labor and benefit costs, professional fees for legal and compliance initiatives and government investigations, integration costs associated with the DVA Renal Healthcare acquisition and stock-based compensation expense under SFAS No. 123(R). The increase in general and administrative expense for 2005 was primarily due to infrastructure costs for expanding business operations, professional fees for legal and compliance initiatives and government investigations, higher labor costs, and integration costs associated with the DVA Renal Healthcare acquisition.

 

Depreciation and amortization.    Depreciation and amortization was approximately 4% of current period operating revenues for each of the past three years. The absolute dollar increase in depreciation and amortization in 20062007 was primarily due to additional centers from acquisitions and newly opened centers. The absolute dollar increase in 2006 was also due to additional centers from acquisitions and newly opened centers, as well as amortization of intangible assets associated with the DVA Renal Healthcare acquisition, offset by the amortization of the Alliance and Product Supply Agreement as described below.

 

Provision for uncollectible accounts.    As a result of the DVA Renal Healthcare acquisition and the higher historical provision rate for DVA Renal Healthcare, the post-acquisition averageThe provision for uncollectible accounts receivable was 2.6% in the fourth quarter of 2005. This rate was consistently maintained infor 2007 and 2006 and is expected to remain stable in 2007.2008. The provisionsprovision for uncollectible accounts receivable werewas approximately 2.1% of current period operating revenues for the full year 2005, and 1.8% for 2004.2005.

 

Minority interests and equity income, net.    Minority interests net of equity income increased toby approximately $36$10 million in 2006, an increase of2007, and increased by approximately $14 million over 2005.in 2006. The increase wasincreases for both years were primarily due to an increase in new dialysis centers having minority partners, as well as growth in the earnings of our joint ventures.ventures and an increase in non-wholly-owned subsidiaries.

 

Product Supply Agreement.    On May 29, 2006, we notified Gambro Renal Products Inc. (Gambro Renal Products) that we were terminating theWe entered into an Alliance and Product Supply Agreement (the Product(Product Supply Agreement) with Gambro AB and Gambro Renal Products. The Product Supply Agreement was entered intoProducts, Inc. on October 5, 2005, in conjunction with our acquisition of DVA Renal Healthcare andHealthcare. The agreement committed us to purchase a significant majority of our hemodialysis products, supplies and equipment at fixed prices. Our termination notice claimed a material breach by Gambro Renal Products for failure to perform its obligations under theprices through 2015. The agreement was amended on August 25, 2006 (the Amended Product Supply Agreement, primarily as a resultAgreement) to reduce our purchase obligations for certain hemodialysis product supplies and equipment and to allow for the termination of purchase obligations for certain equipment then affected by an import ban issued by the U.S. Food and Drug Administration affecting certain hemodialysis products.

On August 25, 2006, we entered into an amended and restated Product Supply Agreement (the Amended Supply Agreement), with Gambro Renal Products and Gambro AB. The Amended Supply Agreement effectively revoked our notice of termination of the Product Supply Agreement. The Amended Supply Agreement, among other things, relieves us of certain obligations, including releasing us from the purchase requirements for certain affected products during the import ban, permits us to secure alternate sources of supplies for the products affected by the import ban, reduces our purchase obligations for certain hemodialysis product supplies and equipment and also allows for the termination of the purchase obligations for equipment affected by the import ban(FDA) if the import ban iswas not lifted by June 30, 2007.

 

As a result of the reductions in the amount of purchase obligations that are now required under the Amended Product Supply Agreement, we recorded a net valuation gain of approximately $38.0 million.$38 million during 2006. This valuation gain represents the difference in the amortized original fair value between the Product Supply Agreement and that of the Amended Product Supply Agreement, as of the effective date of the amendment.

On July 2, 2007, we notified Gambro Renal Products, Inc. that we were electing to be permanently relieved of our obligation under the Amended Product Supply Agreement to purchase dialysis machines (the Affected Products) because the Affected Products remained subject to the FDA import ban after June 30, 2007. All other

43


purchase obligations under the Amended Product Supply Agreement, which continues to require us to purchase a significant majority of our hemodialysis non-equipment product supplies, such as dialyzers, at fixed prices, remain in place.

As a result of the termination of our purchase obligations for the Affected Products, we recorded a net valuation gain of $55 million in 2007. This valuation gain represents the difference in the amortized original fair value of the Amended Product Supply Agreement and that of the Amended Product Supply Agreement as adjusted for the termination of the Affected Products as of June 30, 2007.

 

Impairments and valuation adjustments.    We perform impairment or valuation reviews for our property and equipment, amortizable intangibles, investments in and advances to third-party dialysis businesses, and our ancillary services and strategic initiatives at least annually and whenever a change in condition indicates that a

review is warranted. Such changes include shifts in our business strategy or plans, the quality or structure of our relationships with our partners, or when a center experiences deteriorating operating performance. Goodwill is also assessed at least annually for possible valuation impairment using fair value methodologies. No significant impairments or valuation adjustments were recognized during the periods presented.

 

Debt expense

 

Debt expense for 2007, 2006, 2005, and 20042005 consisted of interest expense of approximately $243 million, $263 million, $134 million, and $50$134 million, respectively, amortization of deferred financing costs of approximately $10 million in 2007, $10 million in 2006, and $5 million in 2005, and $2 million in 2004,2007 and in 2006, included the write-off of approximately $3.3$4 million and $3 million of deferred financing costs associated with the principal prepayments on our term loans. The decrease in interest expense in 2007 as compared to 2006 was primarily attributable to lower average outstanding principal balances during 2007 under our Senior Secured Credit Facilities, as a result of principal prepayments, and decreases in the LIBOR-based variable interest rates on the unhedged portion of our debt. Our overall weighted average interest rate in 2007 was 6.49% as compared to 6.64% in 2006. The increase in interest expense in 2006 as compared to 2005 was primarily attributable to additional borrowings outstanding during 2006 under our credit facility,Senior Secured Credit Facilities, the increase in the average outstanding balances of our senior and senior subordinated notes, which were issued in March 2005, and increases in the LIBOR-based variable interest rates on the unhedged portion of our debt. The increase in interest expense in 2005 as compared to 2004 was primarily attributable to borrowings under our credit facility in connection with the acquisition of DVA Renal Healthcare that was effective October 1, 2005, increases in the LIBOR-based variable interest rates and issuance of our new senior and senior subordinated notes that have average fixed interest rates of approximately 7.0%, offset by changes in our LIBOR-based receipts from swap settlements.

 

Other income

 

Other income, whichnet was a net of approximately $22 million, $13 million, and $9 million for 2007, 2006, and $4 million for 2006, 2005, and 2004, respectively, consisted principally of interest income. The increase in other income in 2007 and 2006 was primarily due to an increase in our cash and investments. The increase in 2007 was also due to gains on sale of investments.

 

Provision for income taxes

 

The provision for income taxes for 20062007 represented an effective annualized tax rate of 39.2%, compared with 39.2% and 37.4% in 2006 and 38.6% in 2005, and 2004 respectively. The changes in the effective tax rates in 2006 were primarily due to state income taxes and tax valuation allowance adjustments. We currently project that the effective income tax rate for 20072008 will be in the range of 39.5%39.0% to 40%40.0%.

 

Accounts receivable

 

Our accounts receivable balances at December 31, 20062007 and 20052006 represented approximately 7066 and 7170 days of revenue, respectively, net of bad debt provision. The relative decrease in the days of net revenue in accounts receivable as of December 31, 20062007 was a result of improved cash collections.

 

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As of December 31, 20062007 approximately $50$23 million in unreserved accounts receivable, representing approximately 5%2% of our total accounts receivable balance, were more than six months old. There were no significant unreserved balances over one year old. Less than one-half ofApproximately 1% of our treatments are classified as “patient pay”. Virtually all revenue realized is from government and commercial payors, as discussed above.

 

Amounts pending approval from third-party payors as of December 31, 20062007 and 2005,2006, other than the standard monthly processing, consisted of approximately $16$31 million and $24$16 million, respectively, associated with Medicare bad debt claims, classified as “other receivables”. OurCurrently, our Medicare bad debt claims are typically not paid to us untilbefore the Medicare fiscal intermediary audits the claims, and suchclaims. However, the payment received from Medicare is subject to adjustment based upon the actual results of the audits. Such audits typically occur one to four years after the claims are filed. As a kidney dialysis provider, our revenue is not subject to cost report settlements except for potentially limiting the collectibility of Medicare bad debt claims.

DVA Renal Healthcare acquisition

 

On October 5, 2005, we completed our acquisition of DVA Renal Healthcare, Inc. from Gambro, Inc. under a Stock Purchase Agreementstock purchase agreement dated December 6, 2004, for $3.06 billion. DVA Renal Healthcare was one of the largest dialysis service providers in the United States, operating 566 outpatient dialysis centers serving approximately 43,000 patients and generating annual revenues of approximately $2 billion. The operating results of DVA Renal Healthcare are included in our consolidated financial statements from October 1, 2005.

 

Divestitures per Federal Trade Commission Consent Order.    As a condition of completing the DVA Renal Healthcare acquisition, we were required by the Federal Trade Commission to divest a total of 69 outpatient dialysis centers and to terminate two management services agreements. On October 6, 2005, DaVita and DVA Renal Healthcare completed the sale of 71 outpatient renal dialysis centers, and terminated the two management services agreements. In addition, effective January 1, 2006, we completed the sale of three additional centers to Renal Advantage, Inc. that were previously pending state regulatory approval in Illinois. We received total cash consideration of approximately $330 million for all of the centers divested and used approximately $13 million to purchase the minority interest ownership of a joint venture, to distribute a minority owner’s share of the sale proceeds, and to pay related transaction costs. We also paid related income taxes of approximately $85 million on these divestitures during the first quarter of 2006. As part of this transaction, Renal Advantage assumed specific liabilities related to the centers and all other liabilities were retained by us. See Note 419 to the Consolidated Financial Statements.

 

The operating results of the historical DaVita divested centers are accounted for as discontinued operations in our consolidated financial statements for 2005 and prior.2005.

 

Liquidity and capital resources

 

Available liquidity.    As of December 31, 20062007 our cash balance was $310$447 million and we had undrawn credit facilitiesSenior Secured Credit Facilities totaling $253.6$250 million, ($250 million with our senior secured credit facility and $3.6 million associated with several joint ventures) of which approximately $50$41 million was committed for outstanding letters of credit. We also had other undrawn revolving lines of credit totaling $7.2 million associated with several of our joint ventures. We believe that we will have sufficient liquidity, and operating cash flows and access to borrowings to fund our scheduled debt service and other obligations for the foreseeable future. Our primary sources of liquidity are cash from operations and cash from borrowings.

 

Cash flow from operations during 20062007 amounted to $520$533 million, compared with $486$520 million for 2005.2006. Cash flow from operations in 2007 included cash interest payments of approximately $245 million and cash tax payments of $206 million. Cash flow from operations in 2006 included an income tax payment of approximately $85 million associated with divestituresthe divestiture of certain centers in conjunction with the DVA Renal Healthcare acquisition, and also included cash interest payments of approximately $272 million reflectingand other cash tax payments of $125 million. Non-operating cash outflows in 2007 included $272 million for capital asset expenditures, including $162 million for new center developments and relocations, and an additional $127 million for acquisitions.

45


During 2007 we also received $37 million from the maturity and sale of investments as well as an additional $88 million associated with stock option exercises and other share issuances and the related excess tax benefits. We also repurchased 0.1 million shares of our higher outstanding debt balances as a result of the DVA Renal Healthcare acquisition. Cash interest payments in 2005 werecommon stock for approximately $86$6.4 million. Non-operating cash outflows in 2006 included $263 million for capital asset expenditures, including $143 million for new center developments and relocations, and an additional $87 million for acquisitions. We alsoIn 2006, we received in 2006 approximately $22 million fromfor the sale of discontinued operations and asset sales. Non-operating cash outflows in 2005 included $161 million for capital asset expenditures, including $93 million forDuring 2007, we acquired a total of 16 dialysis centers, opened 64 new center developments,dialysis centers, sold or closed 6 centers, and an additional $3,202 million for acquisitions.discontinued providing management and administrative services to 21 centers. We also receivedacquired a 50% noncontrolling ownership interest in 2005 approximately $299 million from the sale of discontinued operations.a joint venture that operates six dialysis centers. During 2006 we acquired a total of 26 dialysis centers, including two centers that we previously held a minority-ownedminority owned interest, opened 55 new dialysis centers and divested, sold or closed 14 centers. The acquisition of DVA Renal Healthcare in the fourth quarter of 2005 resulted in the net addition of 492 dialysis centers after related divestitures. We acquired 54 other dialysis centers and opened 46 new dialysis centers during 2005.

 

We currently expect to spend approximately $110 million to $120 million for general maintenance capital asset expenditures in 2007,2008, and approximately $200 million to $220 million for new center development, relocations and center acquisitions. Our current projections include opening approximately the same number of

centers in 20072008 that we opened in 2006.2007. We expect to generate approximately $440$480 million to $510$530 million of operating cash flow in 2007.2008.

 

20062007 capital structure changes and other capital items.

Our Senior Secured Credit Facilities are guaranteed by substantially all of our direct and indirect wholly-owned subsidiaries and are secured by substantially all of our and our subsidiary guarantors’ assets. The Senior Secured Credit Facilities also contain customary affirmative and negative covenants and require compliance with financial covenants, including an interest rate coverage ratio and a leverage ratio that determines the interest rate margins on term loan A and the revolving line of credit. The Senior Secured Credit Facilities in general also contain limits on the general amount of capital expenditures for internal growth, acquisitions and capital improvements, see discussion below, as well as limits on the amount of tangible net assets for non-guarantor subsidiaries.

During 2006,2007, we made principal payments totaling $62$50 million on the term loan A and $338$400 million on theterm loan B. The term loan B payment was made from the proceeds of issuing new senior notes as discussed below. These principal payments were prepayments. As a result of the principal prepayment made in 2007 we wrote off a total of $4.4 million of deferred financing costs, which is included mandatoryin debt expense.

Term Loan A

On February 27, 2007, our interest rate margin on term loan A was reduced by 0.25% as a result of achieving certain financial ratios as defined in the Senior Secured Credit Facilities. Term loan A currently bears interest at LIBOR plus a margin of 1.50%, for an overall effective rate of 6.35% at December 31, 2007. The interest rate margin is subject to adjustment depending upon certain financial conditions and could range from 1.50% to 2.25%. Term loan A matures in October 2011 and requires annual principal payments of $35 million and $24.5 million respectively. All of the mandatory principal payments were paid in advance of the scheduled payment dates in 2006. Because of the principal prepayments, our next mandatory principal payments are $12.4 million in 2007, $52.5$14.9 million in 2008, $61.3 million in 2009, $87.5 million in 2010 and $65.6 million in 2011, for the term loan A and $379 million in 2011 and $1,727 million in 2012, for the term loan B. As a result of the principal prepayment made in 2006, we wrote-off approximately $3.3 million of deferred financing costs, which is included in debt expense.respectively.

Term Loan B

 

On March 1, 2006,February 23, 2007, we amended and restated our existing Senior Secured Credit Facilities to, among other things, reduce the interest rate marginsmargin on our term loan A and term loan B (collectively, the Credit Facility)by 0.50%, were reduced by 0.25% as a result of achievingand to amend certain financial ratios as defined in the Credit Facility. At December 31, 2006, the term loan A bears interest at LIBOR plus 1.75% and thecovenants. The amended term loan B bears interest at LIBOR plus 2.00%. The margins are subject to adjustment depending upon changes ina margin of 1.50%, for an overall effective rate of 5.80%, including the impact of our financial ratios and can range from 1.50% to 2.25%swap agreements, except for the forward interest rate swap agreements, as of December 31, 2007. Other terms that were changed included the amount by which we can elect to increase the revolving credit facility and term loan A,commitments from $500 million to $750 million and 2.00% to 2.25%certain limitations on purchases, redemptions or acquisitions of capital stock, the payment of dividends and distributions in cash. Further,

46


limitations on capital expenditures for internal growth will not apply during the periods in which our leverage ratio is less than 3.5:1. Our leverage ratio as of December 31, 2007 was less than 3.5:1. We incurred financing costs of $1.8 million which were deferred and also expensed $0.2 million of other costs in connection with this transaction. Term loan B matures in October 2012 and requires principal payments of $1.7 billion in year 2012.

Senior and Senior Subordinated Notes

On February 23, 2007, we issued $400 million of 6 5/8% senior notes due 2013 in a private offering, realizing $405 million in proceeds, which included a $5 million premium, and incurred $2.7 million in related deferred financing costs. These senior notes are part of the same series of debt securities as the $500 million aggregate principal amount of 6 5/8% senior notes that were issued in March 2005. The effective interest rate for the $400 million of 6 5/8% senior notes is 6.45%. The senior notes are guaranteed by substantially all of our direct and indirect wholly-owned subsidiaries and require semi-annual interest payments which began March 15, 2007. The senior notes may be redeemed by us in whole or part at any time on or after March 15, 2009, at certain specified prices. We used $400 million of these proceeds to pay down our term loan B. Our credit agreement contains customary affirmative and negative covenants and requires compliance with certain financial covenants, including a leverage ratio and an interest coverage ratio that determine the interest rate margins describedB as discussed above. The credit agreement also contains limits on the annual amount of expenditures for acquisitions and capital improvements.

 

Our senior and senior subordinated notes, consistas of $500December 31, 2007, consisted of $900 million of 6 5/8% senior notes due 2013 and $850 million of 7 1/4% senior subordinated notes due 2015. The notes are guaranteed by substantially all of our direct and indirect wholly-owned subsidiaries and require semi-annual interest payments.payments in March and September. We may redeem some or all of the senior notes at any time on or after March 15, 2009as described above and some or all of the senior subordinated notes at any time on or after March 15, 2010.

 

Interest rate swaps

As of December 31, 2006,2007, we maintained a total of nine interest rate swap agreements with amortizing notional amounts totaling $1,341$968 million. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of our debt to fixed rates ranging from 3.08% to 4.27%, resulting in aan overall weighted average effective interest rate of 5.88%,5.37% on the hedged portion of our Senior Secured Credit Facility,Facilities, including the term loan B margin of 2.00%1.50%. The swap agreements expire in 2008 through 2010 and require quarterly interest payments. In addition, we maintain two forward interest rate swap agreements with notional amounts totaling $200 million. These forward interest rate swaps will have the economic effect of modifying the LIBOR-based interest rates to fixed rates of 4.05% and 4.70% on our term loan B outstanding debt. These forward interest rate swaps agreements take effect September 30, 2008, require quarterly interest payments bear amortizing notional amounts,beginning in December 2008, and expire in 2008 through 2010. During 2007, 2006, and 2005 we accrued net cash benefits (obligations) of approximately $14.5 million, $15.8 million, and $(0.3) million, respectively from these swaps, which are included in debt expense. During 2005, we also incurred additional net cash obligations of $1.5 million from these swaps, which is included in debt expense.swap valuation gains. We estimate that approximately $0.5 million of existing unrealized pre-tax losses in other comprehensive income at December 31, 2007 will be reclassified into income in 2008. As of December 31, 2007 and 2006, the total fair value of these swaps was a net liability of $0.5 million, and an asset of $29.5 million. Wemillion, respectively. The 2007 amount was primarily included in other long-term liabilities and the 2006 amount was primarily included in other long-term assets. Also during 2007 and 2006, we recorded $7.9$16.0 million and $1.8 million, respectively, net of tax, as an increasereductions to other comprehensive income for the change in fair valuevaluation losses, net of the effective portions of these swaps during 2006.amounts reclassified into income.

 

As of December 31, 2006, the interest rates were economically fixed on2007, we had approximately 56%50% of our variable rate debt and approximately 72%74% of our total debt.debt economically fixed.

 

As a result of the swap agreements, at December 31, 2006, our overall effective weighted average interest rate on the Senior Secured Credit FacilityFacilities was 6.61%5.90%, based upon the current margins in effect ranging from 1.75% to 2.00%of 1.50%, andas of December 31, 2007.

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At December 31, 2007, our overall average effective interest rate was 6.76%6.37%.

 

On February 23, 2007, we issued $400 million of 6 5NxStage Agreement/8% senior notes due 2013 in a private offering. These senior notes are part of the same series of debt securities as the $500 million aggregate principal amount of 6 5/8% senior notes that were issued in March 2005. The senior notes are guaranteed by our direct and indirect wholly-owned subsidiaries and require semi-annual interest payments beginning March 15, 2007. The senior notes may be redeemed in whole or part at any time on or after March 15, 2009, at certain specified prices. We used the proceeds to pay down our term loan B and also wrote off approximately $4 million of term loan B deferred financing costs.

On February 23, 2007, we amended and restated our existing Senior Secured Credit Facilities to, among other things, reduce the interest rate margin on our term loan B by 0.50%, and to amend certain covenants. The new term loan B will bear interest at LIBOR plus 1.50%. If we refinance the term loan B prior to February 23, 2008, we will be subject to a prepayment penalty of 1.0%, otherwise the payment terms remain the same. In addition, the amount by which we can elect to increase the revolving and term loan commitments was changed from $500 million to $750 million.

 

On February 7, 2007, we entered into a National Provider Agreement with NxStage, Inc. The agreement provides us the ability to purchase NxStage home-based hemodialysis products at a potential discount depending upon the achievement of certain volume targets. The agreement has an initial term of three years, terminating on December 31, 2009, and may be extended in six monthsix-month increments up to two additional years if certain volume targets are met. As a part of the agreement, we purchased outright all of our NxStage System One equipment currentlythen in use for $5.1 million, and will purchase a majority of our future home-based hemodialysis equipment and supplies from NxStage. In connection with the provider agreement, we purchased 2two million shares of NxStage common stock in a private placement offering for $20 million, representing an ownership position of approximately 7%. In connection withWe subsequently sold our NxStage Inc. shares, in the purchasesecond and third quarters of the shares, we entered into2007 for approximately $25.9 million and recognized a Registration Rights Agreement under which NxStage has agreed to register the shares.pre-tax gain of $5.9 million or $3.6 million after tax. This pre-tax gain is included in other income.

 

Stock-based compensation and other equity matters

 

Effective January 1, 2006, we implemented Statement of Financial Accounting Standards (SFAS) No. 123(R)Share-Based Payment, which requires the measurement and recognition of cost for all stock-based awards made to employees and directors, including stock options, stock appreciation rights, stock units, and discounted employee stock purchases. Under SFAS No. 123 (R)123(R) our stock-based compensation awards are measured at estimated fair value on the date of grant and recognized as compensation expense over their requisite service periods. SFAS No. 123(R) supersedes our previous accounting under Accounting Principles Board Opinion (APB) No. 25Accounting for Stock Issued to Employees, under which we did not recognize compensation expense for most of our stock options. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the application of SFAS No. 123(R), and we have applied the provisions of SAB No. 107 in our adoption of SFAS No. 123(R).

 

We implemented SFAS No. 123(R) using the modified prospective transition method. In accordance with this method, our consolidated financial statements for periods prior to fiscal year 2006 have not been restated to reflect this change. SFAS No. 123(R) also requires that tax benefits realized from stock award exercise gains in excess of stock-based compensation expense recognized for financial statement purposes be reported on a prospective basis as cash flows from financing activities rather than as operating cash flows. We also elected to use the method available under Financial Accounting Standards Board, or FASB, Staff Position FSP No. 123(R)-3Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, which provides an alternative method for calculating historical excess tax benefits from the method described in SFAS No. 123(R) for stock-based compensation awards.

 

Under SFAS No. 123(R), stock-based compensation recognized during a period is based on the estimated grant-date fair value of the portion of the stock-based award vesting during that period, adjusted for expected forfeitures. Stock-based compensation recognized in our consolidated financial statements for 2007 and 2006 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, December 31, 2005 and subsequent stock-based awards granted in 2006. We previouslythrough December 31, 2006 and 2007. Prior to 2006, we recognized the effect of stock unit forfeitures as they occurred, and the effect of transitioning to recognition of expense based on expected forfeitures was insignificant. Shares issued upon exercise of stock awards are generally issued from shares in treasury. We have utilized the Black-Scholes-Merton valuation model for estimating the fair value of stock options and stock-settled stock appreciation rights granted in 2007, 2006 as well as for stock option grants duringand all prior periods.

 

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For the yearyears ended December 31, 2007 and 2006, we recognized $34.1 million and $26.4 million, respectively, in stock-based compensation expense for stock options, stock-settled stock appreciation rights, stock units and discounted employee stock plan

purchases, which is primarily included in general and administrative expenses in continuing operations. The estimated tax benefitbenefits recorded for this stock-based compensation wasin 2007 and 2006 were $12.8 million and $9.7 million.million, respectively. As of December 31, 2006,2007, there was $67.7$78.6 million of total estimated unrecognized compensation cost related to nonvested stock-based compensation arrangements under our equity compensation and stock purchase plans. We expect to recognize this cost over a weighted average remaining period of 1.71.6 years.

 

During the year-endedyears ended December 31, 2007 and 2006, we received $54.7 million and $37.9 million, respectively, in cash proceeds from stock option exercises and $32.8 million and $40.4 million, respectively, in total actual tax benefits upon the exercise of stock awards.

 

On May 29, 2007, our stockholders approved an amendment to our Amended and Restated Certificate of Incorporation, to increase the number of shares of authorized common stock from 195,000,000 to 450,000,000 shares. Our stockholders also approved an amendment and restatement of our Employee Stock Purchase Plan to increase the number of shares of common stock available for issuance under that plan by 800,001 shares, and approved an amendment and restatement of our 2002 Equity Compensation Plan to increase the number of shares of common stock available for issuance under that plan by 6,000,000 shares and, among other things, to remove certain available share recycling features, to change the limit on the maximum number of shares of common stock that may be subject to awards granted to any single recipient in any consecutive twenty-four month period so that it applies only to awards of stock options and stock appreciation rights, and to provide additional exceptions from the three year minimum vesting period generally applicable to grants of restricted stock units and other full share awards.

20052006 capital structure changes.    On October 5, 2005,During 2006, we entered into a credit agreement allowing for borrowings of up to $3.05 billion. The facilities under the credit agreement consist of a $250made principal payments totaling $62 million six-year revolving credit facility, a $350 million six-yearon our term loan A facility and a $2,450$338 million seven-yearon term loan B facility (the Facilities). Existing borrowings underwhich included mandatory principal payments of $35 million and $24.5 million respectively. All of the Facilities bearmandatory principal payments were paid in advance of the scheduled payment dates in 2006. As a result of the principal prepayment made in 2006, we wrote-off approximately $3.3 million of deferred financing costs, which is included in debt expense.

On March 1, 2006, our interest atrate margins on our term loan A and term loan B were reduced by 0.25% as a result of achieving certain financial ratios as defined in the Senior Secured Credit Facilities. At December 31, 2006, the term loan A interest rate was based on LIBOR plus margins initially ranging from1.75% and the term loan B interest rate was based on LIBOR plus 2.00% to 2.25%. The margins arewere subject to adjustment depending upon changes in our achievement of certain financial ratios and can rangecould have ranged from 1.50% to 2.25% for the revolving line of credit facility and the term loan A, and 2.00% to 2.25% for the term loan B. The Facilities are guaranteed by substantially all of our direct and indirect wholly-owned subsidiaries and are secured by substantially all of our and our subsidiary guarantors’ assets. The credit agreement also contains customary affirmative and negative covenants and requires compliance with financial covenants, including a leverage ratio and an interest coverage ratio that determine the interest rate margins described above. The aggregate amount of the Facilities may be increased by up to $500 million as long as no default exists or would result from such increase and we remain in compliance with the financial covenants after such increase. Such additional loans would be on substantially the same terms as the original borrowings under the Facilities.

On October 5, 2005, we borrowed $2,850 million under the Facilities ($50 million on the revolving credit facility, $350 million on the term loan A and $2,450 million on term loan B), and used these borrowings, along with available cash of $252 million, to purchase DVA Renal Healthcare and pay related bank fees and expenses of approximately $47 million and to pay fees and expenses in connection with terminating our then-existing credit facility. On October 7, 2005, we repaid the $50 million of the revolving credit facility with proceeds from the sale of the divested centers.

 

On March 22, 2005, we issuedAs of December 31, 2006, our senior and senior subordinated notes consisted of $500 million of 65/8% senior notes due 2013 and $850 million of 7 1/4% senior subordinated notes due 2015 and incurred related deferred financing costs of $28.6 million.2015. The notes are guaranteed by substantially all of our direct and indirect wholly-owned subsidiaries and require semi-annual interest payments. We may redeem some or all of the senior notes at any time on or after March 15, 2009 and some or all of the senior subordinated notes at any time on or after March 15, 2010. We used the net proceeds of $1,323 million along with available cash of $46 million to repay all outstanding amounts under the term loan portions of our then-existing credit facilities, including accrued interest.

In conjunction with the repayment and extinguishment of our prior credit facilities during 2005, we wrote-off deferred financing costs of $8.2 million and reclassified into net income $8.1 million of swap valuation gains that were previously recorded in other comprehensive income. These gains represented the accumulated fair value of several interest rate swap instruments that became ineffective as cash flow hedges as a result of the repayment of our prior credit facilities. In addition we recorded a net loss of $2.1 million related to changes in fair values of these swaps that were not effective as interest rate hedges until they were redesignated in the second quarter of 2005.

Portions of our various interest rate swap agreements that were previously designated and expected to be effective as forward cash flow hedges became ineffective as a result of us not having any variable rate LIBOR-based interest payments during a portion of 2005. This resulted in a net charge of $1.7 million to swap valuation gains, which includes the $1.5 million discussed below as well as a reclassification into income of $2.0 million of swap valuation losses that were previously recorded in other comprehensive income. The swap payment periods

that began after October 2005 were highly effective cash flow hedges with gains or losses from changes in their fair values reported in other comprehensive income.

 

As of December 31, 2005,2006, we maintained a total of nine interest rate swap agreements, with amortizing notional amounts totaling $1,580$1,341 million. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of our debt to fixed rates ranging from 3.08% to 4.27%, resulting in an overalla weighted average effective interest rate of 6.1%5.88%, which includedon the hedged portion of our Senior Secured Credit Facilities, including the term loan B margin of 2.25%2.00%. The swap agreements require quarterly interest payments, bear amortizing notional amounts, and expire in 2008 through 2010 and require quarterly interest payments. During 2005, we incurred net cash obligations of approximately $1.8 million from these swaps, $0.3 million of which is included in debt expense and $1.5 million of which is included in swap valuation gains. 2010.

As of December 31, 2005,2006, the interest rates were economically fixed on approximately 56% of our variable rate debt and approximately 72% of our total fair value of these swaps was an asset of approximately $30.8 million. Also during 2005, we recorded $16.8 million, net of tax, of additional comprehensive income for the changes in fair valuedebt.

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As a result of the effective portions of these swaps.

Atswap agreements at December 31, 2005,2006, our overall credit facilityeffective weighted average effective interest rate on our Senior Secured Credit Facilities was 6.62%6.61%, based upon the current margins in effect ranging from 1.75% to 2.00%, and our overall average effective interest rate was 6.74%6.76%.

As of December 31, 2005, we had approximately 55% of our variable rate debt and approximately 70% of our total debt economically fixed.

 

Off-balance sheet arrangements and aggregate contractual obligations

 

In addition to the debt obligations reflected on our balance sheet, we have commitments associated with operating leases, letters of credit and our investments in third-party dialysis businesses. Substantially all of our facilities are leased. We have potential acquisition obligations for several jointly-owned centers and for some of our non-wholly-owned subsidiaries, in the form of put provisions, in joint venture agreements, which are exercisable at the third-party owners’ future discretion. These put provisions, if exercised, would require us to purchase the third-party owners’ interests at either the appraised fair market value or a predetermined multiple of earnings or cash flow attributable to the equity interest put to us.us, which approximates fair value. We also have potential cash commitments to provide operating capital advances as needed to several other third-party owned centers, minority ownednoncontrolling-owned centers and physician–owned vascular access clinics that we operate under administrative services agreements.

The following is a summary of these contractual obligations and commitments as of December 31, 20062007 (in millions):

 

  Less Than
1 Year


  

1-3

Years


  

3-5

Years


  

After

5 Years


  Total

  Less Than
1 year
  1-3
years
  3-5
years
  After
5 years
  Total

Scheduled payments under contractual obligations:

                         

Long-term debt

  $18  $117  $532  $3,077  $3,744  $22  $152  $1,772  $1,750  $3,696

Interest payments on senior and senior subordinated notes

   95   190   190   264   739   121   243   243   183   790

Capital lease obligations

   3   1   1   2   7   1   1   1   4   7

Operating leases

   148   258   198   294   898   170   288   223   336   1,017

FIN No. 48 tax liabilities

   4   9   4   —     17
  

  

  

  

  

               
  $264  $566  $921  $3,637  $5,388  $318  $693  $2,243  $2,273  $5,527
  

  

  

  

  

               

Potential cash requirements under existing commitments:

                         

Letters of credit

  $50           $50  $41        $41

Acquisition of dialysis centers

   100   38   33   21   192   131   99   54   46   330

Working capital advances to third-parties under administrative services agreements

   11            11   18         18
  

  

  

  

  

               
  $161  $38  $33  $21  $253  $190  $99  $54  $46  $389
  

  

  

  

  

               

 

Not included above are interest payments related to our credit facilities.Senior Secured Credit Facilities. Our credit facilitiesSenior Secured Credit Facilities as of December 31, 2007 bear interest at LIBOR plus current margins ranging from 1.75%of 1.50%. The term loan A and 2.00% andthe revolving line of credit are adjustable depending upon our achievement of certain financial ratios. At December 31, 20062007, our credit facilitiesSenior Secured Credit Facilities had an overall effective weighted average interest rate of 6.61%.5.90%, including the effects of our swap agreements. Interest payments are due at the maturity of specific debt tranches within each Term Loan,term loan, which can range in maturity from one month to twelve months. Future interest payments will depend upon the amount of mandatory principal payments and principal prepayments, as well as changes in the LIBOR-based interest rates and changes in the interest rate margins. Assuming no principal prepayments on our credit facilitiesSenior Secured Credit Facilities during 20072008 and no changes in the effective interest rate, during 2007, approximately $158$116 million of interest would be required to be paid in 2007.2008.

 

In addition to the above commitments, we entered into anOur Amended Alliance and Product Supply Agreement on October 5, 2005, with Gambro AB and Gambro Renal Products, Inc. in conjunction with our acquisition of DVA Renal Healthcare that committed(the Amended Product Supply Agreement) requires us to purchase a significant majority of ourcertain hemodialysis products, supplies and equipment at fixed prices overthrough 2015. On July 2, 2007, we notified Gambro Renal Products, Inc. that we were electing to be permanently relieved of our purchase obligation under the next ten years. The Alliance and Amended

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Product Supply Agreement was amended on August 25, 2006 to reduce our purchase obligations for certain hemodialysis product supplies and equipment anddialysis machines (the Affected Products) because the Affected Products remained subject to allow for the termination of purchase obligations for certain equipment currently affected by an FDA import ban issued by the U.S. Food and Drug Administration if the import ban is not lifted byafter June 30, 2007. The amended supply agreement continues to require us to purchase a significant majority of our hemodialysis product supplies and equipment at fixed prices. Our total expenditures infor the years ended December 31, 2007 and 2006 on such products under the Amended Product Supply Agreement were approximately 2% and 4%, respectively, of our total operating costs. The actual amount of purchases in future years under the amended supply agreementAmended Product Supply Agreement will depend upon a number of factors, including the operating and capital requirements of our centers, the number of centers we acquire, growth of our existing centers, and Gambro Renal Products’ ability to meet our needs and Gambro Renal Products’ ability to have the import ban lifted by June 30, 2007.needs. See Note 419 to the Consolidated Financial Statements regardingconsolidated financial statements.

Settlements of approximately $11.0 million of existing FASB Interpretation 48 (FIN 48) liabilities are excluded from the valuationabove table as reasonably reliable estimates of this commitment.their timing cannot be made.

 

Contingencies

 

The majority of our revenues are from government programs and 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; and (4) retroactive applications or interpretations of governmental

requirements. In addition, our revenues from commercial payors may be subject to adjustment as a result of potential claims for refunds, from commercial payors, as a result of government actions or as a result of other claims by commercial payors.

 

United States Attorney inquiries

 

In February 2007, we received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services, or OIG, for records relating to Epogen®, or EPO, claims submitted to Medicare. In August 2007, we received a subpoena from the OIG seeking similar documents. The requested documents relate to services provided from 2001 to 2004 by a number of our centers. The request and subpoena were sent from the OIG’s offices in Houston and Dallas, Texas. We are cooperating with the inquiry and are producing the requested records. We have been in contact with the United States Attorney’s Office, or U.S. Attorney’s Office, for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. There appears to be substantial overlap between this issue and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office, for the Eastern District of Missouri in St. Louis described below. To our knowledge, no proceedings have been initiated against us at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena will continue to require management’s attention and significant legal expense. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs.

On March 4, 2005, we received a subpoena from the United States Attorney’s Office, or U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. The subpoena requires production of a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies, and financial relationships with physicians and joint ventures. The subpoena covers the period from December 1, 1996 through the present. In October 2005, we received a follow-up request for additional documents related to specific medical director and joint venture arrangements. In February 2006, we received an additional subpoena for documents, including certain patient records relating to the administration and billing of Epogen (EPO).EPO. In May 2007, we received a request for documents related to durable medical equipment (DME) and supply companies owned and operated by us. We are producing documents and providing information to the government. We are also cooperating, and intend to continue to cooperate, with the government’s investigation, including by participating in discussions and meetings with the government. The subpoenas have been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against us in connection with this inquiry. Any negative findings could result in

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substantial financial penalties against us, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To our knowledge, no proceedings have been initiated against us at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

 

On October 25, 2004, we received a subpoena from the U.S. Attorney’s Office for the Eastern District of New York in Brooklyn. The subpoena covers the period from 1996 to present and requires the production of a wide range of documents relating to our operations, including DaVita Laboratory Services. Gambro Healthcare received a similar subpoena in November 2004. The subpoena also includes specific requests for documents relating to testing for parathyroid hormonePTH levels (PTH), and to products relating to vitamin D therapies. The subpoena has been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against us in connection with this inquiry. Any negative findings could result in substantial financial penalties against us, and DVA Renal Healthcare, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. Other participants in the dialysis industry received a similar subpoena, including Fresenius Medical Group, Renal Care Group and DVA Renal Healthcare, which was acquired by us in October of 2005.Group. To our knowledge, no proceedings have been initiated against us or DVA Renal Healthcare at this time. Although we cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena may continue to require management’s attention and significant legal expense.

 

In February 2001, the Civil Division of the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted us and requested our cooperation in a review of some of our historical practices, including billing and other operating procedures and our financial relationships with physicians. We cooperated in this review and provided the requested records to the U.S. Attorney’s Office. In May 2002, we received a subpoena from the U.S. Attorney’s Office and the Philadelphia Office of the Office of Inspector General of the Department of Health and Human Services (OIG). The subpoena required an update to the information we provided in our response to the February 2001 request, and also sought 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 our financial relationships with physicians and pharmaceutical companies. The subpoena covered the period from May 1996 to May 2002. We provided the documents requested and cooperated with the United States Attorney’s Office and the OIG in its investigation. In January 2007, the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia informed us that it has

decided to close its investigation of DaVita. No charges were made against us, no fines were assessed and no mandatory policy changes were required in connection with this investigation.

In February 2007, we received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services for records relating to EPO claims submitted to Medicare. The claims relate to services provided from 2002 to 2004 by a number of our centers. The request was sent from the OIG’s office in Houston, Texas. We have been in contact with the U.S. Attorney’s Office for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. We are cooperating with the inquiry and will be producing the requested records. There appears to be substantial overlap between this issue, and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. EPO utilization was also one of the subjects of the multi-year investigation by the U.S. Attorney’s Office for the Eastern District of Pennsylvania, which was recently closed as described herein. To the best of our knowledge, the government has not initiated any proceeding against us in connection with this request although we cannot predict whether we will receive further inquiries or whether or when a proceeding might be initiated.

Other

 

We have received several notices of claims from commercial payors and other third parties related to historical billing practices and claims against DVA Renal Healthcare (formerly known as Gambro Healthcare) related to historical DVA RenalGambro Healthcare billing practices and other matters covered by their settlement agreement with the Department of Justice. At least one commercial payor has filed an arbitration demand against us, as described below, and additional commercial payors have threatened litigation. We intend to defend against these claims vigorously; however, we may not be successful and these claims may lead to litigation and any such litigation may be resolved unfavorably. Although the ultimate outcome of these claims cannot be predicted at this time, an adverse result in excess of our established reserves, with respect to one or more of these claims could have a material adverse effect on our business, financial condition, and results of operations.operations and liquidity.

 

We have received several informal inquiries from representativesIn December 2007, we entered into a Settlement Agreement with the State of New York to resolve certain billing issues that had been the subject of inquiry by the New York Attorney General’s Medicaid Fraud Control Unit, (MFCU) regarding certain aspectsor MFCU. We had received several informal inquiries from representatives of the EPO and otherMFCU regarding billing practices taking place atfor facilities managed by us in New York. The Settlement Agreement covers numerous dialysis facilities in New York for which we, through our subsidiaries, provide administrative services. We are cooperating withpaid approximately $1.5 million in settlement, which included the MFCU’s informal inquiriesamount of the overpayments by the New York Medicaid program plus interest; no fines or penalties were assessed.

In October 2007, we were contacted by the Attorney General’s Office for the State of Nevada. The Attorney General’s Office informed us that it was conducting a criminal investigation of our operations in Nevada and have provided documents and informationthat the investigation related to the MFCU.billing of pharmaceuticals, including EPO. On February 8, 2008, the Attorney General’s Office informed us that the criminal investigation has been discontinued. The Attorney General’s Office further advised us that Nevada Medicaid intends to conduct audits of ESRD providers in Nevada, including us, and that such audits will relate to the issues that were the subjects of the criminal investigation. Any negative findings could result in substantial financial penalties against us and exclusion from future participation in the Medicare and Medicaid programs. To the best of our knowledge, no proceedings have been initiated against us and the MFCU has not indicated an intention to do so, although we cannot predict whether we will receive further inquiries or whether or when proceedings might be initiated.at this time.

 

In June 2004, DVA Renal Healthcare was served withOn August 28, 2007, Sheet Metal Workers National Health Fund and Glenn Randle filed a complaint filed in the SuperiorUnited States District Court for the Central District of California by one of its former employees who worked for its California acute services program.against us. The complaint whichalso names as

52


defendants Amgen, Inc. and Fresenius Medical Care Holdings, Inc. The complaint is styled as a class action and alleges among other things,four claims against us, including violations of the federal RICO statute, California’s unfair competition law, California’s false advertising law and for unjust enrichment. The complaint’s principal allegations against us are that DVA Renal Healthcare failedthe defendants engaged in a scheme to provide overtime wages, defined rest periodsunlawfully promote the administration of EPO to hemodialysis patients intravenously, as opposed to subcutaneously, and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements.over-utilize EPO. We are evaluating the claims and intend to vigorously defend ourselves in the matter.against these claims. We also intend to vigorously oppose the certification of this matter as a class action. AlthoughAt this time, we cannot predict the ultimate outcome of these claims cannot be predicted, we do not expect that an unfavorable result,this matter or the potential range of damages, if any, would have a material adverse effect on our business, financial condition, liquidity or results of operations.any.

 

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the Western District of Louisiana against Gambro AB, DVA Renal Healthcare (formerly Gambro Healthcare) and related entities. The plaintiff sought to bring its claims as a class action on behalf of itself and all entities that paid any of the defendants for health care goods and services from on or about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying DVA RenalGambro Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against us

and DVA Renal Healthcare. We intend to vigorously defend against these claims. We also intend to vigorously oppose the certification of this matter as a class action. At this time, we cannot estimatepredict the ultimate outcome of this matter or the potential range of damages, if any.

In June 2004, Gambro Healthcare was served with a complaint filed in the Superior Court of California by one of its former employees who worked for its California acute services program. The complaint, which is styled as a class action, alleges, among other things, that DVA Renal Healthcare (formerly Gambro Healthcare) failed to provide overtime wages, defined rest periods and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements. We are investigating these claims and continueintend to vigorously defend ourselves inagainst this claim. We also intend to vigorously oppose the matter.certification of this matter as a class action. Although the ultimate outcome of these claims cannot be predicted, we do not expect that an unfavorable result, if any, would have a material adverse effect on our business, financial condition, liquidity or results of operations.

 

In addition to the foregoing, we are subject to claims and suits, in the ordinary course of business, including from time to time, contractual disputes and professional and general liability claims.claims, as well as audits and investigations by various government entities, in the ordinary course of business. We believe that the ultimate resolution of any such pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on our financial condition, results of operations or cash flows.

 

Critical accounting estimates and judgments

 

Our consolidated financial statements and accompanying notes are prepared in accordance with United States generally accepted accounting principles. These accounting principles require us to make estimates, judgments and assumptions that affect the reported amounts of revenues, expenses, assets, liabilities, and contingencies. All significant estimates, judgments and assumptions are developed based on the best information available to us at the time made and are regularly reviewed and updated when necessary. Actual results will generally differ from these estimates. Changes in estimates are reflected in our financial statements in the period of change based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. Interim changes in estimates are applied prospectively within annual periods. Certain accounting estimates, including those concerning revenue recognition and provision for uncollectible accounts receivable, impairments of long-lived assets, accounting for income taxes, quarterly variable compensation accruals, and purchase accounting valuation estimates and stock-based compensation are considered to be critical to evaluating and understanding our financial results because they involve inherently uncertain matters and their application requires the most difficult and complex judgments and estimates.

 

Revenue recognition and accounts receivable.    There are significant estimating risks associated with the amount of revenue that we recognize forin a reporting period. Payment rates are often subject to significant

53


uncertainties related to wide variations in the coverage terms of the more than 1,2001,100 commercial healthcare plans under which we receive payments. In addition, ongoing insurance coverage changes, geographic coverage differences, differing interpretations of contract coverage, and other payor issues complicate the billing and collection process. Revenue recognition uncertainties inherent in our operations are addressed in AICPA Statement of Position (SOP) No. 00-1. As addressed in SOP No. 00-1, net revenue recognition and allowances for uncollectible billings require the use of estimates of the amounts that will actually be realized considering, among other items, retroactive adjustments that may be associated with regulatory reviews, audits, billing reviews and other matters.

 

Revenues associated with Medicare and Medicaid programs are recognized based on a) the payment rates that are established by statute or regulation for the portion of the payment rates paid by the government payor (e.g,(e.g., 80% for Medicare patients) and b) for the portion not paid by the primary government payor, the estimated amounts that will ultimately be collectible from other government programs paying secondary coverage (e.g,(e.g., Medicaid secondary coverage), the patient’s commercial health plan secondary coverage, or the patient.

 

Commercial healthcare plans, including contracted managed-care payors, are billed at our usual and customary rates, however, revenue is recognized based on estimated net realizable revenue for the services provided. Net realizable revenue is estimated based on contractual terms for the patients under healthcare plans with which we have formal agreements, non-contracted healthcare plan coverage terms if known, estimated secondary collections, historical collection experience, historical trends of refunds and payor payment adjustments (retractions), inefficiencies in our billing and collection processes that can result in denied claims for payments, and regulatory compliance issues. Determining applicable primary and secondary coverage for our more than 103,000107,000 patients at any point in time, together with the changes in patient coverages that occur each month, requires complex, resource-intensive processes. Collections, refunds and payor retractions typically continue to occur for up to three years and longer after services are provided.

OurWe generally expect our range of dialysis revenue estimating risk is generally expected to be within 1% of total revenue, which can represent as much as 6.5%6.0% of operating income. Changes in estimates are reflected in the then currentthen-current financial statements based on on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. Changes in revenue estimates for prior periods are separately disclosed and reported if material to the current reporting period and longer term trend analyses.analyses, and have not been significant.

 

Lab service revenues for current period dates of services are recognized at the estimated net realizable amounts to be received.

 

Impairments of long-lived assets.    We account for impairment of long-lived assets, which include property and equipment, investments including our investments in third-party dialysis businesses, and our ancillary services and strategic initiatives, amortizable intangible assets and goodwill, in accordance with the provisions of SFAS No. 144Accounting for the Impairment or Disposal of Long-Lived Assets or SFAS No. 142Goodwill and Other Intangible Assets,as applicable.applicable accounting guidance. Impairment reviews are performed at least annually, and whenever a change in condition occurs which indicates that the carrying amounts of assets may not be recoverable.

 

Such changes include changes in our business strategies and plans, changes in the quality or structure of our relationships with our partners and deteriorating operating performance of individual dialysis centers. We use a variety of factors to assess the realizable value of assets depending on their nature and use. Such assessments are primarily based upon the sum of expected future undiscounted net cash flows over the expected period the asset will be utilized, as well as market values and conditions. The computation of expected future undiscounted net cash flows can be complex and involves a number of subjective assumptions. Any changes in these factors or assumptions could impact the assessed value of an asset and result in an impairment charge equal to the amount by which its carrying value exceeds its actual or estimated fair value.

 

54


Accounting for income taxes.    We estimate our income tax provision to recognize our tax expense for the current year, and our deferred tax liabilities and assets for future tax consequences of events that have been recognized in our financial statements, measured using enacted tax rates and laws expected to apply in the periods when the deferred tax liabilities or assets are expected to be realized. In accordance with Financial Accounting Standards Board Interpretation 48 (FIN 48)Accounting for Income Tax Uncertainties, which went effective January 1, 2007, we assess our tax positions on a more-likely-than-not criteria and also determine the actual amount of benefit to recognize in the financial statements. Deferred tax assets are assessed based upon the likelihood of recoverability from future taxable income and, to the extent that recovery is not likely, a valuation allowance is established. The allowance is regularly reviewed and updated for changes in circumstances that would cause a change in judgment about the realizability of the related deferred tax assets. See Note 13 to the Consolidated Financial Statements.

We are also in the process of determining the impact of implementing Financial Account Standard Interpretation (FIN) No. 48Accounting for Income Tax Uncertainties effective January 1, 2007, that requires us to assess our tax positions on a more-likely-than-not criteria and to also determine the actual amount of benefit to recognize in the financial statements. These calculations and assessments involve complex estimates and judgments because the ultimate tax outcome can be uncertain orand future events unpredictable.

 

Variable compensation accruals.    We estimate variable compensation accruals quarterly based upon the annual amounts expected to be earned and paid out resulting from the achievement of certain teammate-specific and/or corporate financial and operating goals. Our estimates, which include compensation incentives for bonuses, and other awards, are updated periodically based on changes in our economic condition or cash flows that could ultimately impact the actual final award. Actual results reflected in each fiscal quarter may vary due to the subjectivity involved in anticipating fulfillment of specific and/or corporate goals, as well as the final determination and approval of amounts by our Board of Directors.

 

Purchase accounting valuation estimates.    The valuation of the tangible and intangible assets and liabilities acquired or assumed in connection with the DVA Renal Healthcare acquisition required numerous assessments and assumptions, including those concerning dialysis industry trends, our company’s business strategies and

plans, the strategies of present or potential competitors, the quality of our continuing relationships with physicians and teammates and the likely effects of changes in those relationships, and other competitive and market conditions including those that involve dialysis product suppliers. These assumptions include expected outcomes under different acquisition agreement terms, and as a result, involve estimates of which the ultimate accuracy will never be known. We also make various assumptions and estimates regarding the valuation of tangible and intangible assets associated with other routineour acquisitions. These assumptions can have a material effect on our balance sheet valuations and the related amount of depreciation and amortization expense that will be recognized in the future. Long-lived tangible and intangible assets are subject to our regular ongoing impairment assessments.

Stock-based compensation.    We account for stock-based awards to employees and directors in accordance with the provisions of SFAS No. 123(R) Share-Based Payments. Under SFAS No. 123(R),stock-based compensation is recognized during a period based on the estimated grant-date fair value of the portion of the stock-based award vesting during that period, adjusted for expected forfeitures. Stock-based compensation recognized in our consolidated financial statements for the year ended December 31, 2007 and 2006 includes compensation costs for stock-based awards granted prior to, but not fully vested as of December 31, 2005, and stock-based awards granted in those years. We estimate the grant-date fair value of stock awards using complex option pricing models that rely heavily on estimates from us about uncertain future events, including the expected term of the awards, the expected future volatility of our stock price, and expected future risk-free interest rates.

 

Significant new accounting standards

 

EffectiveOn January 1, 2006,2008, we adopted SFAS No. 123(R)157Share-Based Payment,Fair Value Measurementswhich amendedexcept for the nonfinancial assets and liabilities that are subject to a one-year deferral allowed by FASB Staff Position (FSP) FAS157-2 Effective Date of FASB Statement No. 157. This standard establishes a framework for measuring fair value and also requires additional disclosures about fair value measurements. The standard applies to assets and liabilities that are carried at fair value on a recurring basis. On February 12, 2008, FSP FAS157-2 was issued delaying the effective date of SFAS No. 123157 until fiscal years beginning after November 15, 2008 for nonfinancial assets and 95liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The implementation of this standard relating to the assets and supersedes Accounting Principles Board (APB)liabilities carried at fair value on a recurring basis is not expected to have a material impact on our consolidated financial statements.

On January 1, 2008, we adopted SFAS No. 25159AccountingFair Value Option for Stock IssuedFinancial Assets and Financial Liabilities, including an amendment of SFAS No. 115.This standard allows companies the alternative to Employees.measure

55


certain financial assets and liabilities at fair value on an instrument-by-instrument basis that are currently not required to be measured at fair value. The standard is also designed to reduce the volatility in earnings caused by measuring related assets and liabilities differently and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The implementation of this standard is not expected to have a material impact on our consolidated financial statements.

In December 2007, the FASB issued Statement No. 141(R)Business Combinations, which replaces SFAS No. 141Business Combinations. This standard requires usall business combinations to measurebe accounted for under the costacquisition method (previously referred to as the purchase method). Under the acquisition method, the acquirer recognizes the assets acquired, the liabilities assumed, contractual contingencies, as well as any noncontrolling interest in the acquiree at their fair values at the acquisition date. Noncontractual contingencies are recognized at the acquisition date at their fair values only if it is more likely than not that they meet the definition of employee services receivedan asset or a liability in exchange forFASB Concepts Statement No. 6Elements of Financial Statements. Transaction costs are excluded from the acquisition accounting and will be expensed as incurred. Any contingent consideration included by the acquirer as part of the purchase price must also be measured at fair value at the acquisition date and will be classified as either equity or a liability. This standard also requires a company that obtains control but acquires less than 100% of an awardacquiree to record 100% of equity instruments, such as stock options, stock appreciation rights, stock units and discounted employee stock purchases, based on the grant-date fair value of the awardacquiree assets, liabilities, and to recognize such cost overnoncontrolling interests at the requisite period during which an employee provides service. The grant-date fair valueacquisition date. This standard is to be estimated using option-pricing models adjusted for unique characteristics of the equity instruments. The standard also addresses the accounting for transactions that involve the creation of a liability in exchange for goods or services that are based on the fair value of a company’s equity instruments or that may be settled through the issuance of such equity instruments. The standard does not change the accounting for transactions involving equity instruments issued for services to non-employees or the accounting for employee stock ownership plans. The standard also requires that the tax benefits realized from stock award exercises in excess of the stock-based compensation expenses recognizable for financial statement purposes be reported on a prospective basis as a cash flow from financing activities rather than as an operating cash flow as previously required. This reduces net operating cash flows and increases net financing cash flowseffective for periods beginning on or after adoptionDecember 15, 2008. We are currently in the process of SFAS No. 123(R). During 2006, we recorded $26.4 millionassessing the expected impact of stock-based compensation expenses including stock-based compensation associated with implementing SFAS No. 123(R).this standard on our consolidated financial statements.

 

In June 2006,December 2007, the FASB issued Statement No. 160Noncontrolling Interests in Consolidated Financial Statements, which amends Accounting Standards Board issuedResearch Bulletin, No. 51Consolidated Financial Statements. This standard requires noncontrolling interests to be treated as a separate component of equity, but apart from the parent’s equity and not as a liability, or an item outside of equity. This will eliminate diversity that currently exists in accounting for transactions between an entity and its noncontrolling interests. This standard also specifies that consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, and that changes in the parent’s ownership interest while it retains a controlling financial interest should be accounted for as equity transactions. This standard also expands disclosures in the financial statements to include a reconciliation of the beginning and ending balances of the equity attributable to the parent and the noncontrolling owners and a schedule showing the effects of changes in a parent’s ownership interest in a subsidiary on the equity attributable to the parent. This standard is effective for periods beginning on or after December 15, 2008. We are currently in the process of assessing the expected impact of this standard on our consolidated financial statements.

On January 1, 2007, we adopted the provisions of FASB Interpretation (FIN) No. 48 (FIN 48)Accounting for Income Tax Uncertainties, which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS Statement No. 109Accounting for Income Taxes. The Interpretation prescribes a recognition threshold of more-likely-than-not and a measurement attribute on all tax positions taken or expected to be taken in a tax return in order to be recognized in the financial statements. In making this assessment, a company must determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based solely on the technical merits of the position and must assume that the tax position will be examined by the appropriate taxing authority that would have full knowledge of all relevant information. Once the recognition threshold is met, the tax position is then measured to determine the actual amount of benefit to recognize in the financial statements. In addition, the recognition threshold of more-likely-than-not must continue to be met in each reporting period to support continued recognition of the tax benefit. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the financial reporting period in which that threshold is no longer met. We are currently assessingSee note 12 to the expectedconsolidated financial statements for the impact of adopting this Interpretation on our consolidated financial statements.interpretation.

 

In the fourth quarter of 2006, we adopted the U.S. Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 108, which provides interpretive guidance on how the effects of prior year misstatements should be considered in quantifying current year financial statement misstatements. The interpretations in SAB No. 108, which expresses the SEC’s staff views, were issued to address the diversity in the practice of quantifying financial statement misstatements and the potential under current practice for a build56

up of improper amounts on the balance sheet. The SEC staff indicated that companies should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in material misstatement. The adoption of this interpretation did not have an impact on our consolidated financial statements.


Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

 

Interest rate sensitivity

 

The tables below provide information about our financial instruments that are sensitive to changes in interest rates. For our debt obligations the table presents principal repayments and current weighted average interest rates on our debt obligations as of December 31, 2006.2007. The variable rates presented reflect the weighted average rates in effect at the end of 2006 including the economic effects of our swap agreements. These rates are based on the weighted average LIBOR rates plus margins in effect thatat the end of 2007 including the economic effects of our swap agreements. Term loan A and revolving line of credit interest rate margins are subject to adjustment depending upon changes in certain of our financial ratios including a leverage ratio plus the economic impact from the swap agreements.ratio. The margins currently in effect range from 1.75% to 2.00%at December 31, 2007 were 1.50%. For our interest rate swap agreements, the table below presents the notional amounts by contract maturity date and the related interest rate terms of the agreements (to pay fixed rates, and to receive LIBOR).

 

 Expected maturity date

 

Total


  

Fair

Value


 

Average

interest

rate


 Expected maturity date 

Total

 Fair
Value
 Average
interest
rate
 
 2007

 2008

 2009

 2010

 2011

 Thereafter

  2008 2009 2010 2011 2012 Thereafter 
 (dollars in millions)     (dollars in millions)     

Long-term debt:

          

Fixed rate

 $5 $1 $1 $1 $0 $1,352 $  1,360  $    1,372  7.02% $4 $1 $1 $1 $0 $1,753 $  1,760 $    1,755  6.89%

Variable rate

 $16 $54 $62 $88 $444 $1,727 $  2,391  $2,391  6.61% $20 $63 $88 $66 $1,706 $—   $  1,943 $    1,943  5.91%
 Notional
amount


 Contract maturity date

 

Pay

fixed


  Receive
variable


 Fair
value


 Notional
amount
 Contract maturity date 

Pay

fixed

 Receive
variable
 Fair
value
 
 2007

 2008

 2009

 2010

 2011

   2008 2009 2010 2011 2012 
 (dollars in millions) (dollars in millions)     

Swaps:

          

Pay-fixed swaps

 $1,341 $373 $378 $401 $189 $0 3.08% to 4.27%  LIBOR $29.5 $968 $378 $401 $189 $—   $—   3.08% to 4.27%  LIBOR $2.2 

Forward pay-fixed swaps

 $200 $—   $—   $200 $—   $—   4.05% to 4.70%  LIBOR $(2.7)

 

As of December 31, 2006,2007, we maintained a total of nine interest rate swap agreements, with amortizing notional amounts totaling $1,341$968 million. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of our debt to fixed rates ranging from 3.08% to 4.27%, resulting in aan overall weighted average effective interest rate of 5.88%,5.37% on the hedged portion of our Senior Secured Credit Facility,Facilities, including the term loan B margin of 2.00%1.50%. The swap agreements expire in 2008 through 2010 and require quarterly interest payments. In addition, we maintain two forward interest rate swap agreements with notional amounts totaling $200 million. These forward interest rate swaps will have the economic effect of modifying the LIBOR-based interest rates to fixed rates of 4.05% and 4.70% on our term loan B outstanding debt. These forward interest rate swaps agreements take effect September 30, 2008, require quarterly interest payments bear amortizing notional amounts,beginning in December 2008, and expire in 2008 through 2010. During 2006,2007, we accrued net cash benefits of $15.8$14.5 million from these swaps which is included in debt expense. As of December 31, 2006,2007, the total fair value of these swaps was an asseta net liability of $29.5$0.5 million. WeDuring 2007, we recorded $7.9$16.0 million, net of tax, as an increasea reduction to other comprehensive income for the change in fair valuevaluation losses, net of the effective portions of these swaps during 2006.amounts reclassified into income.

 

AtAs of December 31, 2006,2007, the interest rates were economically fixed on approximately 50% of our overall Credit Facility effective weighted average interestvariable rate was 6.61%,debt and approximately 74% of our overall average effective interest rate was 6.76%.total debt.

 

As a result of all of ourthe swap agreements, we had over 56%the overall effective weighted average interest rate on the Senior Secured Credit Facilities was 5.90%, based upon the current margins in effect of our outstanding variable rate debt economically fixed and approximately 72% of our total debt economically fixed1.50% as of December 31, 2006.2007.

Our overall average effective interest rate during 2007 was 6.49% and as of December 31, 2007 was 6.37%.

 

One means of assessing exposure to debt-related interest rate changes is a duration-based analysis that

measures the potential loss in net income resulting from a hypothetical increase in interest rates of 100 basis

57


points across all variable rate maturities (referred to as a “parallel shift in the yield curve”). Under this model, with all else constant, it is estimated that such an increase would have reduced net income by approximately $5.5 million, $6.8 million, $3.2 million, and $5.9$3.2 million, net of tax, for the years ended December 31, 2007, 2006, and 2005, and 2004, respectively.

Exchange rate sensitivity

 

We are currently not exposed to any foreign currency exchange rate risk.

 

Item 8.    Financial Statements and Supplementary Data.

 

See the Index to Financial Statements and Index to Financial Statement Schedules included at “Item 15. Exhibits, Financial Statement Schedules.”

 

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

Item 9A.    Controls and Procedures.

 

Management has established and maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the reports that it files or submits pursuant to the Securities Exchange Act of 1934, as amended, or Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’sour management including itsour Chief Executive Officer and Acting Chief Financial Officer as appropriate to allow for timely decisions regarding required disclosures.

 

At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of the Company’sour Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures in accordance with the Exchange Act requirements. Based upon that evaluation, the Chief Executive Officer and Acting Chief Financial Officer concluded that the Company’sour disclosure controls and procedures are effective for timely identification and review of material information required to be included in the Company’sour Exchange Act reports, including this report on Form 10-K. Management recognizes that these controls and procedures can provide only reasonable assurance of desired outcomes, and that estimates and judgments are still inherent in the process of maintaining effective controls and procedures.

 

There has not been any change in the Company’sour internal control over financial reporting that was identified during the evaluation that occurred during the fourth fiscal quarter and that has materially affected, or is reasonably likely to materially affect, the Company’sour internal control over financial reporting.

 

Item 9B.    Other Information.

 

None.

58


PART III

 

Item 10.    Directors, Executive Officers and Corporate Governance.

 

In 2002, we adopted a Corporate Governance Code of Ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, and to all of our financial accounting and legal professionals who are directly or indirectly involved in the preparation, reporting and fair presentation of our financial statements and Exchange Act Reports. The Code of Ethics is posted on the Company’sour website, located athttp://www.davita.com. The CompanyWe also maintainsmaintain a Corporate Code of Conduct that applies to all of itsour employees, which is posted on the Company’sour website.

 

Under our Corporate Governance Guidelines all Board Committees including the Audit Committee, Nominating and Governance Committee and the Compensation Committee, which are comprised solely of Independent Directors as defined within the listing standards of the New York Stock Exchange, have written charters that outline the committee’s purpose, goals, membership requirements and responsibilities. These charters are regularly reviewed and updated as necessary by our Board of Directors. All Board Committee charters as well as the Corporate Governance Guidelines are posted on our website located athttp://www.davita.com. This information is also available in print to any shareholders who request it.

 

On June 14, 2006,28, 2007, we submitted to the New York Stock Exchange a certification signed by our Chief Executive Officer that he was not aware of any violation by us of the NYSE corporate governance listing standards.

 

The other information required to be disclosed by this item will appear in, and is incorporated by reference from, the sections entitled “Proposal No. 1. Election of Directors”, “Corporate Governance”, and “Security Ownership of Certain Beneficial Owners and Management” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting.

 

Item 11.    Executive Compensation.

 

The information required by this item will appear in, and is incorporated by reference from, the sections entitled “Executive Compensation” and “Compensation Committee Interlocks and Insider Participations” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting. The information required by Item 407(e)(5) of Regulation S-K will appear in and is incorporated by reference from the section entitled “Compensation Committee Report” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting; however, this information shall not be deemed to be “filed”.

59


Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

The following table provides information about our common stock that may be issued upon the exercise of options, warrants and rights under all of our existing equity compensation plans and arrangements as of December 31, 2006,2007, including the 1994 Equity Compensation Plan, the 1995 Equity Compensation Plan, the 1997 Equity Compensation Plan, the 1999 Equity Compensation Plan, the 1999 Non-Executive Officer and Non-Director Equity Compensation Plan, the Special Purpose Option Plan (RTC Plan), the 2002 Equity Compensation Plan, the Employee Stock Purchase Plan and the deferred stock unit agreements. The material terms of each of these plans and arrangements are described in Note 3 of the Notes17 to the Consolidated Financial Statements. The 1999 Non-Executive Officer and Non-Director Equity Compensation Plan and the deferred stock unit arrangementsagreements were not required to be approved by our shareholders.

 

Plan category


  Number of shares to be
issued upon exercise of
outstanding options,
warrants and rights


  Weighted average
exercise price of
outstanding options,
warrants and rights


  

Number of shares
remaining available for
future issuance

under equity compensation
plans (excluding securities
reflected in column (a))


  Total of
shares
reflected in
columns (a)
and (c)


  Number of shares to be
issued upon exercise of
outstanding options,
warrants and rights
 Weighted average
exercise price of
outstanding options,

warrants and rights
 Number of shares
remaining available for
future issuance
under equity compensation

plans (excluding securities
reflected in column (a))
 Total of
shares
reflected in
columns
(a) and (c)
  (a)  (b)  (c)  (d)  (a)  (b) (c) (d)

Equity compensation plans approved by shareholders

  9,073,128  $39.38  8,537,940  17,611,068  10,573,588 $45.81 12,101,429 22,675,017

Equity compensation plans not requiring shareholder approval

  1,268,332  $16.51  246,580  1,514,912  333,287 $19,68 305,274 638,561
  
  

  
  
         

Total

  10,341,460  $36.58  8,784,520  19,125,980  10,906,875 $45.02 12,406,703 23,313,578
  
  

  
  
         

 

Other information required to be disclosed by Item 12 will appear in, and is incorporated by reference from, the section entitled “Security Ownership of Certain Beneficial Owners and Management” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting.

 

Item 13.    Certain Relationships and Related Transactions and Director Independence.

 

The information required by this item will appear in, and is incorporated by reference from, the section entitled “Certain Relationships and Related Transactions” and the section entitled “Corporate Governance” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting.

 

Item 14.    Principal Accounting Fees and Services.

 

The information required by this item will appear in, and is incorporated by reference from, the section entitled “Ratification of Appointment of Independent Registered Public Accounting Firm” included in our definitive proxy statement relating to our 20072008 annual stockholder meeting.

60


PART IV

 

Item 15.    Exhibits, Financial Statement Schedules.

 

(a) Documents filed as part of this Report:

 

(1)Index to Financial Statements:

 

   Page

Management’s Report on Internal Control Over Financial Reporting

  F-1

Report of Independent Registered Public Accounting Firm

  F-2

Report of Independent Registered Public Accounting Firm

  F-3

Consolidated Statements of Income for the years ended December 31, 2007, 2006, 2005, and 20042005

  F-4

Consolidated Balance Sheets as of December 31, 2006,2007, and December 31, 20052006

  F-5

Consolidated Statements of Cash Flow for the years ended December 31, 2007, 2006, 2005, and 20042005

  F-6

Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the years ended December 31, 2007, 2006, 2005, and 20042005

  

F-7

Notes to Consolidated Financial Statements

  F-8

(2)  Index to Financial Statement Schedules:

  

Report of Independent Registered Public Accounting Firm

  S-1

Schedule II—Valuation and Qualifying Accounts

  S-2

 

(3)Exhibits:

 

2.1  Stock Purchase Agreement dated as of December 6, 2004, among Gambro AB, Gambro, Inc. and DaVita Inc.(14)
2.2  Amended and Restated Asset Purchase Agreement effective as of July 28, 2005, by and among DaVita Inc., Gambro Healthcare, Inc. and Renal Advantage Inc., a Delaware corporation, formerly known as RenalAmerica, Inc.(17)
3.1  Amended and Restated Certificate of Incorporation of Total Renal Care Holdings, Inc., or TRCH, dated December 4, 1995.(1)
3.2  Certificate of Amendment of Certificate of Incorporation of TRCH, dated February 26, 1998.(2)
3.3  Certificate of Amendment of Certificate of Incorporation of DaVita Inc. (formerly Total Renal Care Holdings, Inc.), dated October 5, 2000.(6)
3.4  Certificate of Amendment of Amended and Restated BylawsCertificate of Incorporation of DaVita, Inc. (formerly Total Renal Care Holdings, Inc.), as amended dated June 3, 2004.(11)May 30, 2007.(29)
3.5  Amended and Restated Bylaws for DaVita, Inc,Inc. dated as of December 14, 2006.(26)March 2, 2007.(32)
4.1  Registration Rights Agreement for the 6 5/8% Senior Notes due 2013 dated as of March 22, 2005.(3)
4.2  Registration Rights Agreement for the 7 1/4% Senior Subordinated Notes due 2015 dated as of March 22, 2005.(3)

61


4.3  Indenture for the 6 5/8% Senior Notes due 2013 dated as of March 22, 2005.(3)
4.4  Indenture for the 7 1/4% Senior Subordinated Notes due 2015 dated as of March 22, 2005.(3)
4.5  Supplemental Indenture, dated October 5, 2005, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and Senior Trustee.(16)
4.6  Supplemental Indenture, dated October 5, 2005, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and Senior Subordinated Trustee.(16)
4.7  Rights Agreement, dated as of November 14, 2002, between DaVita Inc. and the Bank of New York, as Rights Agent.(27)
4.8Second Supplemental Indenture (Senior), dated February 9, 2007, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and The Bank of New York Trust Company, N.A., as Trustee.(28)
4.9Second Supplemental Indenture (Senior Subordinated), dated February 9, 2007, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and the Bank of New York Trust Company, N.A., as Trustee.(28)
4.10Registration Rights Agreement for the 6 5/8% Senior Notes due 2013 dated as of February 23, 2007.(33)
10.1  Employment Agreement, dated as of October 18, 1999, by and between TRCH and Kent J. Thiry.(4)*
10.2  Amendment to Mr. Thiry’s Employment Agreement, dated May 20, 2000.(5)*
10.3  Second Amendment to Mr. Thiry’s Employment Agreement, dated November 28, 2000.(6)*
10.4  Third Amendment to Mr. Thiry’s Employment Agreement, dated March 31, 2005.(15)*
10.5  Employment Agreement, dated as of November 29, 1999, by and between TRCH and Gary W. Beil.(6)*
10.6  Employment Agreement, dated as of July 19, 2000, by and between TRCH and Charles J. McAllister.(6)*
10.7  Employment Agreement, dated as of June 15, 2000, by and between DaVita Inc. and Joseph Mello.(8)*
10.8  Employment Agreement effective as of June 7, 2004, by and between DaVita Inc. and Tom Kelly.(11)*
10.9  Employment Agreement, effective as of August 16, 2004, by and between DaVita Inc. and Tom Usilton.(12)*
10.10  Amendment to Mr. Usilton’s Employment Agreement, dated February 12, 2007.(31)*
10.11Employment Agreement, effective as of November 18, 2004, by and between DaVita Inc. and Joseph Schohl.(19)*
10.1110.12  Employment Agreement, dated as of October 31, 2005, effective October 24, 2005, by and between DaVita Inc. and Dennis Kogod.(18)*
10.1210.13  Employment Agreement, effective November 2, 2005, by and between DaVita Inc. and Christopher J. Riopelle.(18)*
10.1310.14  Severance and General Release Agreement between DaVita Inc. and Lori Pelliccioni, entered into as of November 3, 2005.(18)*
10.1410.15  Amended and restated Employment Agreement effective as of February 28, 2005, by and between DaVita Inc. and Denise Fletcher.(19)*
10.1510.16Employment Agreement, effective September 22, 2005, by and between DaVita Inc. and James Hilger.(21)*

62


10.17Employment Agreement, effective September 1, 2006, by and between DaVita Inc. and Mark G. Harrison.(22)*
10.18Offer of Employment Letter to Mary Kowenhoven dated February 15, 2007.(28)*
10.19Employment Agreement, entered into effective July 16, 2007, by and between DaVita Inc. and Patricia Jones.(30)*
10.20Memorandum relating to Bonus Structure for Charles J. McAllister.(19)*
10.21Memorandum relating to Bonus Structure for Thomas O. Usilton.(16)*
10.22Memorandum relating to Bonus Structure for Joseph Schohl.(16)*
10.23Amended Director Compensation Philosophy and Plan.(25)*
10.24Form of Indemnity Agreement.(26)*
10.25Form of Indemnity Agreement.(19)*
10.26First Amended and Restated DaVita Inc. Executive Incentive Plan.(15)*
10.27Post-Retirement Deferred Compensation Arrangement.(19)*
10.28DaVita Voluntary Deferral Plan.(16)*
10.29Deferred Bonus Plan.ü*
10.30Deferred Bonus Plan (Prosperity Plan).ü*
10.31Amended and Restated Employee Stock Purchase Plan.(34)*
10.32DaVita Inc. Severance Plan.(35)*
10.33September 18, 2001 DaVita Inc. Change in Control Bonus Program.(23)*
10.34  Second Amended and Restated 1994 Equity Compensation Plan.(9)*
10.1610.35  First Amended and Restated 1995 Equity Compensation Plan.(9)*
10.1710.36  First Amended and Restated 1997 Equity Compensation Plan.(9)*
10.1810.37  First Amended and Restated Special Purpose Option Plan.(9)*
10.1910.38  Amended and Restated 1999 Equity Compensation Plan.(10)*
10.2010.39  First Amended and Restated Total Renal Care Holdings, Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan.(7)
10.2110.40  Amended and Restated DaVita Inc. 2002 Equity Compensation Plan.(15)*
10.2210.41  Form of Non-Qualified Stock Option Agreement for stock options grants to employees under the Company’s 2002 Equity Compensation Plan.(12)*

10.2310.42  Form of Restricted Stock Unit Agreement for restricted stock unit grants to employees under the Company’s 2002 Equity Compensation Plan.(12)*
10.2410.43Form of Stock Appreciation Rights Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.44Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan. (22)*
10.45Form of Restricted Stock Units Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.46Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.47Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan.(24)*

63


10.48Form of Restricted Stock Units Agreement – Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.49Form of Stock Appreciation Rights Agreement – Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.50Amended and Restated 2002 Equity Compensation Plan.(25)*
10.51Amended and Restated 2002 Equity Compensation Plan.(34)*
10.52  Credit Agreement, dated as of October 5, 2005, among DaVita Inc., the Guarantors party thereto, the Lenders party thereto, Bank of America, N.A., Wachovia Bank, National Association, Bear Stearns Corporate Lending Inc., The Bank of New York, The Bank of Nova Scotia, The Royal Bank of Scotland plc, WestLB AG, New York Branch as Co-Documentation Agents, Credit Suisse, Cayman Islands Branch, as Syndication Agent, JPMorgan Chase Bank, N.A., as Administrative Agent and Collateral Agent, JPMorgan Securities Inc., as Sole Lead Arranger and Bookrunner and Credit Suisse, Cayman Islands Branch, as Co-Arranger.(16)
10.2510.53Credit Agreement, dated as of October 5, 2005, as Amended and Restated as of February 23, 2007, by and among DaVita Inc., the Guarantors party thereto, the Lenders party thereto and JPMorgan Chase Bank, N.A.(33)
10.54Amendment Agreement, dated February 23, 2007, by and among DaVita Inc., the Guarantors party thereto, the Lenders party thereto and JPMorgan Chase Bank, N.A.(33)
10.55  Security Agreement, dated as of October 5, 2005, by DaVita Inc., the Guarantors party thereto and JPMorgan Chase Bank, N.A., as Collateral Agent.(16)
10.26Amended and Restated Agreement dated December 2, 2004, between Amgen USA Inc. and DaVita Inc.(19)**
10.27Alliance and Product Supply Agreement, dated as of October 5, 2005, among Gambro Renal Products, Inc., DaVita Inc. and Gambro AB.(16)**
10.28Freestanding Dialysis Center Agreement No. 200308359, effective January 1, 2004, between Amgen USA and Gambro Healthcare, Inc.(16)**
10.2910.56  Corporate Integrity Agreement between the Office of Inspector General of the Department of Health and Human Services and Gambro Healthcare, Inc. effective as of December 1, 2004.(16)
10.3010.57  FormAlliance and Product Supply Agreement, dated as of Indemnity Agreement.(19)*
10.31First Amended and RestatedOctober 5, 2005, among Gambro Renal Products, Inc., DaVita Inc. Executive Incentive Plan.(15)*
10.32Post-Retirement Deferred Compensation Arrangement.(19)*
10.33Memorandum relating to bonus structure for Charles J. McAllister.(19)*
10.34Memorandum Relating to Bonus Structure for Thomas O. Usilton.(16)*
10.35Memorandum Relating to Bonus Structure for Joseph Schohl.(16)*
10.36Director Compensation Philosophy and Plan.Gambro AB.(16)*
10.37DaVita Voluntary Deferral Plan.(16)*
10.38Dialysis Organization Agreement effective February 3, 2006 between Amgen USA Inc. and DaVita Inc.(20)**
10.39Employment Agreement, effective September 22, 2005, by and between DaVita Inc. and James Hilger.(21)*
10.40Form of Stock Appreciation Rights Agreement –Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.41Form of Non-Qualified Stock Option Agreement –Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.42Form of Restricted Stock Units Agreement –Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.43Employment Agreement, effective September 1, 2006, by and between DaVita Inc. and Mark G. Harrison.(22)*
10.4410.58  Amended and Restated Alliance and Product Supply Agreement, dated as of August 25, 2006, among Gambro Renal Products, Inc., DaVita Inc.Inc, and Gambro AB.(23)**
10.4510.59  FormLetter dated March 19, 2007 from Willard W. Brittain, Jr. to Peter T. Grauer, Lead Independent Director of Non-Qualified Stock Option Agreement – Employee (DaVita Inc. 2002 Equity Compensation Plan)(24)*the Company.(28)

10.4610.60  Form of Non-Qualified Stock OptionAmended and Restated Agreement (DaVitadated December 2, 2004, between Amgen USA Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan(24)DaVita Inc.(19)**
10.4710.61  Form of Restricted Stock UnitsDialysis Organization Agreement – Employee (DaVitaeffective February 3, 2006 between Amgen USA Inc. 2002 Equity Compensation Plan(24)and DaVita Inc.(20)**
10.4810.62  Form of Stock Appreciation RightsDialysis Organization Agreement – Employee (DaVita Inc. 2002 Equity Compensation Plan(24)*
10.49Amended Director Compensation Philosophy and Plan(25)
10.50Amended and Restated 2002 Equity Compensation Plan(25)*
10.51September 18, 2001between DaVita Inc. Change in Control Bonus Program.(23)
10.52Form of Indemnity Agreement.(26)and Amgen USA Inc. dated December 20, 2007.ü**
12.1  Computation of RatiosRatio of Earnings to Fixed Charges.ü
14.1  DaVita Inc. Corporate Governance Code of Ethics.(13)
21.1  List of our subsidiaries.ü
23.1  Consent of KPMG LLP, independent registered public accounting firm.ü
24.1  Powers of Attorney with respect to DaVita. (Included on Page II-1)
31.1  Certification of the Chief Executive Officer, dated February 26, 2007,27, 2008, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.ü
31.2  Certification of the Chief Financial Officer, dated February 26, 2007,27, 2008, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.ü

64


32.1  Certification of the Chief Executive Officer, dated February 26, 2007,27, 2008, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
32.2  Certification of the Chief Financial Officer, dated February 26 2007,27, 2008, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü

üIncluded in this filing.
*Management contract or executive compensation plan or arrangement.
**Portions of this exhibit are subject to a request for confidential treatment and have been redacted and filed separately with the SEC.
(1)Filed on March 18, 1996 as an exhibit to the Company’s Transitional Report on Form 10-K for the transition period from June 1, 1995 to December 31, 1995.
(2)Filed on March 31, 1998 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997.
(3)Filed on March 25, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(4)Filed on November 15, 1999 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
(5)Filed on August 14, 2000 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.
(6)Filed on March 20, 2001 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
(7)Filed on February 2, 2003 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
(8)Filed on August 15, 2001 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(9)Filed on March 29, 2000 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
(10)Filed on April 27, 2001 as an exhibit to the Definitive Proxy Statement for our 2001 Annual Meeting of Stockholders.

(11)Filed on August 5, 2004 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.
(12)Filed on November 8, 2004 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004.
(13)Filed on February 27, 2004 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
(14)Filed on December 8, 2004 as an exhibit to the Company’s Current Report on Form 8-K.
(15)Filed on May 4, 2005 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending March 31, 2005.
(16)Filed on November 8, 2005 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending September 30, 2005.
(17)Filed on October 11, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(18)Filed on November 4, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(19)Filed on March 3, 2005 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
(20)Filed on May 8, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006.
(21)Filed on August 7, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending June 30, 2006.
(22)Filed on July 6, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(23)Filed on November 3, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.
(24)Filed on October 18, 2006 as an exhibit to the Company’s Current Report on Form 8-K.

65


(25)Filed on July 31, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(26)Filed on December 20, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(27)Filed on November 19, 2002 as an exhibit to the Company’s Current Report on Form 8-K.
(28)Filed on May 3, 2007 as an exhibit to the Company’s Quarterly Report as Form 10-Q for the quarter ended March 31, 2007.
(29)Filed on August 6, 2007 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.
(30)Filed on November 7, 2007 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the third quarter ended September 30, 2007.
(31)Filed on February 16, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(32)Filed on March 8, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(33)Filed on February 28, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(34)Filed on June 4, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(35)Filed on November 7, 2007 as an exhibit to the Company’s Current Report on Form 8-K.

66


DAVITA INC.

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

We areManagement is responsible for establishing and maintaining an adequate system of internal control over financial reporting designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and which includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

 

During the last fiscal year, the Company conducted an evaluation, under the oversight of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s internal control over financial reporting. This evaluation was completed based on the criteria established in the report titled “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

Based upon our evaluation under the COSO framework, we have concluded that the Company’s internal control over financial reporting was effective as of December 31, 2006.2007.

 

The Company’s consolidated financial statements have also been audited and reported on by our independent registered public accounting firm, KPMG LLP, whohas issued an attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting, which report is included in this Annual Report.

F-1


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

DaVita Inc.:

 

We have audited the accompanying consolidated balance sheets of DaVita Inc. and subsidiaries as of December 31, 2006,2007, and 2005,2006, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006.2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of DaVita Inc. and subsidiaries as of December 31, 20062007 and 20052006 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006,2007, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 312 to the consolidated financial statements, DaVita Inc. and subsidiaries adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Income Tax Uncertainties, effective January 1, 2007. As discussed in Note 17 to the consolidated financial statements, DaVita Inc. and subsidiaries adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (R)123(R), Share-Based Payment, effective January 1, 2006.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of DaVita Inc.’s internal control over financial reporting as of December 31, 2006,2007, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 26, 200727, 2008 expressed an unqualified opinion on management’s assessmentthe effectiveness of and the effective operation of,DaVita Inc.’s internal control over financial reporting.

 

/s/ KPMG LLP

 

Seattle, Washington

February 26, 200727, 2008

F-2


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

DaVita Inc:Inc.:

 

We have audited management’s assessment, included in the accompanying management’s report on internal control over financial reporting, that DaVita Inc. maintained effective’s internal control over financial reporting as of December 31, 2006,2007, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). DaVita Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.reporting, included in the accompanying “Management’s Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment,assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control andbased on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that DaVita Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by COSO. Also, in our opinion, DaVita Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006,2007, based on criteria established inInternal Control—Integrated Framework issued by COSO.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of DaVita Inc. and subsidiaries as of December 31, 20062007 and 20052006, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006,2007, and our report dated February 26, 200727, 2008 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP

 

Seattle, Washington

February 26, 200727, 2008

F-3


DAVITA INC.

 

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data)

 

  Year ended December 31,

   Year ended December 31, 
  2006

 2005

 2004

   2007 2006 2005 

Net operating revenues

  $4,880,662  $2,973,918  $2,177,330   $5,264,151  $4,880,662  $2,973,918 

Operating expenses and charges:

       

Patient care costs

   3,390,351   2,035,243   1,470,175    3,590,344   3,390,351   2,035,243 

General and administrative

   453,516   272,463   192,082    491,236   453,516   272,463 

Depreciation and amortization

   173,295   116,836   82,912    193,470   173,295   116,836 

Provision for uncollectible accounts

   126,203   61,916   38,786    136,682   126,203   61,916 

Minority interests and equity income, net

   35,833   22,089   12,249    45,485   35,833   22,089 

Valuation gain on Product Supply Agreement

   (37,968)  —     —   

Valuation gain on alliance and product supply agreement

   (55,275)  (37,968)  —   
  


 


 


          

Total operating expenses and charges

   4,141,230   2,508,547   1,796,204    4,401,942   4,141,230   2,508,547 
  


 


 


          

Operating income

   739,432   465,371   381,126    862,209   739,432   465,371 

Debt expense

   (276,706)  (139,586)  (52,411)   (257,147)  (276,706)  (139,586)

Swap valuation gain

   —     4,548   —      —     —     4,548 

Refinancing charges

   —     (8,170)  —      —     —     (8,170)

Other income, net

   13,033   8,934   4,125    22,460   13,033   8,934 
  


 


 


          

Income from continuing operations before income taxes

   475,759   331,097   332,840    627,522   475,759   331,097 

Income tax expense

   186,430   123,675   128,332    245,744   186,430   123,675 
  


 


 


          

Income from continuing operations

   289,329   207,422   204,508    381,778   289,329   207,422 

Discontinued operations

       

Income from operations of discontinued operations, net of tax

   —     13,157   17,746 

Income from discontinued operations, net of tax

   —     —     13,157 

Gain on disposal of discontinued operations, net of tax

   362   8,064   —      —     362   8,064 
  


 


 


          

Net income

  $289,691  $228,643  $222,254   $381,778  $289,691  $228,643 
  


 


 


          

Earnings per share:

       

Basic earnings per share from continuing operations

  $2.79  $2.06  $2.07   $3.61  $2.79  $2.06 
  


 


 


          

Basic earnings per share

  $2.80  $2.27  $2.25   $3.61  $2.80  $2.27 
  


 


 


          

Diluted earnings per share from continuing operations

  $2.73  $1.99  $1.99   $3.55  $2.73  $1.99 
  


 


 


          

Diluted earnings per share

  $2.74  $2.20  $2.16   $3.55  $2.74  $2.20 
  


 


 


     ��     

Weighted average shares for earnings per share:

       

Basic

   103,520,000   100,762,000   98,727,000    105,893,000   103,520,000   100,762,000 
  


 


 


          

Diluted

   105,793,000   104,068,000   102,861,000    107,418,000   105,793,000   104,068,000 
  


 


 


          

 

See notes to consolidated financial statements.

F-4


DAVITA INC.

 

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except per share data)

 

  December 31,

   December 31, 
  2006

 2005

   2007 2006 
ASSETS         

Cash and cash equivalents

  $310,202  $431,811   $447,046  $310,202 

Accounts receivable, less allowance of $171,757 and $138,598

   932,385   853,560 

Short-term investments

   40,278   4,734 

Accounts receivable, less allowance of $195,953 and $171,757

   927,949   932,385 

Inventories

   89,119   69,130    80,173   89,119 

Other receivables

   148,842   116,620    198,744   148,842 

Other current assets

   29,858   38,463    34,482   25,124 

Deferred income taxes

   199,090   144,824    247,578   199,090 
  


 


       

Total current assets

   1,709,496   1,654,408    1,976,250   1,709,496 

Property and equipment, net

   849,966   750,078    939,326   849,966 

Amortizable intangibles, net

   203,721   235,944    183,042   203,721 

Investments in third-party dialysis businesses

   1,813   3,181    19,446   1,813 

Long-term investments

   22,562   13,174 

Other long-term assets

   58,967   41,768    35,401   45,793 

Goodwill

   3,667,853   3,594,383    3,767,933   3,667,853 
  


 


       
  $6,491,816  $6,279,762   $6,943,960  $6,491,816 
  


 


       
LIABILITIES AND SHAREHOLDERS’ EQUITY         

Accounts payable

  $251,686  $212,049   $225,461  $251,686 

Other liabilities

   473,219   381,964    486,151   473,219 

Accrued compensation and benefits

   341,766   231,994    334,961   341,766 

Current portion of long-term debt

   20,871   71,767    23,431   20,871 

Income taxes payable

   24,630   91,959    16,492   24,630 
  


 


       

Total current liabilities

   1,112,172   989,733    1,086,496   1,112,172 

Long-term debt

   3,730,380   4,085,435    3,683,887   3,730,380 

Other long-term liabilities

   50,076   26,416    83,448   50,076 

Alliance and product supply agreement and other intangibles, net

   105,263   163,431 

Alliance and product supply agreement, net

   41,307   105,263 

Deferred income taxes

   125,642   75,499    166,055   125,642 

Minority interests

   122,359   88,639 

Minority interests (fair value of potential put obligations—$330,000 and $192,000)

   150,517   122,359 

Commitments and contingencies

      

Shareholders’ equity:

      

Preferred stock ($0.001 par value, 5,000,000 shares authorized; none issued)

      

Common stock ($0.001 par value, 195,000,000 shares authorized; 134,862,283 shares issued; 104,636,608 and 101,935,257 shares outstanding)

   135   135 

Common stock ($0.001 par value, 450,000,000 and 195,000,000 shares authorized; 134,862,283 shares issued; 107,130,127 and 104,636,608 shares outstanding)

   135   135 

Additional paid-in capital

   630,091   569,751    707,080   630,091 

Retained earnings

   1,129,621   839,930    1,515,290   1,129,621 

Treasury stock, at cost (30,225,675 and 32,927,026 shares)

   (526,920)  (574,013)

Accumulated other comprehensive income

   12,997   14,806 

Treasury stock, at cost (27,732,156 and 30,225,675 shares)

   (487,744)  (526,920)

Accumulated other comprehensive (loss) income

   (2,511)  12,997 
  


 


       

Total shareholders’ equity

   1,245,924   850,609    1,732,250   1,245,924 
  


 


       
  $6,491,816  $6,279,762   $6,943,960  $6,491,816 
  


 


       

 

See notes to consolidated financial statements.

F-5


DAVITA INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOW

(dollars in thousands)

 

  Year ended December 31,

   Year ended December 31, 
  2006

 2005

 2004

   2007 2006 2005 

Cash flows from operating activities:

       

Net income

  $289,691  $228,643  $222,254   $381,778  $289,691  $228,643 

Adjustments to reconcile net income to cash provided by operating activities:

       

Depreciation and amortization

   173,295   119,719   86,666    193,470   173,295   119,719 

Valuation gain on Product Supply Agreement

   (37,968)  —     —   

Valuation gain on alliance and product supply agreement

   (55,275)  (37,968)  —   

Stock-based compensation expense

   26,389   3,353   1,690    34,149   26,389   3,353 

Tax benefits from stock award exercises

   40,375   38,484   41,080    32,788   40,375   38,484 

Excess tax benefits from stock-based compensation

   (37,251)  —     —   

Excess tax benefits from stock award exercises

   (25,541)  (37,251)  —   

Deferred income taxes

   2,342   (63,357)  29,115    18,601   2,342   (63,357)

Minority interests in income of consolidated subsidiaries

   38,141   24,714   15,135    46,702   38,141   24,714 

Distributions to minority interests

   (32,271)  (16,246)  (10,461)   (48,029)  (32,271)  (16,246)

Equity investment income

   (2,308)  (1,406)  (1,441)   (1,217)  (2,308)  (1,406)

Loss (gain) on disposal of discontinued operations and other dispositions

   239   (15,856)  764 

(Gain)/loss on disposal of discontinued operations and other dispositions

   (2,825)  239   (15,856)

Non-cash debt expense and non-cash rent charges

   27,736   5,157   2,088    12,713   27,736   5,157 

Refinancing charges

   —     8,170   —      —     —     8,170 

Swap valuation gain

   —     (4,548)  —      —     —     (4,548)

Changes in operating assets and liabilities, net of effect of acquisitions and divestitures:

       

Accounts receivables

   (74,737)  (62,021)  (40,263)   15,911   (74,737)  (62,021)

Inventories

   (18,587)  11,980   4,257    11,271   (18,587)  11,980 

Other receivables and other current assets

   (34,044)  1,893   (381)   (61,049)  (34,044)  1,893 

Other long-term assets

   (9,791)  (2,039)  3,345    (14,528)  (9,791)  (2,039)

Accounts payable

   40,712   28,869   17,764    (9,216)  40,712   28,869 

Accrued compensation and benefits

   101,555   21,664   32,899    9,691   101,555   21,664 

Other current liabilities

   88,841   72,615   42,784    657   88,841   72,615 

Income taxes

   (67,329)  90,958   (25,995)   (12,779)  (67,329)  90,958 

Other long-term liabilities

   4,541   (5,192)  (1,355)   5,764   4,541   (5,192)
  


 


 


          

Net cash provided by operating activities

   519,571   485,554   419,945    533,036   519,571   485,554 
  


 


 


          

Cash flows from investing activities:

       

Additions of property and equipment, net

   (262,708)  (161,365)  (128,328)   (272,212)  (262,708)  (161,365)

Acquisitions and purchases of other ownership interests

   (86,504)  (3,202,404)  (266,265)   (127,094)  (86,504)  (3,202,404)

Proceeds from discontinued operations and asset sales

   22,179   298,849   1,223    12,289   22,179   298,849 

Investments in and advances to affiliates, net

   20,567   20,308   14,344 

Purchase of investments held-for-sale

   (52,085)  (3,726)  —   

Purchase of investments held-to-maturity

   (23,061)  —     —   

Proceeds from the sale of investments held-for-sale

   32,274   3,030   —   

Maturities of investments

   4,795   —     —   

Purchase of a noncontrolling ownership interest in an unconsolidated joint venture

   (17,550)  —     —   

Contributions from minority owners

   18,463   21,263   20,308 

Purchase of intangible assets

   (5,597)  (751)  (635)   (2,291)  (5,597)  (751)
  


 


 


          

Net cash used in investing activities

   (312,063)  (3,045,363)  (379,661)   (426,472)  (312,063)  (3,045,363)
  


 


 


          

Cash flows from financing activities:

       

Borrowings

   6,354,784   6,832,557   4,444,160    13,113,640   6,354,784   6,832,557 

Payments on long-term debt

   (6,761,743)  (4,058,951)  (4,236,861)   (13,160,942)  (6,761,743)  (4,058,951)

Deferred financing costs

   (2)  (77,884)  (4,153)   (4,511)  (2)  (77,884)

Excess tax benefits from stock award exercises

   25,541   37,251   —   

Stock award exercises and other share issuances, net

   62,902   40,593   43,919 

Purchase of treasury stock

   —     —     (96,540)   (6,350)  —     —   

Excess tax benefits from stock-based compensation

   37,251   —     —   

Stock option exercises and other share issuances, net

   40,593   43,919   43,432 
  


 


 


          

Net cash (used in) provided by financing activities

   (329,117)  2,739,641   150,038 

Net cash provided by (used in) financing activities

   30,280   (329,117)  2,739,641 
  


 


 


          

Net (decrease) increase in cash and cash equivalents

   (121,609)  179,832   190,322 

Net increase (decrease) in cash and cash equivalents

   136,844   (121,609)  179,832 

Cash and cash equivalents at beginning of year

   431,811   251,979   61,657    310,202   431,811   251,979 
  


 


 


          

Cash and cash equivalents at end of year

  $310,202  $431,811  $251,979   $447,046  $310,202  $431,811 
  


 


 


          

 

See notes to consolidated financial statements.

F-6


DAVITA INC.

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

AND

COMPREHENSIVE INCOME

(dollars and shares in thousands)

 

 Common stock

 

Additional

paid-in

capital


  

Retained

earnings


  Treasury stock

 

Accumulated

other

comprehensive

income


  Total

  Common stock Additional
paid-in
capital
  Retained
earnings
 Treasury stock Accumulated
other
comprehensive
(loss)income
  Total 
 Shares

 Amount

 Shares

 Amount

  Shares Amount Shares Amount 

Balance at December 31, 2003

 134,806 $135 $539,575  $389,083  (38,052) $(620,998) $(924) $306,871 

Balance at December 31, 2004

 134,862 $135 $542,714  $611,287 (36,295) $(632,732) $1,730  $523,134 

Comprehensive income:

         

Net income

  222,254   222,254      228,643     228,643 

Unrealized gain on interest rate swaps, net of tax

  2,654   2,654         16,821   16,821 

Less reclassification of net swap realized gains into net income, net of tax

        (3,745)  (3,745)
 


          

Total comprehensive income

  224,908          241,719 
 


          

Stock purchase shares issued

 56  959   959     657   64   1,118    1,775 

Stock unit shares issued

  (936) 161   2,629   1,693     (492)  28   492    —   

Stock option shares issued

  (39,497) 4,946   82,177   42,680     (14,965)  3,276   57,109    42,144 

Stock-based compensation expense

  1,690   1,690     3,353       3,353 

Tax benefits from stock awards exercised

  41,080   41,080 

Payment of stock split fractional shares and related costs

  (157)  (50)  (207)

Treasury stock purchases

 (3,350)  (96,540)  (96,540)
 
 

 


 


 

 


 


 


Balance at December 31, 2004

 134,862 $135 $542,714  $611,287  (36,295) $(632,732) $1,730  $523,134 

Comprehensive income:

 

Net income

  228,643   228,643 

Unrealized gain on interest rate swaps, net of tax

  16,821   16,821 

Less reclassification of net swap valuation gains into net income, net of tax

  (3,745)  (3,745)
 


Total comprehensive income

  241,719 
 


Stock purchase shares issued

  657  64   1,118   1,775 

Stock unit shares issued

  (492) 28   492   —   

Stock option shares issued

  (14,965) 3,276   57,109   42,144 

Stock-based compensation expense

  3,353   3,353 

Tax benefits from stock awards exercised

  38,484   38,484 

Excess tax benefits from stock awards exercised

    38,484       38,484 
 
 

 


 


 

 


 


 


                     

Balance at December 31, 2005

 134,862 $135 $569,751  $839,930  (32,927) $(574,013) $14,806  $850,609  134,862 $135 $569,751  $839,930 (32,927) $(574,013) $14,806  $850,609 

Comprehensive income:

         

Net income

  289,691   289,691      289,691     289,691 

Unrealized gains on interest rate swaps, net of tax

  7,862   7,862         7,862   7,862 

Less reclassification of net swap realized gains into net income, net of tax

  (9,671)  (9,671)        (9,671)  (9,671)
 


          

Total comprehensive income

  287,882          287,882 
 


          

Stock purchase shares issued

  1,861  80   1,403   3,264     1,861   80   1,403    3,264 

Stock unit shares issued

  (1,860) 160   2,790   930     (1,860)  160   2,790    930 

Stock option shares issued

  (5,023) 2,461   42,900   37,877     (5,023)  2,461   42,900    37,877 

Stock-based compensation expense

  26,389   26,389     26,389       26,389 

Excess tax benefits from stock awards exercised

  38,973   38,973     38,973       38,973 
 
 

 


 


 

 


 


 


                     

Balance at December 31, 2006

 134,862 $135 $630,091  $1,129,621  (30,226) $(526,920) $12,997  $1,245,924  134,862 $135 $630,091  $1,129,621 (30,226) $(526,920) $12,997  $1,245,924 
 
 

 


 


 

 


 


 


Comprehensive income:

        

Net income

     381,778     381,778 

Unrealized losses on interest rate swaps, net of tax

        (7,169)  (7,169)

Less reclassification of net swap realized gains into net income, net of tax

        (8,858)  (8,858)

Unrealized gains on investments, net of tax

        4,211   4,211 

Less reclassification of net investment realized gains into net income, net of tax

        (3,692)  (3,692)
          

Total comprehensive income

         366,270 
          

Cumulative effect of change in accounting principle SFAS Interpretation No (FIN) 48

     3,891     3,891 

Stock purchase shares issued

    3,831   124   2,160    5,991 

Stock unit shares issued

    (1,848)  120   2,098    250 

Stock options and SSARs exercised

    13,429   2,361   41,268    54,697 

Stock-based compensation expense

    34,149       34,149 

Excess tax benefits from stock awards exercised

    27,428       27,428 

Purchase of treasury stock

     (111)  (6,350)   (6,350)
                     

Balance at December 31, 2007

 134,862 $135 $707,080  $1,515,290 (27,732) $(487,744) $(2,511) $1,732,250 
                     

 

See notes to consolidated financial statements.

F-7


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

 

1.    Organization and summary of significant accounting policies

 

Organization

 

DaVita Inc. operates kidney dialysis centers and provides related medicalrenal care services primarily in dialysis centers and in contracted hospitals across the United States. These operations represent a single reportable segment. On October 5, 2005,As of December 31, 2007, the Company completed its acquisition of DVA Renal Healthcare, Inc. from Gambro Inc. under the Stock Purchase Agreement dated December 6, 2004, for approximately $3,060,000. DVA Renal Healthcare was one of the largest dialysis service providers in the United States, operating 566operated or provided administrative services to 1,359 outpatient dialysis centers located in 43 states and the District of Columbia, serving approximately 43,000 patients107,000 patients. The business includes dialysis and generating annual revenuesrelated services and other ancillary services and strategic initiatives which relate primarily to our core business of approximately $2,000,000. In order for the Company to complete the acquisition of DVA Renal Healthcare, it was required to divest a number of outpatient dialysis centers and to terminate two management services agreements. See Note 4 to the Consolidated Financial Statements for a discussion of these transactions.

The operating results of DVA Renal Healthcare, Inc. are included in the Company’s consolidated financial statements from October 1, 2005. The operating results of the historical DaVita divested centers and its one management services agreement are reflected as discontinued operations for 2005 and prior.

All share and per share data prior to 2005 have been adjusted to retroactively reflect the effects of a three-for-two stock split in the form of a stock dividend in the second quarter of 2004.providing renal care services.

 

Basis of presentation

 

These consolidated financial statements and accompanying notes are prepared in accordance with United States generally accepted accounting principles. The financial statements include the Company’sDaVita and its subsidiaries, partnerships and partnerships that are wholly-owned, majority-owned, orother entities in which the Companyit maintains a 100% or majority voting interest, an other controlling financial interest.interest, or of which it is the primary beneficiary (collectively, the Company). All significant intercompany transactions and balances have been eliminated. Non-consolidated equity investments are recorded under the equity or cost method of accounting based upon whether the Company has significant influence over the investee. Prior year balances and amounts have been classified to conform to the current year presentation.

The operating results of DVA Renal Healthcare, Inc. are included in the Company’s consolidated financial statements from October 1, 2005. The operating results of the historical DaVita divested centers and its one related management services agreement are reflected as discontinued operations for 2005.

 

Use of estimates

 

The preparation of financial statements in conformity with United States generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of revenues, expenses, assets, liabilities and contingencies. Although actual results in subsequent periods will differ from these estimates, such estimates are developed based on the best information available to management and management’s best judgments at the time made. All significant assumptions and estimates underlying the reported amounts in the financial statements and accompanying notes are regularly reviewed and updated. Changes in estimates are reflected in the financial statements based upon on-going actual experience trends, or subsequent settlements and realizations depending on the nature and predictability of the estimates and contingencies. Interim changes in estimates related to annual operating costs are applied prospectively within annual periods.

 

The most significant assumptions and estimates underlying these financial statements and accompanying notes involve revenue recognition and provisions for uncollectible accounts, impairments and valuation adjustments, accounting for income taxes, quarterly variable compensation accruals, and purchase accounting valuation estimates.estimates and stock-based compensation. Specific estimating risks and contingencies are further addressed within these notes to the consolidated financial statements.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Net operating revenues and accounts receivable

 

Revenues associated with Medicare and Medicaid programs are recognized based on a)on: (a) the payment rates that are established by statute or regulation for the portion of the payment rates paid by the government payor (e.g., 80% for Medicare patients) and b)(b) for the portion not paid by the primary government payor, estimates of the estimated amounts that will ultimately be collectible from other government programs paying secondary coverage (e.g., Medicaid secondary coverage), the patient’s commercial health plan secondary coverage, or the patient. Revenues

F-8


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

associated with commercial health plans are estimated based on contractual terms for the patients under healthcare plans with which we have formal agreements, commercialnon-contracted health plan coverage terms if known, estimated secondary collections, historical collection experience, historical trends of refunds and payor payment adjustments (retractions), inefficiencies in our billing and collection processes that can result in denied claims for payments, and regulatory compliance issues.

 

Operating revenues are recognized in the period services are provided. Revenues consist primarily of payments from Medicare, Medicaid and commercial health plans for dialysis and ancillary services provided to patients. A usual and customary fee schedule is maintained for our dialysis treatment and other patient services; however, actual collectible revenue is normally recognized at a discount tofrom the fee schedule.

 

Commercial revenue recognition involves substantial estimating risks. With many larger, commercial insurers the Company has several different contracts and payment arrangements, and these contracts often include only a subset of the Company’s centers. It is often not possible to determine which contract, if any, should be applied prior to billing. In addition, for services provided by non-contracted centers, final collection may require specific negotiation of a payment amount, typically at a significant discount from the Company’s usual and customary rates.

 

Services covered by Medicare and Medicaid are less subject to estimating risk. Both Medicare and Medicaid rates use prospective payment methods established in advance with definitive terms. Medicare payments for bad debt claims are subject to individual center profitability, as established by cost reports, and require evidence of collection efforts. As a result, billing and collection of Medicare bad debt claims are often delayed significantly;significantly, and final payment is subject to audit.

Medicaid payments, when Medicaid coverage is secondary, may also be difficult to estimate. For many states, Medicaid payment terms and methods differ from Medicare, and may prevent accurate estimation of individual payment amounts prior to billing.

 

Revenue recognition uncertainties inherent in the Company’s operations are addressed in AICPA Statement of Position (SOP) NO.No. 00-1 Auditing Health Care Third-Party Revenues and Related Receivables. As addressed in SOP No. 00-1, net revenue recognition and allowances for uncollectible billings require the use of estimates of the amounts that will actually be realized considering, among other items, retroactive adjustments that may be associated with regulatory reviews, audits, billing reviews and other matters.

 

OurThe Company’s range of revenue estimating risk is generally expected to be within 1% of total revenue. Changes in revenue estimates for prior periods are separately disclosed, if material.

 

Management and administrative support services are provided to dialysis centers and physician practices not owned bythat the Company does not own or wherein which the Company hasdoes not maintain a minoritycontrolling ownership interest. The management fees are principally determined as a percentage of the managed operations’ revenues or cash collections and in some cases an additional component based upon a percentage of operating income. Management fees are included in net operating revenues as earned.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)earned, and represent less than 1% of total operating revenues.

 

Other income, net

 

Other income includes interest income on cash investments and other non-operating gains and losses.

F-9


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Cash and cash equivalents

 

Cash equivalents are highly liquid investments with maturities of three months or less at date of purchase.

 

Inventories

 

Inventories are stated at the lower of cost (first-in, first-out) or market and consist principally of pharmaceuticals and dialysis relateddialysis-related supplies. Rebates are recorded when earned and are based on the achievement of certain factors such as process improvements, data submission and some combination of these factors.

 

Assets of discontinued operations

 

Assets to be disposed of that the Company has committed to sell, are available for immediate sale, or for which a sale of assets is probable, will be classified as held for sale in accordance with SFAS No. 144Accounting for the Impairment or Disposal of Long-Lived Assetsand are included in other current assets. Assets held for sale are not depreciated while they are classified as held for sale.

 

Property and equipment

 

Property and equipment is stated at cost less accumulated depreciation and amortization and is further reduced by any impairment.impairments. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization expenses are computed using the straight-line method over the useful lives of the assets estimated as follows: buildings, 20 to 40 years; leasehold improvements, the shorter of their economic useful life or the expected lease term; and equipment and information systems, principally 3 to 8 years. Disposition gains and losses are included in current operating expenses.

 

Investments

In accordance with SFAS No. 115Accounting for Certain Investments in Debt and Equity Securities, and based upon the Company’s intentions and ability to hold certain assets until maturity, the Company classifies certain debt securities as held-to-maturity and measures them at amortized cost. Based upon the Company’s other strategies involving investments, the Company classifies equity securities that have readily determinable fair values and certain other debt securities as available for sale and records them at fair value. Unrealized gains or losses from available for sale investments are recorded in other comprehensive income until realized.

Amortizable intangibles

 

Amortizable intangible assets and liabilities include non-competition and similar agreements, lease agreements, hospital acute services contracts, deferred debt issuance costs and the Gambro Alliance and Product Supply Agreement, each of which have determinate useful lives. Non-competition and similar agreements are amortized over the terms of the agreements, typically ten years, using the straight-line method. Lease agreements and hospital acute service contracts are amortized straight-line over the term of the lease and the contract period, respectively. Deferred debt issuance costs are amortized to debt expense over the term of the related debt using the effective interest method. The Alliance and Product Supply Agreement intangible liability is being amortized straight-line over the term of the agreement, which is ten years.

 

F-10


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Goodwill

 

Goodwill represents the difference between the purchase cost of acquired businesses and the fair value of the identifiable tangible and intangible net assets acquired. Goodwill is not amortized, but is assessed for valuation impairment as circumstances warrant and at least annually. An impairment charge would be recorded to the extent the book value of goodwill exceeds its fair value. The Company operates as one reporting unit for goodwill impairment assessments.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Impairment of long-lived assets

 

Long-lived assets, including property and equipment, investments in third party dialysis businesses, and amortizable intangible assets, are reviewed for possible impairment at least annually and whenever significant events or changes in circumstances indicate that an impairment may have occurred, including changes in our business strategy and plans, changes in the quality or structure of our relationships with our partners and deteriorating operating performance of individual dialysis centers. An impairment is indicated when the sum of the expected future undiscounted net cash flows identifiable to an asset or asset group is less than its carrying value. Impairment losses are determined from actual or estimated fair values, which are based on market values, net realizable values or projections of discounted net cash flows, as appropriate. Impairment charges are included in operating expenses. Interest is not accrued on impaired loans unless the estimated recovery amounts justify such accruals.

 

Income taxes

 

Federal and state income taxes are computed at current enacted tax rates, less tax credits using the asset and liability method. TaxesDeferred taxes are adjusted both for items that do not have tax consequences and for the cumulative effect of any changes in tax rates from those previously used to determine deferred tax assets or liabilities. Tax provisions include amounts that are currently payable, changes in deferred tax assets and liabilities that arise because of temporary differences between the timing of when items of income and expense are recognized for financial reporting and income tax purposes, which are measured using enacted tax rates and laws expected to applychanges in the periods whenrecognition of tax positions due to the deferred tax liabilityapplication of Financial Accounting Standards Board, or asset is expected to be realized,FASB, Interpretation 48 (FIN 48), and any changes in the valuation allowance caused by a change in judgment about the realizability of the related deferred tax assets. A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.

 

Self insurance

 

The Company maintains insurance reserves for professional and general liability and workers’ compensation in excess of certain individual and or aggregate amounts not covered by third-party carriers. The Company estimates the self-insured retention portion of professional and general liability and workers’ compensation risks using third-party actuarial calculations that are based upon historical claims experience and expectations for future claims.

 

Minority interests

 

Consolidated income is reduced by the proportionate amount of income accruingattributable to minority interests.interests in majority-owned joint ventures and other non-wholly-owned subsidiaries. Minority interests represent the equity interests of third-party owners in consolidated entities which are not wholly-owned. As of December 31, 2006,2007, third parties held minority ownership interests in 86106 consolidated entities.

F-11


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Stock-based compensation

 

Effective January 1, 2006, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 123(R)Share-Based Payment, which requires the measurement and recognition of cost for all stock-based awards made to employees and directors, including stock options, stock appreciation rights, stock units and discounted employee stock purchases. Under this standard, the Company’s stock-based compensation awards are measured at their estimated fair value on the date of grant and recognized as compensation expense on the straight-line method over their individual requisite service periods. The Company implemented SFAS No. 123(R) using the modified prospective transition method.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Prior to 2006, the Company accounted for stock-based compensation in accordance with Accounting Principles Board Opinion (APB) No. 25Accounting for Stock Issued to Employees, as permitted under SFAS No. 123Accounting for Stock-Based Compensation. Under APB No. 25, stock option grants to employees and directors did not result in an expense if the exercise price was at least equal to the market price at the date of grant. However, under APB No. 25 the Company did recognize compensation expense for stock units, which were valued at the closing stock price on the date of grant and amortized over thetheir respective vesting periods, and for modifications to stock awards as required under FASB Interpretation No. 44Accounting for Certain Transactions Involving Stock Compensation.

 

Interest rate swap agreements

The Company has entered into interest rate swap agreements as a means of hedging its exposure to variable-based interest rate changes (LIBOR). These agreements are not held for trading or speculative purposes, and have the economic effect of converting portions of our variable rate debt to a fixed rate. At December 31, 2007, the Company had nine interest rate swap agreements with amortizing notional amounts totaling $968,000 and two forward interest rate swap agreements with notional amounts totaling $200,000. These agreements are designated as cash flow hedges, and as a result hedge-effective gains or losses resulting from changes in the fair values of these swaps are reported in other comprehensive income until such time as each specific swap tranche is realized, at which time the amounts are reclassified into net income. Net amounts paid or received under the hedge-effective swaps have been reflected as adjustments to interest expense. In 2005, certain portions of the swap agreements were ineffective as hedges as a result of changes in the Company’s debt structure, and as such the ineffective portions of $4,548 were included in net income, see Note 13 to the consolidated financial statements.

New accounting standards

 

EffectiveOn January 1, 20062008, the Company adopted SFAS No. 123(R)157Share-Based Payment,Fair Value Measurementswhich amendedexcept for the nonfinancial assets and liabilities that are subject to a one-year deferral allowed by FASB Staff Position (FSP) FAS 157-2Effective Date of FASB Statement No. 157. This standard establishes a framework for measuring fair value and also requires additional disclosures about fair value measurements. The standard applies to assets and liabilities that are carried at fair value on a recurring basis. On February 12, 2008, FSP FAS157-2 was issued delaying the effective date of SFAS No. 123157 until fiscal years beginning after November 15, 2008 for nonfinancial assets and 95liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The implementation of this standard relating to assets and supersedes APBliabilities carried at fair value on a recurring basis is not expected to have a material impact on the Company’s consolidated financial statements.

On January 1, 2008, the Company adopted SFAS No. 25159AccountingFair Value Option for Stock Issued Financial Assets and Financial Liabilities, including an amendment of SFAS No. 115.This standard allows companies the alternative

F-12


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

to Employees.measure certain financial assets and liabilities at fair value on an instrument-by-instrument basis that are currently not required to be measured at fair value. The standard is also designed to reduce the volatility in earnings caused by measuring related assets and liabilities differently and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The implementation of this standard is not expected to have a material impact on the Company’s consolidated financial statements.

In December 2007, the FASB issued Statement No. 141(R)Business Combinations, which replaces SFAS No. 141Business Combinations. This standard requires all business combinations to be accounted for under the Companyacquisition method (previously referred to measureas the costpurchase method). Under the acquisition method, the acquirer recognizes the assets acquired, the liabilities assumed, contractual contingencies, as well as any noncontrolling interest in the acquiree at their fair values at the acquisition date. Noncontractual contingencies are recognized at the acquisition date at their fair values only if it is more likely than not that they meet the definition of employee services receivedan asset or a liability in exchange forFASB Concepts Statement No. 6Elements ofFinancial Statements. Transaction costs are excluded from the acquisition accounting and will be expensed as incurred. Any contingent consideration included by the acquirer as part of the purchase price must also be measured at fair value at the acquisition date and will be classified as either equity or a liability. This standard also requires a company that obtains control but acquires less than 100% of an awardacquiree to record 100% of equity instruments, such as stock options, stock appreciation rights, stock units and discounted employee stock purchases, based on the grant-date fair value of the awardacquiree assets, liabilities, and to recognize such cost overnoncontrolling interests at the requisite period during which an employee provides service.acquisition date. This standard is effective for periods beginning on or after December 15, 2008. The grant-date fair valueCompany is to be estimated using option-pricing models adjusted for unique characteristicscurrently in the process of assessing the equity instruments. The standard also addresses the accounting for transactions that involve the creation of a liability in exchange for goods or services that are based on the fair value of a company’s equity instruments or that may be settled through the issuance of such equity instruments. The standard does not change the accounting for transactions involving equity instruments issued for services to non-employees or the accounting for employee stock ownership plans. The standard also requires that the tax benefits realized from stock award exercises in excess of the stock-based compensation expense recognizable for financial statement purposes be reported as a cash flow from financing activities rather than as an operating cash flow as reported in years prior to the adoptionexpected impact of this standard. This reduces net operating cash flows and increases net financing cash flows for periods after adoption of SFAS No. 123(R). During 2006, the Company recorded $26,389 of stock-based compensation expenses including stock-based compensation expenses associated with implementing SFAS No. 123(R). See further discussion in Note 3 to thestandard on its consolidated financial statements.

 

In JuneDecember 2007, the FASB issued Statement No. 160Noncontrolling Interests in Consolidated Financial Statements, which amends Accounting Research Bulletin No. 51Consolidated Financial Statements.This standard requires noncontrolling interests to be treated as a separate component of equity, but apart from the parent’s equity and not as a liability, or as an item outside of equity. This will eliminate diversity that currently exists in accounting for transactions between an entity and its noncontrolling interests. This standard also specifies that consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, and that changes in the parent’s ownership interest while it retains a controlling financial interest should be accounted for as equity transactions. This standard also expands disclosures in the financial statements to include a reconciliation of the beginning and ending balances of the equity attributable to the parent and the noncontrolling owners and a schedule showing the effects of changes in a parent’s ownership interest in a subsidiary on the equity attributable to the parent. This standard is effective for periods beginning on or after December 15, 2008. The Company is currently in the process of assessing the expected impact of this standard on its consolidated financial statements.

F-13


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

2.    Earnings per share

Basic net income per share is calculated by dividing net income by the weighted average number of common shares and vested stock units outstanding. Diluted net income per share includes the dilutive effect of stock options, stock-settled stock appreciation rights and unvested stock units under the treasury stock method.

The reconciliations of the numerators and denominators used to calculate basic and diluted net income per share are as follows:

   Year ended December 31,
   2007  2006  2005
   (in thousands, except per share)

Basic:

      

Income from continuing operations

  $381,778  $289,329  $207,422

Income from discontinued operations, net of tax

   —     —     13,157

Gain on disposal of discontinued operations, net of tax

   —     362   8,064
            

Net income

  $381,778  $289,691  $228,643
            

Weighted average shares outstanding during the year

   105,848   103,471   100,713

Vested stock units

   45   49   49
            

Weighted average shares for basic earnings per share calculation

   105,893   103,520   100,762
            

Basic earnings per share from continuing operations, net of tax

  $3.61  $2.79  $2.06

Income from discontinued operations, net of tax

   —     —     0.13

Gain on disposal of discontinued operations, net of tax

   —     0.01   0.08
            

Basic net income per share

  $3.61  $2.80  $2.27
            

Diluted:

      

Income from continuing operations

  $381,778  $289,329  $207,422

Income from discontinued operations, net of tax

   —     —     13,157

Gain on disposal of discontinued operations, net of tax

   —     362   8,064
            

Net income

  $381,778  $289,691  $228,643
            

Weighted average shares outstanding during the year

   105,848   103,471   100,713

Vested stock units

   45   49   49

Assumed incremental shares from stock plans

   1,525   2,273   3,306
            

Weighted average shares for diluted earnings per share calculation

   107,418   105,793   104,068
            

Diluted earnings per share from continuing operations, net of tax

  $3.55  $2.73  $1.99

Income from discontinued operations, net of tax

   —     —     0.13

Gain on disposal of discontinued operations, net of tax

   —     0.01   0.08
            

Diluted net income per share

  $3.55  $2.74  $2.20
            

Stock plan award shares for stock options and stock appreciation rights that have exercise or base prices greater than the average market price of shares outstanding during the year were not included in the computation of diluted earnings per share because they were anti-dilutive. These excluded stock plan shares were as follows: 260,000 shares at $56.63 to $64.21 per share in 2007, 932,600 shares at $54.86 to $60.21 per share in 2006, and 2,419,750 shares at $45.60 to $52.81 per share in 2005.

F-14


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

3.    Accounts receivable

Less than 10% of the accounts receivable balances as of December 31, 2007 and 2006 were more than six months old, and there were no significant balances over one year old. Approximately 1% of our accounts receivable as of December 31, 2007 and 2006 relate to collections from patients. Accounts receivable are principally from Medicare and Medicaid programs and commercial insurance plans.

4.    Other receivables

Other receivables were comprised of the following:

   December 31,
   2007  2006

Supplier rebates and other non-trade receivables

  $151,939  $119,889

Medicare bad debt claims

   31,400   15,990

Transition services receivable associated with divested centers

   —     2,406

Operating advances under management services agreements

   15,405   10,557
        
  $198,744  $148,842
        

Operating advances under management services agreements are generally unsecured.

5.    Other current assets

Other current assets consist principally of prepaid expenses and operating deposits.

6.    Property and equipment

Property and equipment were comprised of the following:

   December 31, 
   2007  2006 

Land

  $11,827  $13,593 

Buildings

   32,448   39,438 

Leasehold improvements

   731,426   620,483 

Equipment and information systems

   814,512   686,426 

New center and capital asset projects in progress

   33,027   48,747 
         
   1,623,240   1,408,687 

Less accumulated depreciation and amortization

   (683,914)  (558,721)
         
  $939,326  $849,966 
         

Depreciation and amortization expense on property and equipment was $178,990, $160,717 and $105,254 for 2007, 2006 and 2005, respectively.

Interest on debt incurred during the development of new centers and other capital asset projects is capitalized as a component of the asset cost based on the respective in-process capital asset balances. Interest capitalized was $3,878, $4,708 and $1,912 for 2007, 2006 and 2005, respectively.

F-15


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

7.    Amortizable intangibles

Amortizable intangible assets were comprised of the following:

   December 31, 
   2007  2006 

Noncompetition and other agreements

  $276,182  $261,836 

Lease agreements

   8,738   8,738 

Deferred debt issuance costs

   72,618   73,826 
         
   357,538   344,400 

Less accumulated amortization

   (174,496)  (140,679)
         

Total amortizable intangible assets

  $183,042  $203,721 
         

Amortizable intangible liabilities were comprised of the following:

   December 31, 
   2007  2006 

Alliance and product supply agreement commitment (See Note 19)

  $68,200  $120,300 

Less accumulated amortization

   (26,893)  (15,037)
         
  $41,307  $105,263 
         

Net amortization expense from noncompetition and other agreements and the amortizable intangible liabilities was $14,480, $12,578 and $11,582 for 2007, 2006 and 2005, respectively. Lease agreements are amortized to rent expense, which was $2,240 in 2007, $3,309 in 2006, and $690 in 2005, respectively. Deferred debt issuance costs are amortized to debt expense as described in Note 13 to the consolidated financial statements.

Scheduled amortization charges from intangible assets and liabilities as of December 31, 2007 were as follows:

   Noncompetition and
other agreements
  Deferred debt
issuance costs
  Alliance and
Product Supply
Agreement liability
 

2008

  $22,808  $9,772  $(5,330)

2009

   19,428   9,646   (5,330)

2010

   18,340   9,374   (5,330)

2011

   17,488   8,914   (5,330)

2012

   16,138   6,418   (5,330)

Thereafter

   39,206   5,510   (14,657)

8.    Investments in third-party businesses

Investments in non-consolidated dialysis businesses and related advances were $19,446 and $1,813 at December 31, 2007 and 2006. During 2007, 2006 and 2005, the Company recognized income of $1,217, $2,308 and $1,406, respectively, relating to investments in non-consolidated businesses under the equity method. These amounts are included as a reduction to minority interest expense in the consolidated statements of income.

F-16


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

On December 31, 2007, the Company acquired a 50% noncontrolling ownership interest in a joint venture that operates six dialysis centers for $17,550. During 2006, the Financial Accounting Standards Board issuedCompany acquired a majority voting interest in one business that was previously minority-controlled and sold its interest in one minority-controlled business. The Company did not recognize a gain or loss on the sale as the investment was carried at fair value as a result of the DVA Renal Healthcare acquisition.

9.    Investments

In accordance with SFAS No. 115 and based on the Company’s intentions and strategy involving investments, the Company classifies certain debt securities as held-to-maturity and records them at amortized cost. Equity securities that have readily determinable fair values and other debt securities classified as available for sale are recorded at fair value.

The Company’s investments consist of the following:

   December 31, 2007  December 31, 2006
   Held to
maturity
  Available
for sale
  Total  Held to
maturity
  Available
for sale
  Total

Certificates of deposit and U.S. treasury notes due within one year

  $19,804  $—    $19,804  $1,500  $—    $1,500

Investments in mutual funds

   —     43,036   43,036   —     16,408   16,408
                        
  $19,804  $43,036  $62,840  $1,500  $16,408  $17,908
                        

Short-term investments

  $19,804  $20,474  $40,278  $1,500  $3,234  $4,734

Long-term investments

   —     22,562   22,562   —     13,174   13,174
                        
  $19,804  $43,036  $62,840  $1,500  $16,408  $17,908
                        

The cost of the certificates of deposit and U.S. treasury notes at December 31, 2007 and 2006, as well as the investments in mutual funds at December 31, 2006, approximates fair value. As of December 31, 2007, the available for sale investments included $850 of gross pre-tax unrealized gains. During 2007, the Company recorded gross pre-tax unrealized gains of $6,892 in other comprehensive income associated with changes in the fair value of these investments as well as the NxStage common stock, as discussed below. During 2007, the Company sold investments in mutual funds for net proceeds of $6,406, and recognized a pre-tax gain of $104, or $64 after tax, that was previously recorded in other comprehensive income. This pre-tax gain is included in other income. The Company also received $4,795 from maturities of certificates of deposits and treasury notes, during 2007.

On February 7, 2007, the Company entered into a National Provider Agreement with NxStage, Inc. The agreement provides the Company with the ability to purchase NxStage home-based hemodialysis products at a potential discount depending upon the achievement of certain volume targets. The agreement has an initial term of three years, terminating on December 31, 2009, and may be extended in six-month increments up to two additional years if certain volume targets are met. As a part of the agreement, the Company purchased outright all of its NxStage System One equipment then in use for $5,100, and will purchase a majority of its future home-based hemodialysis equipment and supplies from NxStage. In connection with the provider agreement, the Company purchased two million shares of NxStage common stock in a private placement offering for $20,000, representing an ownership position of approximately 7% in NxStage. The Company subsequently sold these shares in the second and third quarters of 2007 for net proceeds of $25,868 and recognized a pre-tax gain of $5,938, or $3,628 after tax, that was previously recorded in other comprehensive income. The pre-tax gain is included in other income.

F-17


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

10.    Goodwill

Changes in the book value of goodwill were as follows:

   Year ended December 31, 
   2007  2006 

Balance at January 1

  $3,667,853  $3,594,383 

Acquisitions

   105,609   79,948 

DVA Renal Healthcare income tax adjustments and other adjustments

   (4,951)  (5,811)

Divestitures and other adjustments

   (578)  (667)
         

Balance at December 31

  $3,767,933  $3,667,853 
         

11.    Other liabilities

Other accrued liabilities were comprised of the following:

   December 31,
   2007  2006

Payor refunds and retractions

  $333,089  $322,155

Insurance and self-insurance accruals

   66,222   74,607

Accrued interest

   48,506   48,781

Accrued non-income tax liabilities

   12,386   11,610

Other

   25,948   16,066
        
  $486,151  $473,219
        

12.    Income taxes

On January 1, 2007, the Company adopted the provisions of FASB Interpretation (FIN) No. 48 (FIN 48)Accounting for Income Tax Uncertainties, which clarifies the accounting for uncertainty in income taxes recognized in the consolidated financial statements in accordance with SFAS Statement No. 109Accounting for Income Taxes. The Interpretation prescribes a recognition threshold of more-likely-than-not and a measurement attribute on all tax positions taken or expected to be taken in a tax return in order to be recognized in the financial statements. In making this assessment, a company must determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based solely on the technical merits of the position and must assume that the tax position will be examined by the appropriate taxing authority that would have full knowledge of all relevant information. Once the recognition threshold is met, the tax position is then measured to determine the actual amount of benefit to recognize in the financial statements. In addition, the recognition threshold of more-likely-than-not must continue to be met in each reporting period to support continued recognition of the tax benefit. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be de-recognizedderecognized in the financial reporting period in which that threshold is no longer met. The

As a result of implementing FIN 48, the Company is currently assessingrecognized an increase of $22,860 to the expected impactbeginning balance of this Interpretation onits current and long-term deferred tax assets, offset by increases in its current taxes payable and other long-term liabilities of $18,969. This recognized net tax benefit of $3,891 was recorded as an increase to the consolidated financial statements.

F-18


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Inbeginning balance of retained earnings on January 1, 2007. The Company also recorded a decrease of $4,951 to the fourthbeginning balance of current taxes payable and long-term deferred tax liabilities, and a corresponding decrease to goodwill as a result of recognizing tax benefits associated with our acquisition of DVA Renal Healthcare.

A reconciliation of the beginning and ending amount of unrecognized tax benefits was as follows:

   Year ended December 31,
2007
 
  

Balance January 1, 2007

  $27,925 

Additions for tax positions related to 2007.

   1,798 

Additions for tax positions related to prior years.

   416 

Reductions for tax positions related to prior years

   (3,200)

Settlements

   (1,195)
     

Balance December 31, 2007

  $25,744 
     

As of December 31, 2007, it is reasonably possible that $17,493 of unrecognized tax benefits may be recognized within the next 12 months, primarily related to the filing of a tax accounting method change request for recently acquired entities. This change will have no impact on the Company’s effective tax rate. As of December 31, 2007, unrecognized tax benefits totaling $7,522 would affect the Company’s effective tax rate, if recognized.

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in its income tax expense. At December 31, 2007, the Company had approximately $2,600 accrued for interest and penalties related to unrecognized tax benefits.

The Company and its subsidiaries file U.S. federal income tax returns and various state returns. The Company is no longer subject to U.S. federal, state and local examinations by tax authorities for years before 2003. The Internal Revenue Service (IRS) completed an examination of the Company’s U.S. federal income tax returns for 2003 and 2004 during the second quarter of 2006, the Company adopted the U.S. Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 108, which provides interpretive guidance on how the effects of prior year misstatements should be considered in quantifying current year financial statement misstatements.2007. The interpretations in SAB No. 108, which expresses the SEC’s staff views, were issued to address the diversity in the practice of quantifying financial statement misstatements and the potential under current practice for a build up of improper amounts on the balance sheet. The SEC staff indicated that companies should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in material misstatement. The adoption of this interpretationexamination did not have anresult in any material impact onto the Company’s consolidated financial statements.

 

Income tax expense consisted of the following:

   Year ended December 31, 
   2007  2006  2005 

Current:

     

Federal

  $196,697  $159,054  $178,569 

State

   30,446   24,009   33,564 

Deferred:

     

Federal

   14,945   (12)  (60,866)

State

   3,656   2,354   (10,502)
             
  $245,744  $185,405  $140,765 
             

F-19


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

The allocations of income tax expense were as follows:

   Year ended December 31,
   2007  2006  2005

Continuing operations

  $245,744  $186,430  $123,675

Discontinued operations

   —     —     8,377

Gain on discontinued operations

   —     (1,025)  8,713
            
  $245,744  $185,405  $140,765
            

Deferred tax assets and liabilities arising from temporary differences were as follows:

   December 31, 
   2007  2006 

Receivables, primarily allowance for doubtful accounts

  $61,184  $47,054 

Alliance and product supply agreement

   16,069   40,947 

Accrued liabilities

   191,140   154,169 

Other

   43,218   27,638 
         

Deferred tax assets

   311,611   269,808 

Valuation allowance

   (9,353)  (10,656)
         

Net deferred tax assets

   302,258   259,152 
         

Intangible assets

   (206,236)  (155,762)

Property and equipment

   (12,825)  (18,953)

Other

   (1,674)  (10,989)
         

Deferred tax liabilities

   (220,735)  (185,704)
         

Net deferred tax assets

  $81,523  $73,448 
         

At December 31, 2007, the Company had state net operating loss carryforwards of approximately $147,890 that expire through 2027, and federal net operating loss carryforwards of $16,579 that expire through 2027. The utilization of these losses may be limited in future years based on the profitability of certain separate-return entities. The valuation allowance decrease of $1,303 related to changes in the estimated tax benefit of capital losses and federal and state operating losses of separate-return entities, of which an increase of $1,157 is included as a component of tax expense and a $2,460 decrease is an adjustment to income taxes payable in connection with the adoption of FIN 48. A total of approximately $2,700 of valuation allowance will reduce goodwill when the related tax benefits are first recognized.

F-20


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

The reconciliation between our effective tax rate from continuing operations and the U.S. federal income tax rate is as follows:

   Year ended
December 31,
 
   2007  2006  2005 

Federal income tax rate

  35.0% 35.0% 35.0%

State taxes, net of federal benefit

  3.5  3.9  3.4 

Changes in deferred tax valuation allowances

  0.2  (0.1) (0.7)

Other

  0.5  0.4  (0.3)
          

Effective tax rate

  39.2% 39.2% 37.4%
          

13.    Long-term debt

Long-term debt was comprised of the following:

   December 31, 
   2007  2006 

Senior Secured Credit Facilities:

   

Term loan A

  $229,250  $279,250 

Term loan B

   1,705,875   2,105,875 

Senior and senior subordinated notes

   1,750,000   1,350,000 

Acquisition obligations and other notes payable

   11,047   9,197 

Capital lease obligations

   6,667   6,929 
         

Total principal debt outstanding

   3,702,839   3,751,251 

Premium on the 6- 5/8% senior notes

   4,479   —   
         
   3,707,318   3,751,251 

Less current portion

   (23,431)  (20,871)
         
  $3,683,887  $3,730,380 
         

Scheduled maturities of long-term debt at December 31, 2007 were as follows:

2008

  $23,431

2009

   63,916

2010

   89,034

2011

   66,570

2012

   1,706,541

Thereafter

   1,753,347

Interest rate swap agreementsSenior Secured Credit Facility

 

The Senior Secured Credit Facilities are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and are secured by substantially all of the Company’s and its subsidiary guarantors’ assets. The Senior Secured Credit Facilities also contain customary affirmative and negative covenants and require compliance with financial covenants, including an interest rate coverage ratio, and a leverage ratio that determines the interest rate margins on term loan A and the revolving line of credit. The Senior Secured Credit Facilities in general also contain limits on the general amount of capital expenditures for internal growth,

F-21


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

acquisitions and capital improvements (see discussion below) as well as limits on the amount of tangible net assets for non-guarantor subsidiaries.

Term Loans

Term loan A and term loan B total outstanding borrowings each consist of various individual tranche amounts that can range in maturity from one month to twelve months. Each specific tranche bears interest at a LIBOR rate determined by the maturity of that specific tranche and the interest rates are reset as each specific tranche matures. The overall weighted average interest rate for each term loan is determined based upon the LIBOR interest rates in effect for each individual tranche plus the interest rate margin.

During 2007 and 2006, the Company has entered intomade principal payments totaling $50,000 and $62,000 on term loan A, respectively, and $400,000 and $338,000 on term loan B, respectively. The principal payments made on term loan A and term loan B in 2007 were prepayments. The term loan B prepayment was made from the proceeds of issuing the senior notes as discussed below. In 2006, $35,000 were mandatory principal payments as required for term loan A and $24,500 were mandatory principal payments as required for term loan B. The balance of the principal payments in 2006 were prepayments. As a result of the principal prepayment made in 2007 and 2006, the Company wrote off a total of $4,371 and $3,270, respectively, of deferred financing costs, which is included in debt expense.

Term Loan A

On February 27, 2007, the Company’s interest rate margin on its term loan A was reduced by 0.25% as a result of achieving certain financial ratios as defined in the Senior Secured Credit Facilities.

Term loan A currently bears interest at LIBOR plus a margin of 1.50%, for an overall weighted average effective rate of 6.35% at December 31, 2007. The interest rate margin is subject to adjustment depending upon certain financial conditions and could range from 1.50% to 2.25%. Term loan A matures in October 2011 and requires annual principal payments of $14,875 in 2008, $61,250 in 2009, $87,500 in 2010 and $65,625 in 2011, respectively.

Term Loan B

On February 23, 2007, the Company amended and restated its existing Senior Secured Credit Facilities to, among other things, reduce the interest rate margin on term loan B by 0.50%, and to amend certain financial covenants. The amended term loan B bears interest at LIBOR plus a margin of 1.50%, for an overall weighted average effective rate of 5.80%, including the impact of the Company’s swap agreements, except for the forward interest rate swap agreements, as a means of hedging its exposure to variable-based interest rate changes (LIBOR). These agreements are not held for trading or speculative purposes, and have the economic effect of converting portions of our variable rate debt to a fixed rate. At December 31, 2006,2007. Other terms that were changed included the amount by which the Company had a totalcan elect to increase the revolving and term loan commitments from $500,000 to $750,000 and certain limitations on purchases, redemptions or acquisitions of $1,341,000 notional swap amounts outstanding. The agreements are designated as cash flow hedges,capital stock, the payment of dividends and as a result hedge-effective gains or losses resulting from changesdistributions in cash. Further, limitations on capital expenditures for internal growth will not apply during the fair values of these swaps are reportedperiods in other comprehensive income until such time as the agreements are either de-designated, sold or terminated, at which time the amounts are reclassified into net income. Net amounts paid or received under the effective swaps have been reflected as adjustments to interest expense. In 2005, certain portions of the swap agreements were ineffective as a result of changes in the Company’s debt structure,leverage ratio is less than 3.5:1. The Company’s leverage ratio as of December 31, 2007 was less than 3.5:1. The Company incurred financing costs of $1,781 which were deferred and as such the ineffective portionsalso expensed $248 of $4,548 wereother costs in connection with this transaction, which are included in net income, see Note 14.debt expense. Term loan B matures in October 2012 and requires principal payments of $1,705,875 in year 2012.

F-22


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

2.    Earnings per share

Basic net income per share is calculated by dividing net income by the weighted average numberRevolving Lines of common shares and vested stock units outstanding. Diluted net income per share includes the dilutive effect of stock options, stock-settled stock appreciation rights and unvested stock units (under the treasury stock method).Credit

 

The reconciliationsCompany has an undrawn revolving line under the Senior Secured Credit Facilities totaling $250,000, of which approximately $41,000 was committed for outstanding letters of credit. The Company also has other undrawn revolving lines of credit totaling $7,200 associated with several of its joint ventures.

Senior and Senior Subordinated Notes

On February 23, 2007, the Company issued $400,000 of 65/8% senior notes due 2013 in a private offering, realizing $405,080 in proceeds, which included a $5,080 premium, and incurred $2,719 in related deferred financing costs. These senior notes are part of the numeratorssame series of debt securities as the $500,000 aggregate principal amount of 65/8% senior notes that were issued in March 2005. The effective interest rate for the $400,000 of 65/8% senior notes is 6.45%. The senior notes are guaranteed by substantially all of the Company’s direct and denominatorsindirect wholly-owned subsidiaries and require semi-annual interest payments which began March 15, 2007. The senior notes may be redeemed by the Company in whole or part at any time on or after March 15, 2009, at certain specified prices. The Company used $400,000 of these proceeds to calculate basicpay down its term loan B as discussed above.

The Company’s senior and dilutedsenior subordinated notes, as of December 31, 2007, consisted of $900,000 of 65/8% senior notes due 2013 and $850,000 of 71/4% senior subordinated notes due 2015. The notes are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and require semi-annual interest payments in March and September. The Company may redeem some or all of the senior notes at any time as described above and some or all of the senior subordinated notes at any time on or after March 15, 2010.

Interest rate swaps

As of December 31, 2007, the Company maintained a total of nine interest rate swap agreements with amortizing notional amounts totaling $968,000. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of debt to fixed rates ranging from 3.08% to 4.27%, resulting in an overall weighted average effective interest rate of 5.37% on the hedged portion of our Senior Secured Credit Facilities, including the term loan B margin of 1.50%. The swap agreements expire in 2008 through 2010 and require quarterly interest payments. In addition, the Company maintains two forward interest rate swap agreements with notional amounts totaling $200,000. These forward interest rate swaps will have the economic effect of modifying the LIBOR-based interest rates to fixed rates of 4.05% and 4.70% on the Company’s term loan B outstanding debt. These forward interest rate swaps take effect on September 30, 2008, require quarterly interest payments beginning in December 2008, and expire in 2010. During 2007, 2006, and 2005 the Company accrued net cash benefits (obligations) of approximately $14,497, $15,791, and $(285), respectively, from these swaps, which are included in debt expense. During 2005, the Company also incurred additional net cash obligations of $1,461 from these swaps, which is included in swap valuation gains. The Company estimates that approximately $500 of existing unrealized pre-tax losses in other comprehensive income at December 31, 2007, will be reclassified into income in 2008. As of December 31, 2007 and 2006, the total fair value of these swaps was a net liability of $511 and an asset of $29,544, respectively. The 2007 amount was primarily included in other long-term liabilities and the 2006 amount was primarily included in other long-term assets. Also during 2007, the Company recorded $16,027, net of tax, as reductions to other comprehensive income for valuation losses, net of amounts reclassified into income.

As of December 31, 2007, the Company had approximately 50% of its variable rate debt and approximately 74% of its total debt economically fixed.

F-23


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

As a result of the swap agreements, the Company’s overall Senior Secured Credit Facilities effective weighted average interest rate was 5.90%, based upon the current margins in effect of 1.50%, as of December 31, 2007.

At December 31, 2007, the Company’s overall average effective interest rate was 6.37%.

Debt expense

Debt expense consisted of interest expense of $242,720, $262,967 and $134,429, amortization of deferred financing costs of $9,808, $10,469 and $5,157 for 2007, 2006 and 2005, respectively, and in 2007 and 2006, included the write-off of $4,371 and $3,270, respectively, of deferred financing costs. Debt expense in 2007 also included $248 of other costs associated with the amendment and reinstatement of the Senior Secured Credit Facilities. These interest expense amounts are net of capitalized interest.

2005 Transactions

In conjunction with the repayment and extinguishment of the Company’s prior Senior Secured Credit Facilities during 2005, the Company wrote off deferred financing costs of $8,170 and reclassified into net income $8,100 of swap valuation gains that were previously recorded in other comprehensive income. These gains represented the accumulated fair value of several interest rate swap instruments that became ineffective as cash flow hedges as a result of the repayment of the prior Senior Secured Credit Facilities. In addition, the Company recorded a net loss of $2,100 related to changes in fair values of these swaps that were not effective as interest rate hedges until they were redesignated in the second quarter of 2005.

Portions of the Company’s various interest rate swap agreements that were previously designated and expected to be effective as forward cash flow hedges became ineffective as a result of the Company not having any variable rate LIBOR-based interest payments during a portion of 2005. This resulted in a net charge of $1,700 to swap valuation gains, which includes the $1,461 discussed above as well as a reclassification into income of $2,000 of swap valuation losses that were previously recorded in other comprehensive income. The swap payment periods that began after October 2005 were highly effective as cash flow hedges with gains or losses from changes in their fair values reported in other comprehensive income.

14.    Leases

The majority of the Company’s facilities are leased under non-cancelable operating leases, ranging in terms from five to ten years, which contain renewal options of five to ten years at the fair rental value at the time of renewal or at rates subject to periodic consumer price index increases. The Company also leases certain equipment under capital leases.

F-24


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Future minimum lease payments under non-cancelable operating leases and capital leases are as follows:

 

   Year ended December 31,

   2006

  2005

  2004

   (in thousands, except per share)

Basic:

            

Income from continuing operations

  $289,329  $207,422  $204,508

Income from discontinued operations, net of tax

       13,157   17,746

Gain on disposal of discontinued operations, net of tax

   362   8,064    
   

  

  

Net income

  $289,691  $228,643  $222,254
   

  

  

Weighted average shares outstanding during the year

   103,471   100,713   98,694

Vested stock units

   49   49   33
   

  

  

Weighted average shares for basic earnings per share calculation

   103,520   100,762   98,727
   

  

  

Basic earnings per share from continuing operations, net of tax

  $2.79  $2.06  $2.07

Income from discontinued operations, net of tax

       0.13   0.18

Gain on disposal of discontinued operations, net of tax

   0.01   0.08    
   

  

  

Basic net income per share

  $2.80  $2.27  $2.25
   

  

  

Diluted:

            

Income from continuing operations

  $289,329  $207,422  $204,508

Income from discontinued operations, net of tax

       13,157   17,746

Gain on disposal of discontinued operations, net of tax

   362   8,064    
   

  

  

Net income for diluted earnings per share calculation

  $289,691  $228,643  $222,254
   

  

  

Weighted average shares outstanding during the year

   103,471   100,713   98,694

Vested stock units

   49   49   33

Assumed incremental shares from stock plans

   2,273   3,306   4,134
   

  

  

Weighted average shares for diluted earnings per share calculation

   105,793   104,068   102,861
   

  

  

Diluted earnings per share from continuing operations, net of tax

  $2.73  $1.99  $1.99

Income from discontinued operations, net of tax

       0.13   0.17

Gain on disposal of discontinued operations, net of tax

   0.01   0.08    
   

  

  

Diluted net income per share

  $2.74  $2.20  $2.16
   

  

  

   Operating
leases
  Capital
leases
 

2008

  $170,192  $1,579 

2009

   151,344   1,162 

2010

   136,480   962 

2011

   121,913   966 

2012

   101,035   987 

Thereafter

   336,131   4,452 
         
  $1,017,095   10,108 
      

Less portion representing interest

     (3,441)
       

Total capital lease obligations, including current portion

    $6,667 
       

 

StockRent expense under all operating leases for 2007, 2006, and 2005 was $200,626, $187,139 and $109,511, respectively. Rent expense is recorded on a straight line basis, over the term of the lease, for leases that contain fixed escalation causes. Leasehold improvement incentives are deferred and amortized to rent expense over the term of the lease. The net book value of property and equipment under capital leases was $7,191, $5,765 and $6,094 at December 31, 2007, 2006 and 2005, respectively. Capital lease obligations are included in long-term debt. See Note 13 to the consolidated financial statements.

15.    Employee benefit plans

The Company has a savings plan for substantially all employees which has been established pursuant to the provisions of Section 401(k) of the Internal Revenue Code, or IRC. The plan provides for employees to contribute a percentage of their base annual salaries on a tax-deferred basis not to exceed IRC limitations. The Company does not provide any matching contributions.

During 2000, the Company established the DaVita Inc. Profit Sharing Plan. Contributions to this defined contribution benefit plan are made at the discretion of the Company as determined and approved by the Board of Directors. All contributions are deposited into an irrevocable trust. The profit sharing award shares for each eligible participant is based upon the achievement of employee-specific and/or corporate financial and operating goals. During 2004 the Company elected to discontinue funding the profit sharing plan and to distribute similar awards directly to the recipients, or at their discretion to their 401(k) accounts. In December 2007, the DaVita Profit Sharing Plan was merged into the Company’s 401(k) Plan.

On October 5, 2005, the Company’s Board of Directors approved the adoption of the DaVita Voluntary Deferral Plan. This plan is non-qualified and permits certain employees whose annualized base salary equals or exceeds a minimum annual threshold amount as set by the Company to elect to defer all or a portion of their annual bonus payment and, as originally adopted, up to 15% of their base salary into a deferral account maintained by the Company. Total contributions to this plan in 2007 and 2006 were $1,601, and $1,296, respectively. Effective January 1, 2006, the elective deferral percentage for base salary was increased to up to 50% of a participant’s base salary. Deferred amounts are generally paid out in cash at the participant’s election either in the first or second year following retirement or in a specified future period at least three to four years after the deferral election was effective. Participants are credited with their proportional amount of annual earnings from the plan. The assets of this plan are held in a “rabbi trust” and as such are subject to the claims of the Company’s general creditors in the event of its bankruptcy.

F-25


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

As part of the acquisition of DVA Renal Healthcare on October 5, 2005, the Company acquired an Executive Retirement Plan for certain members of management. The plan is non-qualified and contributions to the plan were made at the discretion of DVA Renal Healthcare based upon a pre-determined percentage of a participant’s base salary. Effective November 2005, all contributions to this plan were discontinued and the balance of the plan assets will be paid out upon termination of each individual participant.

The Company maintains a non-qualified deferred compensation plan for key employees. Company contributions are discretionary and are deposited into a rabbi trust. Participants in the plan are subject to a vesting period and typically receive annual distributions from the plan commencing one year after grant date, although in certain situations distributions are paid upon termination or retirement. Participants also have the option to direct their balances into certain investment funds and are credited with their proportional amount of earnings from the investments. The assets of this plan as held in the rabbi trust and are subject to the claims of the Company’s general creditors in the event of its bankruptcy. During 2007 and 2006, the Company contributed $15,710 and $2,430 into the plan.

The Company also maintains a non-qualified deferred compensation plan for certain employees. Company contributions to the plan are discretionary and are deposited into a rabbi trust that is not subject to general creditors claims in the event of bankruptcy by the Company. Participants in the plan are subject to a vesting period and will receive their proportionate amount of the Company’s contribution plus earnings in December of 2008. Participants are credited with their proportional amount of earnings from the investments within the plan. During 2007, the Company contributed $14,774 into this plan.

The fair value of the assets held in trust as of December 31, 2007, and 2006 totaled $43,036 and $16,408, respectively. The assets are available for sale and as such are recorded at fair market value with changes in the fair market values being recorded in other comprehensive income. Any fair market value changes to the corresponding liability balance will be recorded as compensation expense. See Note 9 to the consolidated financial statements.

Most of the Company’s outstanding employee stock optionsplan awards include a provision accelerating the vesting of the award in the event of a change of control. The Company also maintains a change of control protection program for its employees who do not have a significant number of stock awards, which has been in place since 2001, and stock appreciation rights that have exercise or base prices greater thanwhich provides for cash bonuses to employees in the averageevent of a change of control. Based on the market price of the Company’s stock and the outstanding shares outstanding duringof its common stock on December 31, 2007, these cash bonuses would total approximately $234,000 if a control transaction occurred at that price and the year wereCompany’s Board of Directors did not included inmodify the computationprogram. This amount has not been accrued at December 31, 2007, and would only be accrued upon a change of diluted earnings per share because they were anti-dilutive.control. These excluded stock plan shares werecompensation programs may affect the price an acquirer would be willing to pay.

16.    Contingencies

The majority of the Company’s revenues are from government programs and may be subject to adjustment as follows: 932,600 shares at $54.86a result of: (1) examination by government agencies or contractors, for which the resolution of any matters raised may take extended periods of time to $60.21 per share in 2006, 2,419,750 shares at $45.60finalize; (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; and (4) retroactive applications or interpretations of governmental requirements. In addition, the Company’s revenues from commercial payors may be subject to $52.81 per share in 2005, and 178,369 shares at $30.87 to $39.62 per share in 2004.adjustment as a result of potential claims for refunds, as a result of government actions or as a result of other claims by commercial payors.

F-26


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

3.    Stock-basedUnited States Attorney inquiries

In February 2007, the Company received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services, or OIG, for records relating to Epogen®, or EPO, claims submitted to Medicare. In August 2007, the Company received a subpoena from the OIG seeking similar documents. The requested documents relate to services provided from 2001 to 2004 by a number of the Company’s centers. The request and subpoena were sent from the OIG’s offices in Houston and Dallas, Texas. The Company is cooperating with the inquiry and is producing the requested records. The Company has been in contact with the United States Attorney’s Office, or U.S. Attorney’s Office, for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. There appears to be substantial overlap between this issue and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office, for the Eastern District of Missouri in St. Louis described below. To the Company’s knowledge, no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena will continue to require management’s attention and significant legal expense. Any negative findings could result in substantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs.

On March 4, 2005, the Company received a subpoena from the U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. The subpoena requires production of a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies, and financial relationships with physicians and joint ventures. The subpoena covers the period from December 1, 1996 through the present. In October 2005, the Company received a follow-up request for additional documents related to specific medical director and joint venture arrangements. In February 2006, the Company received an additional subpoena for documents, including certain patient records relating to the administration and billing of EPO. In May 2007, the Company received a request for documents related to durable medical equipment (DME) and supply companies owned and operated by the Company. The Company is producing documents and providing information to the government. The Company is also cooperating, and intends to continue to cooperate, with the government’s investigation, including by participating in discussions and meetings with the government. The subpoenas have been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To the Company’s knowledge, no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

On October 25, 2004, the Company received a subpoena from the U.S. Attorney’s Office for the Eastern District of New York in Brooklyn. The subpoena covers the period from 1996 to present and requires the production of a wide range of documents relating to the Company’s operations, including DaVita Laboratory Services. Gambro Healthcare received a similar subpoena in November 2004. The subpoena also includes specific requests for documents relating to testing for parathyroid hormone levels, or PTH, and to products relating to vitamin D therapies. The subpoena has been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. Other participants in the dialysis industry received a similar subpoena, including Fresenius Medical Group. To the Company’s knowledge,

F-27


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena may continue to require management’s attention and significant legal expense.

Other

The Company has received several notices of claims from commercial payors and other third parties related to historical billing practices and claims against DVA Renal Healthcare (formerly known as Gambro Healthcare) related to historical Gambro Healthcare billing practices and other matters covered by their settlement agreement with the Department of Justice. At least one commercial payor has filed an arbitration demand against the Company, as described below, and additional commercial payors have threatened litigation. The Company intends to defend against these claims vigorously; however, the Company may not be successful and these claims may lead to litigation and any such litigation may be resolved unfavorably. Although the ultimate outcome of these claims cannot be predicted at this time, an adverse result in excess of the Company’s established reserves, with respect to one or more of these claims could have a material adverse effect on the Company’s business, financial condition, results of operations and liquidity.

In December 2007, the Company entered into a Settlement Agreement with the State of New York to resolve certain billing issues that had been the subject of inquiry by the New York Attorney General’s Medicaid Fraud Control Unit, or MFCU. The Company had received several informal inquiries from representatives of MFCU regarding billing practices for facilities managed by the Company in New York. The Settlement Agreement covers numerous dialysis facilities in New York for which the Company, through its subsidiaries, provides administrative services. The Company paid $1,457 in settlement, which included the amount of the overpayments by the New York Medicaid program plus interest; no fines or penalties were assessed.

In October 2007, the Company was contacted by the Attorney General’s Office for the State of Nevada. The Attorney General’s Office informed the Company that it was conducting a criminal investigation of the Company’s operations in Nevada and that the investigation related to the billing of pharmaceuticals, including EPO. On February 8, 2008, the Attorney General’s Office informed the Company that the criminal investigation has been discontinued. The Attorney General’s Office further advised the Company that Nevada Medicaid intends to conduct audits of ESRD providers in Nevada, including the Company, and that such audits will relate to the issues that were the subjects of the criminal investigation. Any negative findings could result in substantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs. To the Company’s knowledge, no proceedings have been initiated against the Company at this time.

On August 28, 2007, Sheet Metal Workers National Health Fund and Glenn Randle filed a complaint in the United States District Court for the Central District of California against the Company. The complaint also names as defendants Amgen, Inc. and Fresenius Medical Care Holdings, Inc. The complaint is styled as a class action and alleges four claims against the Company, including violations of the federal RICO statute, California’s unfair competition law, California’s false advertising law and for unjust enrichment. The complaint’s principal allegations against the Company are that the defendants engaged in a scheme to unlawfully promote the administration of EPO to hemodialysis patients intravenously, as opposed to subcutaneously, and to over-utilize EPO. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the certification of this matter as a class action. At this time, the Company cannot predict the ultimate outcome of this matter or the potential range of damages, if any.

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the Western District of Louisiana against Gambro AB, DVA Renal Healthcare (formerly Gambro Healthcare) and related entities. The plaintiff sought to bring its claims as a class action on behalf of itself and all

F-28


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

entities that paid any of the defendants for health care goods and services from on or about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying Gambro Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against the Company and DVA Renal Healthcare. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the certification of this matter as a class action. At this time, the Company cannot predict the ultimate outcome of this matter or the potential range of damages, if any.

In June 2004, Gambro Healthcare was served with a complaint filed in the Superior Court of California by one of its former employees who worked for its California acute services program. The complaint, which is styled as a class action, alleges, among other things, that DVA Renal Healthcare (formerly Gambro Healthcare) failed to provide overtime wages, defined rest periods and meal periods, or compensation in lieu of such provisions and shareholders’failed to comply with certain other California labor code requirements. The Company intends to vigorously defend against this claim. The Company also intends to vigorously oppose the certification of this matter as a class action. Although the ultimate outcome of these claims cannot be predicted, the Company does not expect that an unfavorable result, if any, would have a material adverse effect on the Company’s business, financial condition, liquidity or results of operations.

In addition to the foregoing, the Company is subject to claims and suits, including from time to time, contractual disputes and professional and general liability claims, as well as audits and investigations by various government entities, in the ordinary course of business. The Company believes that the ultimate resolution of any such pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on its financial condition, results of operations or cash flows.

17.  Shareholders’ equity and stock-based compensation

Authorized capital stock of the Company

On May 29, 2007, DaVita’s stockholders approved an amendment to its Amended and Restated Certificate of Incorporation to increase the number of shares of authorized common stock from 195,000,000 to 450,000,000 shares.

 

Stock-based compensation

 

Effective January 1, 2006, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 123(R)Share-Based Payment, which requires the measurement and recognition of cost for all stock-based awards made to employees and directors, including stock options, stock appreciation rights, stock units and discounted employee stock purchases. Under this standard, the Company’s stock-based compensation awards are measured at estimated grant-date fair value and recognized as compensation expense over their requisite service periods. SFAS No. 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion (APB) No. 25Accounting for Stock Issued to Employees, under which the Company did not recognize compensation expense for most of its stock options. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the application of SFAS No. 123(R), and the Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

 

The Company implemented SFAS No. 123(R) using the modified prospective transition method. In accordance with this method, our consolidated financial statements for periods prior to fiscal year 2006 have not

F-29


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

been restated to reflect this change. The standard also requires that tax benefits realized from stock award exercise gains in excess of stock-based compensation expense recognized for financial statement purposes be reported on a prospective basis as cash flows from financing activities rather than as operating cash flows. The Company also elected to use the method available under FASB Staff Position FSP No. 123(R)-3Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, which provides an alternative method for calculating historical excess tax benefits from the method described in SFAS No. 123(R) for stock-based compensation awards.

 

Under SFAS No. 123(R), stock-based compensation recognized during a period is based on the estimated grant-date fair value of the portion of theeach stock-based award vesting during that period, adjusted for expected forfeitures. Stock-based compensation recognized in the Company’s consolidated financial statements for the yearyears ended December 31, 2007 and 2006 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, December 31, 2005 and stock-based awards granted in 2006.2006 and 2007. The Company previously recognized the effect of stock unit forfeitures as they occurred, and the effect of transitioning to recognition of expense based on expected forfeitures was insignificant. Shares issued upon exercise of stock awards are generally issued from shares in treasury.

 

Prior to 2006, the Company accounted for stock-based compensation in accordance with APB No. 25Accounting for Stock Issued to Employees, as allowed under SFAS No. 123AccountingTerm Loans

Term loan A and term loan B total outstanding borrowings each consist of various individual tranche amounts that can range in maturity from one month to twelve months. Each specific tranche bears interest at a LIBOR rate determined by the maturity of that specific tranche and the interest rates are reset as each specific tranche matures. The overall weighted average interest rate for Stock-based Compensation. Under APB No. 25, stock option grants to employees did not resulteach term loan is determined based upon the LIBOR interest rates in an expense ifeffect for each individual tranche plus the exercise price was at least equal to the market price at the date of grant. However, under APB No. 25interest rate margin.

During 2007 and 2006, the Company did recognize compensation expense for stock units, whichmade principal payments totaling $50,000 and $62,000 on term loan A, respectively, and $400,000 and $338,000 on term loan B, respectively. The principal payments made on term loan A and term loan B in 2007 were valued atprepayments. The term loan B prepayment was made from the closing stock price onproceeds of issuing the date of grant and amortized over the respective vesting periods, and for modifications to stock awardssenior notes as discussed below. In 2006, $35,000 were mandatory principal payments as required under FASB Interpretation No. 44Accounting for Certain Transactions Involving Stock Compensation.term loan A and $24,500 were mandatory principal payments as required for term loan B. The balance of the principal payments in 2006 were prepayments. As a result of the principal prepayment made in 2007 and 2006, the Company wrote off a total of $4,371 and $3,270, respectively, of deferred financing costs, which is included in debt expense.

 

Stock-based compensation plans and agreementsTerm Loan A

 

TheOn February 27, 2007, the Company’s stock-based compensation plans and agreements are described below.interest rate margin on its term loan A was reduced by 0.25% as a result of achieving certain financial ratios as defined in the Senior Secured Credit Facilities.

 

2002 Plan.    The DaVita Inc. 2002 Equity Compensation Plan (the 2002 Plan) providesTerm loan A currently bears interest at LIBOR plus a margin of 1.50%, for grants of stock-based awards to employees, directors and other individuals providing services to the Company, except that incentive stock options may only be awarded to employees. The plan mandates a maximum award term of five

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

years, and stipulates that stock options and stock appreciation rights be granted with prices not less than the fair market value on the date of grant. The plan further requires that full share awards such as restricted stock units reduce shares available under the plan at aan overall weighted average effective rate of 2.75:1. The Company’s nonqualified stock options, stock appreciation rights and stock units awarded under this plan generally vest over 48 to 60 months from the date of grant. At6.35% at December 31, 2006, there were 7,820,075 stock options2007. The interest rate margin is subject to adjustment depending upon certain financial conditions and stock-settled stock appreciation rightscould range from 1.50% to 2.25%. Term loan A matures in October 2011 and 341,457 stock units outstandingrequires annual principal payments of $14,875 in 2008, $61,250 in 2009, $87,500 in 2010 and 8,083,283 shares available for future grants under this plan.

1999 Plan.    The 1999 Non-Executive Officer and Non-Director Equity Compensation Plan provides for grants of stock options to employees and other individuals providing services, other than executive officers and members of the Board of Directors. The Company awards nonqualified stock options under this plan which are generally issued with exercise prices equal to the market price of the stock on the date of grant, vest over 48 to 52 months from the date of grant and bear maximum award terms of five years. At December 31, 2006, there were 1,172,054 stock options outstanding and 246,580 shares available for future grants under this plan.

Predecessor plans.    Upon shareholder approval of the 2002 Plan on April 11, 2002, the following predecessor plans were terminated, except with respect to options then outstanding: the 1994 Equity Compensation Plan, the 1995 Equity Compensation Plan, the 1997 Equity Compensation Plan, and the 1999 Equity Compensation Plan. Shares available for future grants under these predecessor plans were transferred to the 2002 Plan upon its approval, and cancelled predecessor plan awards become available for new awards under the 2002 Plan. Stock options granted under these terminated plans were generally issued with exercise prices equal to the market price of the stock on the date of grant, vested over four years from the date of grant, and bore maximum award terms of five to 10 years. The RTC Plan, a special purpose option plan related to the merger between the Company and Renal Treatment Centers, Inc.$65,625 in 1998, was terminated in 1999. At December 31, 2006, there were 787,676 stock options outstanding under these terminated plans.

Deferred stock unit agreements.    During 2001 through 2003, the Company made nonqualified stock unit awards to members of the Board of Directors and certain key executive officers under stand-alone contractual deferred stock unit agreements. These awards vest over one to four years and are settled in stock when they vest or at a later date at the election of the recipient. At December 31, 2006, there were 96,278 stock units outstanding under these agreements.

A combined summary of the status of awards under these stock-based compensation plans and agreements is as follows:

   Year ended December 31, 2006

   Stock options and stock appreciation rights

  Stock units

   Awards

  

Weighted

average

exercise

price


  

Weighted

average

remaining

contractual life


  Awards

  

Weighted

average

remaining

contractual life


Outstanding at beginning of year

   9,269,781  $26.73      474,956   

Granted

   3,546,600  $51.68      173,385   

Exercised

   (2,460,857) $15.39      (159,268)  

Forfeited

   (575,719) $36.32      (51,338)  
   


 

     


  

Outstanding at end of period

   9,779,805  $38.06  3.3   437,735  3.1
   


 

  
  


 

Awards exercisable at end of period

   2,714,039  $20.62  2.2   50,116  1.7
   


 

  
  


 

Weighted-average fair value of awards granted during the period

  $13.38         $51.72   
   


        


  

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Range of exercise prices


  Awards
outstanding


  Weighted
average
exercise
price


  Awards
exercisable


  Weighted
average
exercise
price


$ 0.00–$ 0.00

  437,735  $—    50,116  $—  

$ 0.01–$10.00

  690,569   4.34  690,569   4.34

$10.01–$20.00

  1,272,593   14.23  823,149   14.40

$20.01–$30.00

  684,161   27.90  309,188   27.68

$30.01–$40.00

  1,182,849   30.89  544,553   30.62

$40.01–$50.00

  4,228,558   47.81  267,184   44.28

$50.01–$60.00

  1,704,075   54.19  79,396   51.05

$60.01–$70.00

  17,000   60.21  —     —  
   
  

  
  

Total

  10,217,540  $36.43  2,764,155  $20.25
   
  

  
  

For the year ended December 31, 2006, the aggregate intrinsic value of stock awards exercised was $109,562. At December 31, 2006, the aggregate intrinsic value of stock awards outstanding was $209,227 and the aggregate intrinsic value exercisable was $101,258. For the years ended December 31, 2005 and 2004, the aggregate intrinsic value of stock awards exercised was $104,000 and $115,500,2011, respectively.

 

Estimated fair value of stock-based compensation awardsTerm Loan B

 

TheOn February 23, 2007, the Company has estimatedamended and restated its existing Senior Secured Credit Facilities to, among other things, reduce the grant-date fair value of stock option and stock-settled stock appreciation rights awards using the Black-Scholes-Merton valuation model and stock unit awards at intrinsic value on the date of grant. The following assumptions were used in estimating these values and determining the total stock-based compensation attributable to the current period:

Expected term of the awards:    The expected term of awards granted represents the period of time that they are expected to remain outstanding from the date of grant. The Company determines the expected term of its stock awards based on its historical experience with similar awards, considering the Company’s historical exercise and post-vesting termination patterns, and the terms expected by peer companies in near industries.

Expected volatility:    Expected volatility represents the volatility anticipated over the expected term of the award. The Company determines the expected volatility for its awards based on the volatility of the price of its common stock over the most recent retrospective period commensurate with the expected term of the award, considering the volatility expectations implied by the market price of its exchange-traded options and the volatilities expected by peer companies in near industries.

Expected dividend yield:    The Company has not paid dividends on its common stock and does not currently expect to pay dividends during the term of stock awards granted.

Risk-free interest rate:    The Company bases the expected risk-free interest rate margin on the implied yield currently available on strippedterm loan B by 0.50%, and to amend certain financial covenants. The amended term loan B bears interest couponsat LIBOR plus a margin of U.S. Treasury issues with a remaining term equivalent to the expected term of the award.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

A summary of the1.50%, for an overall weighted average valuation inputs described above used for estimatingeffective rate of 5.80%, including the grant-date fair value of stock options and stock-settled stock appreciation rights granted in the periods indicated is as follows:

   Year ended December 31,

 
   2006

  2005

  2004

 
      pro-forma  pro-forma 

Expected term

  3.5 years  3.2 years  3.5 years 

Expected volatility

  25% 27% 37%

Expected dividend yield

  0.0% 0.0% 0.0%

Risk-free interest rate

  5.0% 4.1% 2.9%

The Company estimates expected forfeitures based upon historical experience with separate groups of employees that have exhibited similar forfeiture behavior in the past. Stock-based compensation expense is recorded only for awards that are expected to vest.

Employee stock purchase plan

The Employee Stock Purchase Plan entitles qualifying employees to purchase up to $25impact of the Company’s common stock during each calendar year. The amounts used to purchase stock are accumulated through payroll withholdings or through optional lump sum payments made in advance of the first day of the purchase right period. This compensatory plan allows employees to purchase stockswap agreements, except for the lesser of 100% of the fair market value on the first day of the purchase right period or 85% of the fair market value on the last day of the purchase right period. Purchase right periods begin on January 1 and July 1, and end on December 31. Payroll withholdings and lump-sum payments related to the plan, included in accrued compensation and benefits, were $5,991, $3,264, and $1,775 at December 31, 2006, 2005 and 2004, respectively. Subsequent to December 31, 2006, 2005 and 2004, 123,920, 80,442 and 64,169 shares, respectively, were issued to satisfy obligations under the plan. At December 31, 2006, there were 454,657 shares available for future grants under this plan.

The fair value of employees’ purchase rights was estimated as of the beginning dates of the purchase right periods using the Black-Scholes-Merton valuation model with the following weighted average assumptions for purchase right periods in 2006, 2005 and 2004, respectively: expected volatility of 23%, 27% and 38%; risk-freeforward interest rate of 4.9%, 3.2% and 2.7%, and no dividends. Using these assumptions, the weighted average estimated fair value of these purchase rights was $12.35, $10.64 and $8.00 for 2006, 2005 and 2004, respectively.

Stock-based compensation expense and proceeds

For the year ended December 31, 2006, the Company recognized $26,389 in stock-based compensation expense for stock options, stock appreciation rights, stock units and employee stock plan purchases, which is primarily included in general and administrative expenses in continuing operations. The estimated tax benefit recorded for this stock-based compensation was $9,678. Asswap agreements, as of December 31, 2006, there was $67,7002007. Other terms that were changed included the amount by which the Company can elect to increase the revolving and term loan commitments from $500,000 to $750,000 and certain limitations on purchases, redemptions or acquisitions of total estimated unrecognized compensation cost related to nonvested stock-based compensation arrangements undercapital stock, the payment of dividends and distributions in cash. Further, limitations on capital expenditures for internal growth will not apply during the periods in which the Company’s equity compensation and stock purchase plans.leverage ratio is less than 3.5:1. The Company’s leverage ratio as of December 31, 2007 was less than 3.5:1. The Company expects to recognizeincurred financing costs of $1,781 which were deferred and also expensed $248 of other costs in connection with this cost over a weighted average remaining periodtransaction, which are included in debt expense. Term loan B matures in October 2012 and requires principal payments of 1.7 years.$1,705,875 in year 2012.

 

During the years ended December 31, 2006, 2005 and 2004, the Company received $37,877, $42,144 and $42,680 in cash proceeds from stock option exercises and $40,375, $38,484 and $41,080 in total actual tax benefits upon the exercise of stock awards, respectively.F-22


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Pro forma 2006 comparison under SFAS No. 123(R) and APB No. 25Revolving Lines of Credit

 

The following table presentsCompany has an undrawn revolving line under the impactSenior Secured Credit Facilities totaling $250,000, of which approximately $41,000 was committed for outstanding letters of credit. The Company also has other undrawn revolving lines of credit totaling $7,200 associated with several of its joint ventures.

Senior and Senior Subordinated Notes

On February 23, 2007, the Company issued $400,000 of 65/8% senior notes due 2013 in a private offering, realizing $405,080 in proceeds, which included a $5,080 premium, and incurred $2,719 in related deferred financing costs. These senior notes are part of the same series of debt securities as the $500,000 aggregate principal amount of 65/8% senior notes that were issued in March 2005. The effective interest rate for the $400,000 of 65/8% senior notes is 6.45%. The senior notes are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and require semi-annual interest payments which began March 15, 2007. The senior notes may be redeemed by the Company in whole or part at any time on or after March 15, 2009, at certain specified prices. The Company used $400,000 of these proceeds to pay down its term loan B as discussed above.

The Company’s senior and senior subordinated notes, as of December 31, 2007, consisted of $900,000 of 65/8% senior notes due 2013 and $850,000 of 71/4% senior subordinated notes due 2015. The notes are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and require semi-annual interest payments in March and September. The Company may redeem some or all of the senior notes at any time as described above and some or all of the senior subordinated notes at any time on or after March 15, 2010.

Interest rate swaps

As of December 31, 2007, the Company maintained a total of nine interest rate swap agreements with amortizing notional amounts totaling $968,000. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of debt to fixed rates ranging from 3.08% to 4.27%, resulting in an overall weighted average effective interest rate of 5.37% on the hedged portion of our Senior Secured Credit Facilities, including the term loan B margin of 1.50%. The swap agreements expire in 2008 through 2010 and require quarterly interest payments. In addition, the Company maintains two forward interest rate swap agreements with notional amounts totaling $200,000. These forward interest rate swaps will have the economic effect of modifying the LIBOR-based interest rates to fixed rates of 4.05% and 4.70% on the Company’s term loan B outstanding debt. These forward interest rate swaps take effect on September 30, 2008, require quarterly interest payments beginning in December 2008, and expire in 2010. During 2007, 2006, and 2005 the Company accrued net cash benefits (obligations) of approximately $14,497, $15,791, and $(285), respectively, from these swaps, which are included in debt expense. During 2005, the Company also incurred additional net cash obligations of $1,461 from these swaps, which is included in swap valuation gains. The Company estimates that approximately $500 of existing unrealized pre-tax losses in other comprehensive income at December 31, 2007, will be reclassified into income in 2008. As of December 31, 2007 and 2006, the total fair value of these swaps was a net liability of $511 and an asset of $29,544, respectively. The 2007 amount was primarily included in other long-term liabilities and the 2006 amount was primarily included in other long-term assets. Also during 2007, the Company recorded $16,027, net of tax, as reductions to other comprehensive income for valuation losses, net of amounts reclassified into income.

As of December 31, 2007, the Company had approximately 50% of its variable rate debt and approximately 74% of its total debt economically fixed.

F-23


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

As a result of the swap agreements, the Company’s overall Senior Secured Credit Facilities effective weighted average interest rate was 5.90%, based upon the current margins in effect of 1.50%, as of December 31, 2007.

At December 31, 2007, the Company’s overall average effective interest rate was 6.37%.

Debt expense

Debt expense consisted of interest expense of $242,720, $262,967 and $134,429, amortization of deferred financing costs of $9,808, $10,469 and $5,157 for 2007, 2006 and 2005, respectively, and in 2007 and 2006, included the write-off of $4,371 and $3,270, respectively, of deferred financing costs. Debt expense in 2007 also included $248 of other costs associated with the amendment and reinstatement of the Senior Secured Credit Facilities. These interest expense amounts are net of capitalized interest.

2005 Transactions

In conjunction with the repayment and extinguishment of the Company’s prior Senior Secured Credit Facilities during 2005, the Company wrote off deferred financing costs of $8,170 and reclassified into net income $8,100 of swap valuation gains that were previously recorded in other comprehensive income. These gains represented the accumulated fair value of several interest rate swap instruments that became ineffective as cash flow hedges as a result of the repayment of the prior Senior Secured Credit Facilities. In addition, the Company recorded a net loss of $2,100 related to changes in fair values of these swaps that were not effective as interest rate hedges until they were redesignated in the second quarter of 2005.

Portions of the Company’s various interest rate swap agreements that were previously designated and expected to be effective as forward cash flow hedges became ineffective as a result of the Company not having any variable rate LIBOR-based interest payments during a portion of 2005. This resulted in a net charge of $1,700 to swap valuation gains, which includes the $1,461 discussed above as well as a reclassification into income of $2,000 of swap valuation losses that were previously recorded in other comprehensive income. The swap payment periods that began after October 2005 were highly effective as cash flow hedges with gains or losses from changes in their fair values reported in other comprehensive income.

14.    Leases

The majority of the Company’s facilities are leased under non-cancelable operating leases, ranging in terms from five to ten years, which contain renewal options of five to ten years at the fair rental value at the time of renewal or at rates subject to periodic consumer price index increases. The Company also leases certain equipment under capital leases.

F-24


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Future minimum lease payments under non-cancelable operating leases and capital leases are as follows:

   Operating
leases
  Capital
leases
 

2008

  $170,192  $1,579 

2009

   151,344   1,162 

2010

   136,480   962 

2011

   121,913   966 

2012

   101,035   987 

Thereafter

   336,131   4,452 
         
  $1,017,095   10,108 
      

Less portion representing interest

     (3,441)
       

Total capital lease obligations, including current portion

    $6,667 
       

Rent expense under all operating leases for 2007, 2006, and 2005 was $200,626, $187,139 and $109,511, respectively. Rent expense is recorded on a straight line basis, over the term of the lease, for leases that contain fixed escalation causes. Leasehold improvement incentives are deferred and amortized to rent expense over the term of the lease. The net book value of property and equipment under capital leases was $7,191, $5,765 and $6,094 at December 31, 2007, 2006 and 2005, respectively. Capital lease obligations are included in long-term debt. See Note 13 to the consolidated financial statements.

15.    Employee benefit plans

The Company has a savings plan for substantially all employees which has been established pursuant to the provisions of Section 401(k) of the Internal Revenue Code, or IRC. The plan provides for employees to contribute a percentage of their base annual salaries on a tax-deferred basis not to exceed IRC limitations. The Company does not provide any matching contributions.

During 2000, the Company established the DaVita Inc. Profit Sharing Plan. Contributions to this defined contribution benefit plan are made at the discretion of the Company as determined and approved by the Board of Directors. All contributions are deposited into an irrevocable trust. The profit sharing award for each eligible participant is based upon the achievement of employee-specific and/or corporate financial and operating goals. During 2004 the Company elected to discontinue funding the profit sharing plan and to distribute similar awards directly to the recipients, or at their discretion to their 401(k) accounts. In December 2007, the DaVita Profit Sharing Plan was merged into the Company’s 401(k) Plan.

On October 5, 2005, the Company’s Board of Directors approved the adoption of SFAS No. 123(R) on selected itemsthe DaVita Voluntary Deferral Plan. This plan is non-qualified and permits certain employees whose annualized base salary equals or exceeds a minimum annual threshold amount as set by the Company to elect to defer all or a portion of their annual bonus payment and, as originally adopted, up to 15% of their base salary into a deferral account maintained by the Company. Total contributions to this plan in 2007 and 2006 were $1,601, and $1,296, respectively. Effective January 1, 2006, the elective deferral percentage for base salary was increased to up to 50% of a participant’s base salary. Deferred amounts are generally paid out in cash at the participant’s election either in the first or second year following retirement or in a specified future period at least three to four years after the deferral election was effective. Participants are credited with their proportional amount of annual earnings from the plan. The assets of this plan are held in a “rabbi trust” and as such are subject to the claims of the Company’s general creditors in the event of its bankruptcy.

F-25


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

As part of the acquisition of DVA Renal Healthcare on October 5, 2005, the Company acquired an Executive Retirement Plan for certain members of management. The plan is non-qualified and contributions to the plan were made at the discretion of DVA Renal Healthcare based upon a pre-determined percentage of a participant’s base salary. Effective November 2005, all contributions to this plan were discontinued and the balance of the plan assets will be paid out upon termination of each individual participant.

The Company maintains a non-qualified deferred compensation plan for key employees. Company contributions are discretionary and are deposited into a rabbi trust. Participants in the plan are subject to a vesting period and typically receive annual distributions from the plan commencing one year after grant date, although in certain situations distributions are paid upon termination or retirement. Participants also have the option to direct their balances into certain investment funds and are credited with their proportional amount of earnings from the investments. The assets of this plan as held in the rabbi trust and are subject to the claims of the Company’s general creditors in the event of its bankruptcy. During 2007 and 2006, the Company contributed $15,710 and $2,430 into the plan.

The Company also maintains a non-qualified deferred compensation plan for certain employees. Company contributions to the plan are discretionary and are deposited into a rabbi trust that is not subject to general creditors claims in the event of bankruptcy by the Company. Participants in the plan are subject to a vesting period and will receive their proportionate amount of the Company’s contribution plus earnings in December of 2008. Participants are credited with their proportional amount of earnings from the investments within the plan. During 2007, the Company contributed $14,774 into this plan.

The fair value of the assets held in trust as of December 31, 2007, and 2006 totaled $43,036 and $16,408, respectively. The assets are available for sale and as such are recorded at fair market value with changes in the fair market values being recorded in other comprehensive income. Any fair market value changes to the corresponding liability balance will be recorded as compensation expense. See Note 9 to the consolidated financial statementsstatements.

Most of the Company’s outstanding employee stock plan awards include a provision accelerating the vesting of the award in the event of a change of control. The Company also maintains a change of control protection program for its employees who do not have a significant number of stock awards, which has been in place since 2001, and which provides for cash bonuses to employees in the year endedevent of a change of control. Based on the market price of the Company’s stock and the outstanding shares of its common stock on December 31, 2006:2007, these cash bonuses would total approximately $234,000 if a control transaction occurred at that price and the Company’s Board of Directors did not modify the program. This amount has not been accrued at December 31, 2007, and would only be accrued upon a change of control. These compensation programs may affect the price an acquirer would be willing to pay.

 

   Year ended December 31, 2006

 
   

As reported

under

SFAS No. 123(R)


  

If reported

under

APB No. 25


 
      proforma 

Consolidated statement of income:

         

Operating income

  $739,432  $761,752 

Income from continuing operations before income taxes

  $475,759  $498,079 

Income from continuing operations

  $289,329  $303,554 

Net income

  $289,691  $303,916 

Basic earnings per share from continuing operations

  $2.79  $2.93 

Basic earnings per share

  $2.80  $2.94 

Diluted earnings per share from continuing operations

  $2.73  $2.86 

Diluted earnings per share

  $2.74  $2.86 

Consolidated statement of cash flows:

         

Net cash provided by operating activities

  $519,571  $556,822 

Net cash used in financing activities

  $(329,117) $(366,368)

16.    Contingencies

The majority of the Company’s revenues are from government programs and 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; and (4) retroactive applications or interpretations of governmental requirements. In addition, the Company’s revenues from commercial payors may be subject to adjustment as a result of potential claims for refunds, as a result of government actions or as a result of other claims by commercial payors.

F-26


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Pro forma 2005 and 2004 results under SFAS No. 123United States Attorney inquiries

 

The weighted average grant-date fair value of stock awards granted in 2005 and 2004 were $12.94 and $10.53, respectively. IfIn February 2007, the Company had adoptedreceived a request for information from the fair value-based compensation expense provisionsOffice of SFAS No. 123 uponInspector General, U.S. Department of Health and Human Services, or OIG, for records relating to Epogen®, or EPO, claims submitted to Medicare. In August 2007, the issuanceCompany received a subpoena from the OIG seeking similar documents. The requested documents relate to services provided from 2001 to 2004 by a number of the Company’s centers. The request and subpoena were sent from the OIG’s offices in Houston and Dallas, Texas. The Company is cooperating with the inquiry and is producing the requested records. The Company has been in contact with the United States Attorney’s Office, or U.S. Attorney’s Office, for the Eastern District of Texas, which has stated that standard, net earningsthis is a civil inquiry related to EPO claims. There appears to be substantial overlap between this issue and net earnings per share wouldthe ongoing review of EPO utilization and claims by the U.S. Attorney’s Office, for the Eastern District of Missouri in St. Louis described below. To the Company’s knowledge, no proceedings have been adjustedinitiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the pro forma amounts indicated below (sharessubpoena will continue to require management’s attention and significant legal expense. Any negative findings could result in 000’s):

   Year ended December 31,

 
         2005      

        2004      

 

Net income:

         

As reported

  $228,643  $222,254 

Add: Stock-based employee compensation expense included in reported net income, net of tax

   2,112   1,168 

Deduct: Total stock-based employee compensation expense under the fair value-based method, net of tax

   (12,180)  (10,109)
   


 


Pro forma net income

  $218,575  $213,313 
   


 


Pro forma basic earnings per share:

         

Pro forma net income for basic earnings per share calculation

  $218,575  $213,313 
   


 


Weighted average shares outstanding

   100,713   98,694 

Vested stock units

   49   33 
   


 


Weighted average shares for basic earnings per share calculation

   100,762   98,727 
   


 


Basic net income per share—Pro forma

  $2.17  $2.16 
   


 


Basic net income per share—As reported

  $2.27  $2.25 
   


 


Pro forma diluted earnings per share:

         

Pro forma net income for diluted earnings per share calculation

  $218,575  $213,313 
   


 


Weighted average shares outstanding

   100,713   98,694 

Vested stock units

   49   33 

Assumed incremental shares from stock plans

   3,167   4,271 
   


 


Weighted average shares for diluted earnings per share calculation

   103,929   102,998 
   


 


Diluted net income per share—Pro forma

  $2.10  $2.07 
   


 


Diluted net income per share—As reported

  $2.20  $2.16 
   


 


Other equity transactionssubstantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs.

 

On March 4, 2005, the Company received a subpoena from the U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. The subpoena requires production of a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies, and financial relationships with physicians and joint ventures. The subpoena covers the period from December 1, 1996 through the present. In October 2005, the second quarterCompany received a follow-up request for additional documents related to specific medical director and joint venture arrangements. In February 2006, the Company received an additional subpoena for documents, including certain patient records relating to the administration and billing of EPO. In May 2007, the Company received a request for documents related to durable medical equipment (DME) and supply companies owned and operated by the Company. The Company is producing documents and providing information to the government. The Company is also cooperating, and intends to continue to cooperate, with the government’s investigation, including by participating in discussions and meetings with the government. The subpoenas have been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To the Company’s knowledge, no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

On October 25, 2004, the BoardCompany received a subpoena from the U.S. Attorney’s Office for the Eastern District of Directors approvedNew York in Brooklyn. The subpoena covers the period from 1996 to present and requires the production of a three-for-two stock splitwide range of documents relating to the Company’s common stockoperations, including DaVita Laboratory Services. Gambro Healthcare received a similar subpoena in November 2004. The subpoena also includes specific requests for documents relating to testing for parathyroid hormone levels, or PTH, and to products relating to vitamin D therapies. The subpoena has been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, exclusion from future participation in the form of a stock dividend payable on June 15, 2004 to stockholders of record on June 1, 2004. All stockholders entitled to fractional sharesMedicare and Medicaid programs and criminal penalties. Other participants in the dialysis industry received a proportional cash payment. Thesimilar subpoena, including Fresenius Medical Group. To the Company’s stock began trading on a post-split basis on June 16, 2004. All share and per-share data for all periods presented have been adjusted to retroactively reflect the effects of the stock split.knowledge,

 

The total outstanding Board authorizations for share repurchases as of December 31, 2006 were approximately $249,000. There were no share repurchases during 2006 and 2005. Under the previously announced Board authorization for share repurchases, we repurchased a total of 3,350,100 shares of commonF-27


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

stockno proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for $96,540, or an average priceinvestigations such as these to continue for a considerable period of $28.82 per share during 2004. On November 2, 2004, our Board of Directors authorized ustime. Responding to repurchase upthe subpoena may continue to an additional $200,000 of our common stock, from time to time, in the open market or in privately negotiated transactions.require management’s attention and significant legal expense.

 

Shareholder rights planOther

 

The Company’s BoardCompany has received several notices of Directors approved a shareholder rights plan on November 14, 2002. This plan is designedclaims from commercial payors and other third parties related to assure that DaVita’s shareholders receive fair treatmenthistorical billing practices and claims against DVA Renal Healthcare (formerly known as Gambro Healthcare) related to historical Gambro Healthcare billing practices and other matters covered by their settlement agreement with the Department of Justice. At least one commercial payor has filed an arbitration demand against the Company, as described below, and additional commercial payors have threatened litigation. The Company intends to defend against these claims vigorously; however, the Company may not be successful and these claims may lead to litigation and any such litigation may be resolved unfavorably. Although the ultimate outcome of these claims cannot be predicted at this time, an adverse result in the event of any proposed takeover of DaVita.

Pursuant to this plan, the Board approved the declaration of a dividend distribution of one common stock purchase right for each outstanding share of its common stock payable on December 10, 2002 to holders of record of DaVita common stock on November 29, 2002. This rights distribution was not taxable to DaVita shareholders. As a result of the stock split that occurred during the second quarter of 2004, two-thirds of a right are now attached to each shareexcess of the Company’s common stock. Two-thirds of a right will also attachestablished reserves, with respect to each newly issued or reissued share of common stock. These rights will become exercisable if a person or group acquires, or announces a tender offer for, 15%one or more of DaVita’s outstanding common stock. The triggering person’s stock purchase rights will become void at that timethese claims could have a material adverse effect on the Company’s business, financial condition, results of operations and will not become exercisable.liquidity.

 

Each right initially entitlesIn December 2007, the Company entered into a Settlement Agreement with the State of New York to resolve certain billing issues that had been the subject of inquiry by the New York Attorney General’s Medicaid Fraud Control Unit, or MFCU. The Company had received several informal inquiries from representatives of MFCU regarding billing practices for facilities managed by the Company in New York. The Settlement Agreement covers numerous dialysis facilities in New York for which the Company, through its holdersubsidiaries, provides administrative services. The Company paid $1,457 in settlement, which included the amount of the overpayments by the New York Medicaid program plus interest; no fines or penalties were assessed.

In October 2007, the Company was contacted by the Attorney General’s Office for the State of Nevada. The Attorney General’s Office informed the Company that it was conducting a criminal investigation of the Company’s operations in Nevada and that the investigation related to purchase one sharethe billing of common stockpharmaceuticals, including EPO. On February 8, 2008, the Attorney General’s Office informed the Company that the criminal investigation has been discontinued. The Attorney General’s Office further advised the Company that Nevada Medicaid intends to conduct audits of ESRD providers in Nevada, including the Company, and that such audits will relate to the issues that were the subjects of the criminal investigation. Any negative findings could result in substantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs. To the Company’s knowledge, no proceedings have been initiated against the Company at this time.

On August 28, 2007, Sheet Metal Workers National Health Fund and Glenn Randle filed a pricecomplaint in the United States District Court for the Central District of $125.00. IfCalifornia against the rights become exercisable,Company. The complaint also names as defendants Amgen, Inc. and subject to adjustment for authorized shares available, each purchase right will then entitle its holder to purchase $125.00 of common stock atFresenius Medical Care Holdings, Inc. The complaint is styled as a price per share equal to 50%class action and alleges four claims against the Company, including violations of the average daily closing pricefederal RICO statute, California’s unfair competition law, California’s false advertising law and for unjust enrichment. The complaint’s principal allegations against the Company are that the defendants engaged in a scheme to unlawfully promote the administration of EPO to hemodialysis patients intravenously, as opposed to subcutaneously, and to over-utilize EPO. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the Company’s common stockcertification of this matter as a class action. At this time, the Company cannot predict the ultimate outcome of this matter or the potential range of damages, if any.

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the immediately preceding 30 consecutive trading days. If DaVita is acquired inWestern District of Louisiana against Gambro AB, DVA Renal Healthcare (formerly Gambro Healthcare) and related entities. The plaintiff sought to bring its claims as a merger or other business combination transaction after the rights become exercisable, provisions will be made to allow the holderclass action on behalf of each right to purchase $125.00 of common stock from the acquiring company at a price equal to 50% of the average daily closing price of that company’s common stock for the immediately preceding 30 consecutive trading days.itself and all

 

The Board of Directors may elect to redeem the rights at $0.01 per purchase right at any time prior to, or exchange common stock for the rights at an exchange ratio of one share per right at any time after, a person or group acquires or announces a tender offer for 15% or more of DaVita’s outstanding common stock. The exercise price, number of shares, redemption price or exchange ratio associated with each right may be adjusted as appropriate upon the occurrence of certain events, including any stock split, stock dividend or similar transaction. These purchase rights will expire no later than November 14, 2012.

Charter documents & Delaware law

The Company’s charter documents include provisions that may deter hostile takeovers, delay or prevent changes of control or changes in management, or limit the ability of stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting stockholders from acting by written consent, requiring 90 days advance notice of stockholder proposals or nominations to the Board of Directors and granting the 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.

The Company is also subject to Section 203 of the Delaware General Corporation Law that, subject to exceptions, would prohibit the Company from engaging in any business combinations with any interestedF-28


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

stockholder,entities that paid any of the defendants for health care goods and services from on or about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying Gambro Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against the Company and DVA Renal Healthcare. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the certification of this matter as defined in that section, for a periodclass action. At this time, the Company cannot predict the ultimate outcome of three years followingthis matter or the date on which that stockholder became an interested stockholder. These restrictions may discourage, delay or preventpotential range of damages, if any.

In June 2004, Gambro Healthcare was served with a changecomplaint filed in the controlSuperior Court of California by one of its former employees who worked for its California acute services program. The complaint, which is styled as a class action, alleges, among other things, that DVA Renal Healthcare (formerly Gambro Healthcare) failed to provide overtime wages, defined rest periods and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements. The Company intends to vigorously defend against this claim. The Company also intends to vigorously oppose the Company.certification of this matter as a class action. Although the ultimate outcome of these claims cannot be predicted, the Company does not expect that an unfavorable result, if any, would have a material adverse effect on the Company’s business, financial condition, liquidity or results of operations.

In addition to the foregoing, the Company is subject to claims and suits, including from time to time, contractual disputes and professional and general liability claims, as well as audits and investigations by various government entities, in the ordinary course of business. The Company believes that the ultimate resolution of any such pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on its financial condition, results of operations or cash flows.

 

4.    Acquisitions17.  Shareholders’ equity and divestituresstock-based compensation

 

Acquisitions

The total acquisition amounts were as follows:

   Year ended December 31,

   2006

  2005

  2004

Cash paid, net of cash acquired

  $85,658  $3,202,404  $266,265

Deferred purchase price and other acquisition obligations

   585   9,331   429
   

  

  

Aggregate purchase cost

  $86,243  $3,211,735  $266,694
   

  

  

Cash adjustments for previous acquisitions including DVA Renal Healthcare

  $846  $—    $—  
   

  

  

Number of chronic dialysis centers acquired (before divestitures)

   26   609   51
   

  

  

Routine Acquisitions

During 2006, 2005, and 2004,Authorized capital stock of the Company acquired businesses other than DVA Renal Healthcare consisting of 26 centers, 54 centers and 51 centers for a total of $86,243, $168,240, and $266,694 respectively in cash and deferred purchase price obligations. The assets and liabilities for all acquisitions were recorded at their estimated fair market values at the dates of the acquisitions and are included in the Company’s financial statements and operating results from the designated effective dates of the acquisitions.

The initial purchase cost allocations for acquired businesses are recorded at fair values based upon the best information available to management and are finalized when identified pre-acquisition contingencies have been resolved and other information arranged to be obtained has been received. Adjustments to purchase accounting for prior acquisitions and payments for acquisitions in process have been included in the periods recognized. Final allocations have not differed materially from the initial allocations.

The aggregate purchase cost allocations were as follows:

   Year ended December 31,

 
   2006

  2005

  2004

 

Tangible assets, principally leasehold improvements and equipment

  $7,623  $17,381  $42,155 

Amortizable intangible assets

   8,584   15,631   19,471 

Goodwill

   79,948   139,485   222,424 

Liabilities assumed

   (9,912)  (4,257)  (17,356)
   


 


 


Aggregate purchase cost

  $86,243  $168,240  $266,694 
   


 


 


Amortizable intangible assets acquired during 2006, 2005 and 2004 had weighted-average estimated useful lives of ten, ten and nine years, respectively. The total amount of goodwill deductible for tax purposes associated

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

with these acquisitions for 2006, 2005, and 2004 was approximately $80,000, $140,000 and $120,000, respectively.

Acquisition of DVA Renal Healthcare, Inc.

On October 5, 2005, the Company acquired all of the outstanding common stock of DVA Renal Healthcare, Inc. under the Stock Purchase Agreement dated December 6, 2004, for $3,060,000. DVA Renal Healthcare was one of the largest dialysis service providers in the United States. The Company acquired DVA Renal Healthcare in an effort to more effectively offer Chronic Kidney disease services and technologies in a cost efficient manner. The purchase price reflects (i) the cash purchase price of approximately $1,800,000 for all of the outstanding common stock of DVA Renal Healthcare and (ii) the assumption and payment of approximately $1,260,000 of DVA Renal Healthcare indebtedness. The Company also incurred approximately $30,000 in acquisition-related costs. The operating results of DVA Renal Healthcare, Inc. are included in the Company’s Consolidated Financial Statements from October 1, 2005.

The original allocations of purchase cost were recorded at fair value based upon the best information available to management at that time. The fair values of property and equipment and amortizable intangible assets and liabilities were valued by an independent third party. During 2006, the Company completed the final valuations of certain assets, properties and leasehold improvements, settlements liabilities and contingencies that were previously unresolved. These valuation adjustments were not material to the consolidated financial statements and were recorded with a corresponding adjustment to goodwill. See Note 11 to the Consolidated Financial Statements.

The original aggregate purchase cost allocations were as follows:

Current assets

  $490,090 

Property and equipment, net

   313,315 

Other long-term assets and intangible assets

   148,875 

Goodwill

   2,546,565 

Current liabilities assumed

   (272,420)

Alliance and Product Supply agreement and other intangible liabilities

   (168,287)

Other long-term liabilities

   (14,643)
   


Aggregate purchase costs

  $3,043,495 
   


Total consideration paid to purchase DVA Renal Healthcare also included imputed interest of $2,818, which is included in debt expense.

DVA Renal Healthcare is subject to a five-year Corporate Integrity Agreement in connection with its December 2004 settlement with the U.S. Government that imposes significant specific compliance operating and reporting requirements, and requires an annual audit by an independent reporting organization.

In conjunction with the acquisition, the Company entered into an Alliance and Product Supply Agreement (the Supply Agreement) with Gambro AB and Gambro Renal Products, Inc (Gambro Renal Products). The Supply Agreement has an initial term of seven years and will automatically renew for three additional one-year periods if the Company has not negotiated the terms of an extension during the initial term period. Because the Supply Agreement results in higher costs for most of the products covered by the Supply Agreement than would be otherwise available to the Company, the Supply Agreement represents an intangible liability initially valued at $162,100, as of the acquisition date.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

On May 29, 2006,2007, DaVita’s stockholders approved an amendment to its Amended and Restated Certificate of Incorporation to increase the Company notified Gambro Renal Products that the Company was terminating the Supply Agreement. Under the original Supply Agreement the Company was committednumber of shares of authorized common stock from 195,000,000 to purchase a significant majority of its hemodialysis products supplies and equipment at fixed prices. The Company’s termination notice claimed a material breach by Gambro Renal Products for failure to perform its obligations under the Supply Agreement primarily as a result of an import ban issued by the U.S. Food and Drug Administration affecting certain hemodialysis products.

On August 25, 2006, the Company entered into an amended and restated Supply Agreement (the Amended Supply Agreement), with Gambro Renal Products and Gambro AB. The Amended Supply Agreement effectively revoked the Company’s notice of termination of the Product Supply Agreement. The Amended Supply Agreement, among other things, relieves the Company of certain obligations, including releasing it from the purchase requirements for certain affected products during the import ban, permits the Company to secure alternate sources of supplies for the products affected by the import ban, reduces the Company’s purchase obligations for certain hemodialysis product supplies and equipment and allows for the termination of the purchase obligations for equipment affected by the import ban if the import ban is not lifted by June 30, 2007.

As a result of the reductions in the amount of purchase obligations that are now required under the Amended Supply Agreement, the Company recorded a net valuation gain of $37,968. This valuation gain represents the difference in the fair value between the Supply Agreement and the Amended Supply Agreement, as of the effective date of the amendment.

During 2006 and 2005, the Company purchased $146,408 and $26,290 of hemodialysis product supplies from Gambro Renal Products, representing 4% and 1%, respectively, of the Company’s total operating costs.450,000,000 shares.

 

Discontinued operationsStock-based compensation

 

In accordance with a consent order issued by the Federal Trade Commission on October 4, 2005, the Company was required to divest a total of 69 outpatient dialysis centers and to terminate two management services agreements in order to complete the acquisition of DVA Renal Healthcare. In conjunction with the consent order, on October 6, 2005, the Company and DVA Renal Healthcare completed the sale of 70 outpatient dialysis centers to Renal Advantage Inc., formerly known as RenalAmerica, Inc. and also completed the sale of one other center to a separate physician group, and terminated the two management services agreements. In addition, effectiveEffective January 1, 2006, the Company completedimplemented Statement of Financial Accounting Standards (SFAS) No. 123(R)Share-Based Payment, which requires the salemeasurement and recognition of three additional centers to Renal Advantage, Inc. that were pending state regulatory approval in Illinois. The Company received total cash consideration of approximately $330,000cost for all stock-based awards made to employees and directors, including stock options, stock appreciation rights, stock units and discounted employee stock purchases. Under this standard, the Company’s stock-based compensation awards are measured at estimated grant-date fair value and recognized as compensation expense over their requisite service periods. SFAS No. 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion (APB) No. 25Accounting for Stock Issued to Employees, under which the Company did not recognize compensation expense for most of the centers divested and used approximately $13,000 to purchase the minority interest ownership of a joint venture, to distribute a minority owner’s share of the sale proceeds, and to pay related transaction costs. The Company also paid income taxes of approximately $85,000 on these divestitures in the first quarter of 2006. As part of this transaction, Renal Advantage assumed specific liabilities related to the centers, and all other liabilities were retained by the Company.its stock options. In March 2005, the Company recorded a gain of approximately $8,064, net of tax, related to the divestiture of its historical DaVita centers. Included in the gain on divestitures is the recognition of a $26,500 tax valuation allowance benefit resulting from the utilization of prior years’ capital losses offsetting the taxable gain on sale,Securities and income tax expense of $27,133Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the write-offapplication of book goodwill not deductible for tax purposes. In 2006,SFAS No. 123(R), and the Company recorded a losshas applied the provisions of $311, netSAB 107 in its adoption of tax, related to the divesture of its three centers. The loss on disposal of these centers includes an income tax expense totaling $1,274, of which $900 was related to the write off of book goodwill not deductible for tax purposes. In 2006, the company also recorded a net gain of $673 as an adjustment to previously reported gain on disposal of discontinued operations.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)SFAS No. 123(R).

 

The results of operations ofCompany implemented SFAS No. 123(R) using the historical DaVita outpatient dialysis centers and the heldmodified prospective transition method. In accordance with this method, our consolidated financial statements for sale centers, are reflected as discontinued operations for 2005 and prior.periods prior to fiscal year 2006 have not

 

The results from discontinued operations were as follows:

   Year ended December 31,

        2005     

       2004     

Net operating revenues

  $98,454  $121,266

Income before income taxes

   21,534   29,044

Income tax

   8,377   11,298
   

  

Income from discontinued operations

  $13,157  $17,746
   

  

Net assets of discontinued operations sold were as follows:

   2006

  2005

 

Current assets

  $—    $3,075 

Other current assets held for sale

   15,129   —   

Property and equipment, net

   —     17,735 

Amortizable intangibles, net

   —     676 

Goodwill and other purchase price adjustments

   667   114,100 

Other current liabilities and minority interest

   (351)  (2,819)
   


 


Net assets from discontinued operations

  $15,445  $132,767 
   


 


Pro forma financial information

The following summary, prepared on a pro forma basis, combines the results of operations as if the acquisitions in 2006 and 2005 had been consummated as of the beginning of 2005 and 2004, after including the impact of certain adjustments such as amortization of intangibles, interest expense on acquisition financing and income tax effects. The divestitures resulting from the DVA Renal Healthcare acquisition have been reflected in the 2005 and 2004 pro formas.

   Year ended December 31,

 
       2006    

      2005    

      2004    

 
   (unaudited) 

Pro forma net revenues

  $4,908,929  $4,512,847  $4,117,461 

Pro forma net income (loss), including discontinued operations

   291,596   285,771   (41,245)

Pro forma income (loss) from continuing operations

   291,234   250,770   (74,977)

Pro forma basic net income (loss) per share

   2.82   2.84   (0.42)

Pro forma diluted net income (loss) per share

   2.76   2.75   (0.40)

Pro forma basic income (loss) from continuing operations

   2.81   2.49   (0.76)

Pro forma diluted income (loss) from continuing operations

   2.75   2.41   (0.73)

5.    Accounts receivable

Less than 10% of the accounts receivable balances as of December 31, 2006 and 2005 were more than six months old, and there were no significant balances over one year old. Approximately 1% of our accountsF-29

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

receivable relate to collections from patients. Collections are principally from Medicare and Medicaid programs and commercial insurance plans.

6.    Other receivables

Other receivables were comprised of the following:

   December 31,

   2006

  2005

Supplier rebates and other non-trade receivables

  $119,889  $73,597

Medicare bad debt claims

   15,990   23,100

Transition services receivable associated with divested centers

   2,406   12,870

Operating advances under management services agreements

   10,557   7,053
   

  

   $148,842  $116,620
   

  

Operating advances under management services agreements are generally unsecured.

7.    Other current assets

Other current assets consist principally of prepaid expenses, assets held for sale and deposits.

8.    Property and equipment

Property and equipment were comprised of the following:

   December 31,

 
   2006

  2005

 

Land

  $13,593  $14,859 

Buildings

   39,438   35,148 

Leasehold improvements

   620,483   521,464 

Equipment and information systems

   686,426   552,199 

New center and capital asset projects in progress

   48,747   31,683 
   


 


    1,408,687   1,155,353 

Less accumulated depreciation and amortization

   (558,721)  (405,275)
   


 


   $849,966  $750,078 
   


 


Depreciation and amortization expense on property and equipment was $160,717, $105,254 and $71,495 for 2006, 2005 and 2004, respectively.

Interest on debt incurred during the development of new centers and other capital asset projects is capitalized as a component of the asset cost based on the respective in-process capital asset balances. Interest capitalized was $4,708, $1,912 and $1,078 for 2006, 2005 and 2004, respectively.


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

9.    Amortizable intangiblesbeen restated to reflect this change. The standard also requires that tax benefits realized from stock award exercise gains in excess of stock-based compensation expense recognized for financial statement purposes be reported on a prospective basis as cash flows from financing activities rather than as operating cash flows. The Company also elected to use the method available under FASB Staff Position FSP No. 123(R)-3Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, which provides an alternative method for calculating historical excess tax benefits from the method described in SFAS No. 123(R) for stock-based compensation awards.

 

Amortizable intangible assets were comprisedUnder SFAS No. 123(R), stock-based compensation recognized during a period is based on the estimated grant-date fair value of the following:

   December 31,

 
   2006

  2005

 

Noncompetition and other agreements

  $261,836  $246,336 

Lease agreements

   8,738   11,974 

Deferred debt issuance costs

   73,826   77,884 
   


 


    344,400   336,194 

Less accumulated amortization

   (140,679)  (100,250)
   


 


Total amortizable intangible assets

  $203,721  $235,944 
   


 


Amortizable intangible liabilities were comprisedportion of each stock-based award vesting during that period, adjusted for expected forfeitures. Stock-based compensation recognized in the following:

   December 31,

 
   2006

  2005

 

Alliance and Product Supply Agreement commitment (See Note 4)

  $120,300  $162,100 

Hospital acute services contracts

   —     6,187 
   


 


    120,300   168,287 

Less accumulated amortization

   (15,037)  (4,856)
   


 


   $105,263  $163,431 
   


 


Net amortization expense from noncompetitionCompany’s consolidated financial statements for the years ended December 31, 2007 and other agreements and the amortizable intangible liabilities was $12,578, $11,582 and $11,4172006 includes compensation cost for 2006, 2005 and 2004, respectively. Lease agreements are amortizedstock-based awards granted prior to, rent expense, which was $3,309 in 2006 and $690 in 2005. Deferred debt issuance costs are amortized to debt expense as described in Note 14 to the Consolidated Financial Statements.

Scheduled amortization charges from intangible assets and liabilitiesbut not fully vested as of, December 31, 2006 were as follows:

   

Noncompetition and

other agreements


  

Deferred debt

issuance costs


  Alliance and
Product Supply
Agreement liability


 

2007

  $23,377  $9,998  $(12,030)

2008

   20,936   9,890   (12,030)

2009

   16,866   9,714   (12,030)

2010

   15,774   9,464   (12,030)

2011

   15,645   9,039   (12,030)

Thereafter

   51,752   11,266   (45,113)

10.    Investments2005 and stock-based awards granted in third-party businesses

Investments in third-party dialysis businesses and related advances were $1,813 and $3,181 at December 31, 2006 and 2005. During 2006, 20052007. The Company previously recognized the effect of stock unit forfeitures as they occurred, and 2004, the Company recognized incomeeffect of $2,308, $1,406 and $1,441, respectively, relatingtransitioning to investmentsrecognition of expense based on expected forfeitures was insignificant. Shares issued upon exercise of stock awards are generally issued from shares in non-consolidated minority-owned businesses under the equity method.

DAVITA INC.treasury.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

These amounts are included as a reductionPrior to minority interest expense in the consolidated statements of income. During 2006, the Company acquired a majority-owned interestaccounted for stock-based compensation in one business that was previously minority-owned and sold one minority-owned business. The Company did not recognize a gain or loss on the saleaccordance with APB No. 25Accounting for Stock Issued to Employees, as the investment was carried at fair value as a result of the DVA Renal Healthcare acquisition.

On February 7, 2007, the Company entered into a National Provider Agreement with NxStage, Inc. The agreement provides the Company the ability to purchase NxStage home-based hemodialysis products at a potential discount depending upon the achievement of certain volume targets. The agreement has an initial term of three years, terminating on December 31, 2009, and may be extended in six month increments up to two additional years if certain volume targets are met. As a part of the agreement, the Company purchased outright all of its NxStage System One equipment currently in use for $5,100, and will purchase a majority of the Company’s future home-based hemodialysis equipment and supplies from NxStage. In connection with the provider agreement, the Company purchased 2,000,000 shares of NxStage common stock in a private placement offering for $20,000, representing an ownership position of approximately 7%. In connection with the purchase of the shares, the Company entered into a Registration Rights Agreementallowed under which NxStage has agreed to register the shares.

11.    Goodwill

Changes in the book value of goodwill were as follows:

   Year ended December 31,

 
   2006

  2005

 

Balance at January 1,

  $3,594,383  $1,156,226 

Acquisitions

   79,948   2,686,050 

DVA Renal Healthcare adjustments

   (5,811)  —   

Divestitures

   (667)  (247,893)
   


 


Balance at December 31,

  $3,667,853  $3,594,383 
   


 


12.    Other liabilities

Other accrued liabilities were comprised of the following:

   December 31,

   2006

  2005

Payor refunds and retractions

  $322,155  $222,361

Insurance and self-insurance accruals

   74,607   61,255

Accrued interest

   48,781   55,109

Accrued tax liabilities

   11,610   8,488

Other

   16,066   34,751
   

  

   $473,219  $381,964
   

  

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

13.    Income taxes

Income tax expense consisted of the following:

   Year ended December 31,

   2006

  2005

  2004

Current:

            

Federal

  $159,054  $178,569  $94,626

State

   24,009   33,564   17,623

Deferred:

            

Federal

   (12)  (60,866)  23,508

State

   2,354   (10,502)  3,873
   


 


 

   $185,405  $140,765  $139,630
   


 


 

The allocations of income tax expense were as follows:

   Year ended December 31,

   2006

  2005

  2004

Continuing operations

  $186,430  $123,675  $128,332

Discontinued operations

   —     8,377   11,298

Gain on discontinued operations

   (1,025)  8,713   —  
   


 

  

   $185,405  $140,765  $139,630
   


 

  

Deferred tax assets and liabilities arising from temporary differences, were as follows:

   December 31,

 
   2006

  2005

 

Receivables, primarily allowance for doubtful accounts

  $47,054  $28,805 

Alliance and Product Supply Agreement

   40,947   61,480 

Accrued liabilities

   154,169   121,404 

Other

   27,638   20,287 
   


 


Deferred tax assets

   269,808   231,976 

Valuation allowance

   (10,656)  (9,898)
   


 


Net deferred tax assets

   259,152   222,078 
   


 


Intangible assets

   (155,762)  (118,240)

Property and equipment

   (18,953)  (16,930)

Other

   (10,989)  (17,583)
   


 


Deferred tax liabilities

   (185,704)  (152,753)
   


 


Net deferred tax assets

  $73,448  $69,325 
   


 


At December 31, 2006, the Company had state net operating loss carryforwards of approximately $128,000 that expire through 2026, and federal net operating loss carryforwards of $9,200 that expire through 2026. The utilization of these losses may be limited in future years based on the profitability of certain separate-return entities. The valuation allowance change of $758 related to changes in the estimated tax benefit of federal and

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

state operating losses of separate-return entities, of which a reduction of $238 is included as a component of tax expense. Purchase accounting adjustments increased the valuation allowance by $996. A total of approximately $2,700 of valuation allowance will reduce goodwill when the related tax benefits are first recognized.

The reconciliation between our effective tax rate from continuing operations and the U.S. federal income tax rate is as follows:

   Year ended
December 31,


 
   2006

  2005

  2004

 

Federal income tax rate

  35.0% 35.0% 35.0%

State taxes, net of federal benefit

  3.9  3.4  3.8 

Changes in deferred tax valuation allowances

  (0.1) (0.7) (0.3)

Other

  0.4  (0.3) 0.1 
   

 

 

Effective tax rate

  39.2% 37.4% 38.6%
   

 

 

14.    Long-term debt

Long-term debt was comprised of the following:

   December 31,

 
   2006

  2005

 

Senior secured credit facility:

         

Term Loan A

  $279,250  $341,250 

Term Loan B

   2,105,875   2,443,875 

Senior and senior subordinated notes

   1,350,000   1,350,000 

Acquisition obligations and other notes payable

   9,197   14,757 

Capital lease obligations

   6,929   7,320 
   


 


    3,751,251   4,157,202 

Less current portion

   (20,871)  (71,767)
   


 


   $3,730,380  $4,085,435 
   


 


Scheduled maturities of long-term debt at December 31, 2006 were as follows:

2007

  20,871

2008

  55,462

2009

  63,319

2010

  88,068

2011

  444,731

Thereafter

  3,078,800

On October 5, 2005, the Company entered into a credit agreement allowing for borrowings of up to $3,050,000. The facilities under the credit agreement consist of a $250,000 six-year revolving credit facility, a $350,000 six-year term loan A facility and a $2,450,000 seven-year term loan B facility (the Facilities). Existing borrowings under the Facilities bear interest at LIBOR plus margins initially ranging from 2.00% to 2.25%. The

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

margins are subject to adjustment depending upon the Company’s achievement of certain financial ratios and can range from 1.50% to 2.25% for the revolving credit facility and term loan A, and 2.00% to 2.25% for the term loan B. The Facilities are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and are secured by substantially all of the Company’s and its subsidiary guarantors’ assets. The credit agreement also contains customary affirmative and negative covenants and requires compliance with financial covenants, including a leverage ratio and an interest coverage ratio that determine the interest rate margins described above. The credit agreement also contains limits on the annual amount of expenditures for acquisitions and capital improvements. The aggregate amount of the Facilities may be increased by up to $500,000 as long as no default exists or would result from such increase and the Company remains in compliance with the financial covenants after such increase. Such additional loans would be on substantially the same terms as the original borrowings under the Facilities.

On October 5, 2005, the Company borrowed $2,850,000 under the Facilities ($50,000 on the revolving credit facility, $350,000 on the term loan A and $2,450,000 on the term loan B), and used these borrowings, along with available cash of $252,000 to purchase DVA Renal Healthcare and pay related bank fees and expenses of approximately $47,000, and to pay fees and expenses in connection with terminating the Company’s then-existing credit facility. On October 7, 2005, the Company repaid the $50,000 of the revolving credit facility with proceeds from the sale of the divested centers, as discussed in Note 4 to the Consolidated Financial Statements.

SFAS No. 123Term Loans

 

The termTerm loan A and term loan B total outstanding borrowings each consist of various individual tranche amounts that can range in maturity from one month to twelve months. Each specific tranche bears interest at a LIBOR rate depending upondetermined by the maturity of that specific tranche and the interest rates are reset as each specific tranche matures. The overall weighted average interest rate for each term loan is determined based upon the LIBOR interest rates in effect for each individual tranche.tranche plus the interest rate margin.

 

During 20062007 and 2005,2006, the Company made principal payments totaling $50,000 and $62,000 and $8,750 on the term loan A, respectively, and $400,000 and $338,000 and $6,125 on the term loan B, respectively. The principal payments made on term loan A and term loan B in 2007 were prepayments. The term loan B prepayment was made from the proceeds of issuing the senior notes as discussed below. In 2006, and 2005, $35,000 and $8,750 were mandatory principal payments as required for the term loan A and $24,500 and $6,125 were mandatory principal payments as required for the term loan B. The balance of the principal payments in 2006 were prepayments. As a result of thesethe principal prepaymentsprepayment made in 2007 and 2006, the companyCompany wrote off a total of $4,371 and $3,270, respectively, of deferred financing costs, which is included in debt expense.

 

Term Loan A

On March 1, 2006,February 27, 2007, the Company’s interest rate marginsmargin on ourits term loan A and term loan B, the Facilities, werewas reduced by 0.25% as a result of achieving certain financial ratios as defined in the Senior Secured Credit Facilities.

 

Term Loan A

The term loan A currently bears interest at LIBOR plus a margin of 1.75%1.50%, for an overall weighted average effective rate of 7.39%6.35% at December 31, 2006.2007. The interest rate margin is subject to adjustment depending upon certain financial conditions and could range from 1.50% to 2.25%. The Term Loanloan A matures in October 2011 and requires annual principal payments of $12,375 in 2007, $52,500$14,875 in 2008, $61,250 in 2009, $87,500 in 2010 and $65,625 in 2011.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)2011, respectively.

 

Term Loan B

The term loan B bears interest at LIBOR plus a margin of 2.00%, for an overall effective rate of 7.42% at December 31, 2006. The interest rate margin is subject to adjustment depending upon certain financial conditions and can range from 2.00% to 2.25%. The term loan B matures in October 2012 and requires annual principal payments of $378,625 in year 2011 and $1,727,250 in year 2012.

 

On February 23, 2007, the Company amended and restated its existing Senior Secured Credit Facilities to, among other things, reduce the interest rate margin on its term loan B by 0.50%, and to amend certain financial covenants. The newamended term loan B will bearbears interest at LIBOR plus a margin of 1.50%. If, for an overall weighted average effective rate of 5.80%, including the Company refinancesimpact of the term loan B prior to February 23, 2008,Company’s swap agreements, except for the Company will be subject to a prepayment penaltyforward interest rate swap agreements, as of 1.0%, otherwise the paymentDecember 31, 2007. Other terms remain the same. In addition,that were changed included the amount by which the Company can elect to increase the revolving and term loan commitments was changed from $500,000 to $750,000.$750,000 and certain limitations on purchases, redemptions or acquisitions of capital stock, the payment of dividends and distributions in cash. Further, limitations on capital expenditures for internal growth will not apply during the periods in which the Company’s leverage ratio is less than 3.5:1. The Company’s leverage ratio as of December 31, 2007 was less than 3.5:1. The Company incurred financing costs of $1,781 which were deferred and also expensed $248 of other costs in connection with this transaction, which are included in debt expense. Term loan B matures in October 2012 and requires principal payments of $1,705,875 in year 2012.

F-22


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Revolving LineLines of Credit

 

The Company has an undrawn revolving credit facilityline under the Senior Secured Credit Facilities totaling $250,000, of which approximately $50,000$41,000 was committed for outstanding letters of credit. The Company also has other undrawn revolving lines of credit facilities totaling $3,600$7,200 associated with several of its joint ventures.

 

Senior and Senior Subordinated Notes

 

On February 23, 2007, the Company issued $400,000 of 65/8% senior notes due 2013 in a private offering.offering, realizing $405,080 in proceeds, which included a $5,080 premium, and incurred $2,719 in related deferred financing costs. These senior notes are part of the same series of debt securities as the $500,000 aggregate principal amount of 65/8% senior notes that were issued in March 2005. The effective interest rate for the $400,000 of 65/8% senior notes is 6.45%. The senior notes are guaranteed by oursubstantially all of the Company’s direct and indirect wholly-owned subsidiaries and require semi-annual interest payments beginningwhich began March 15, 2007. The senior notes may be redeemed by the Company in whole or part at any time on or after March 15, 2009, at certain specified prices. The Company used the$400,000 of these proceeds to pay down theits term loan B and also wrote-off $4,000 of term loan B deferred financing costs.as discussed above.

 

On March 22, 2005, the Company issued $500,000The Company’s senior and senior subordinated notes, as of December 31, 2007, consisted of $900,000 of 65/8% senior notes due 2013 and $850,000 of 71/4% senior subordinated notes due 2015 and incurred related deferred financing costs of $28,600.2015. The notes are guaranteed by substantially all of the Company’s direct and indirect wholly-owned subsidiaries and require semi-annual interest payments.payments in March and September. The Company may redeem some or all of the senior notes at any time on or after March 15, 2009as described above and some or all of the senior subordinated notes at any time on or after March 15, 2010. The Company used the net proceeds of $1,323,000 along with available cash of $46,000 to repay all outstanding amounts under the term loan portions of the Company’s then-existing credit facilities, including accrued interest.

 

Interest rate swaps

 

As of December 31, 2006,2007, the Company maintained a total of nine interest rate swap agreements with amortizing notional amounts totaling $1,341,000.$968,000. These agreements had the economic effect of modifying the LIBOR-based variable interest rate on an equivalent amount of debt to fixed rates ranging from 3.08% to 4.27%, resulting in an overall weighted average effective interest rate of 5.88%, which included5.37% on the hedged portion of our Senior Secured Credit Facilities, including the term loan B margin of 2.00%1.50%. The swap agreements expire in 2008 through 2010 and require quarterly interest payments. In addition, the Company maintains two forward interest rate swap agreements with notional amounts totaling $200,000. These forward interest rate swaps will have the economic effect of modifying the LIBOR-based interest rates to fixed rates of 4.05% and 4.70% on the Company’s term loan B outstanding debt. These forward interest rate swaps take effect on September 30, 2008, require quarterly interest payments beginning in December 2008, and expire in 2010. During 2007, 2006, 2005, and 20042005 the Company accrued net cash benefits (obligations) of approximately $14,497, $15,791, $285, and $5,256,$(285), respectively, from these swaps, which are included in debt expense. During 2005, the Company also incurred additional net cash obligations of $1,461 from these swaps, which is included in swap valuation gains. The Company estimates that approximately $13,000$500 of existing unrealized pre-tax gainslosses in other comprehensive income at December 31, 2006,2007, will be reclassified into income in 2007.2008. As of December 31, 2006,2007 and 2005,2006, the total fair value of these swaps was a net liability of $511 and an asset of $29,544, and $30,756, which wererespectively. The 2007 amount was primarily included in other long termlong-term liabilities and the 2006 amount was primarily included in other long-term assets. Also during 2006,2007, the Company recorded $7,862,$16,027, net of tax, as an increasereductions to other comprehensive income for valuation losses, net of amounts reclassified into income.

As of December 31, 2007, the changes in fair valueCompany had approximately 50% of the effective portionsits variable rate debt and approximately 74% of these swaps, or $12,869 before tax.its total debt economically fixed.

F-23


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

As a result of the swap agreements, the Company’s overall Senior Secured Credit Facilities effective weighted average interest rate was 5.90%, based upon the current margins in effect of 1.50%, as of December 31, 2007.

At December 31, 2007, the Company’s overall average effective interest rate was 6.37%.

Debt expense

Debt expense consisted of interest expense of $242,720, $262,967 and $134,429, amortization of deferred financing costs of $9,808, $10,469 and $5,157 for 2007, 2006 and 2005, respectively, and in 2007 and 2006, included the write-off of $4,371 and $3,270, respectively, of deferred financing costs. Debt expense in 2007 also included $248 of other costs associated with the amendment and reinstatement of the Senior Secured Credit Facilities. These interest expense amounts are net of capitalized interest.

2005 Transactions

In conjunction with the repayment and extinguishment of the Company’s prior credit facilitiesSenior Secured Credit Facilities during 2005, the Company wrote off deferred financing costs of $8,170 and reclassified into net income $8,100 of swap valuation gains that were previously recorded in other comprehensive income. These gains represented the accumulated fair value of several interest rate swap instruments that became ineffective as cash flow hedges as a result of the repayment of the prior credit facilities.Senior Secured Credit Facilities. In addition, the Company recorded a net loss of $2,100 related to changes in fair values of these swaps that were not effective as interest rate hedges until they were redesignated in the second quarter of 2005.

 

Portions of the Company’s various interest rate swap agreements that were previously designated and expected to be effective as forward cash flow hedges became ineffective as a result of the Company not having any variable rate LIBOR-based interest payments during a portion of 2005. This resulted in a net charge of $1,700 to swap valuation gains, which includes the $1,461 discussed above as well as a reclassification into income of $2,000 of swap valuation losses that were previously recorded in other comprehensive income. The swap payment periods that began after October 2005 were highly effective as cash flow hedges with gains or losses from changes in their fair values reported in other comprehensive income.

 

As of December 31, 2006, the Company had approximately 56% of its variable rate debt and approximately 72% of its total debt economically fixed.

As a result of the swap agreements, the Company’s overall credit facility effective weighted average interest rate was 6.61%, based upon the current margins in effect ranging from 1.75% to 2.00%, as of December 31, 2006.

At December 31, 2006, the Company’s overall average effective interest rate was 6.76%.

Debt expense

Debt expense consisted of interest expense of $262,967, $134,429 and $50,323, amortization of deferred financing costs of $10,469, $5,157 and $2,088 for 2006, 2005 and 2004, respectively, and in 2006, included the write off of $3,270 of deferred financing costs. These interest expense amounts are net of capitalized interest.

15.14.    Leases

 

The majority of the Company’s facilities are leased under non-cancelable operating leases, ranging in terms from five to ten years, andwhich contain renewal options of five to ten years at the fair rental value at the time of renewal or at rates subject to periodic consumer price index increases. The Company hasalso leases certain equipment leased under capital leases.

F-24


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Future minimum lease payments under non-cancelable operating leases and capital leases are as follows:

 

  Operating
leases


  Capital
leases


   Operating
leases
  Capital
leases
 

2007

  $148,442   3,543 

2008

   136,387   1,321   $170,192  $1,579 

2009

   121,268   843    151,344   1,162 

2010

   105,773   688    136,480   962 

2011

   92,037   684    121,913   966 

2012

   101,035   987 

Thereafter

   294,069   1,770    336,131   4,452 
  

  


       
  $897,976   8,849   $1,017,095   10,108 
  

        

Less portion representing interest

      (1,920)     (3,441)
     


      

Total capital lease obligations, including current portion

     $6,929     $6,667 
     


      

 

Rent expense under all operating leases for 2007, 2006, and 2005 was $200,626, $187,139 and 2004 was $187,139, $109,511, and $75,846, respectively. Rent expense is recorded on a straight line basis, over the term of the lease, for leases that contain fixed escalation causes. Leasehold improvement incentives are deferred and amortized to rent expense over the term of the lease. The net book value of property and equipment under capital leases was $7,191, $5,765 $6,094 and $7,711$6,094 at December 31, 2007, 2006 2005 and 2004,2005, respectively. Capital lease obligations are included in long-term debt. See Note 1413 to the Consolidated Financial Statements.consolidated financial statements.

 

16.15.    Employee benefit plans

 

The Company has a savings plan for substantially all employees which has been established pursuant to the provisions of Section 401(k) of the Internal Revenue Code, or IRC. The plan provides for employees to contribute a percentage of their base annual salaries on a tax-deferred basis not to exceed IRC limitations. The Company does not provide any matching contributions.

 

During 2000, the Company established the DaVita Inc. Profit Sharing Plan. Contributions to this defined contribution benefit plan are made at the discretion of the Company as determined and approved by the Board of Directors. All contributions are deposited into an irrevocable trust. The profit sharing award for each eligible participant is based upon the achievement of employee-specific and/or corporate financial and operating goals. During 2004 the Company elected to discontinue funding the profit sharing trustplan and to distribute similar awards directly to the recipients, or at their discretion to their 401(k) accounts. In December 2007, the DaVita Profit Sharing Plan was merged into the Company’s 401(k) Plan.

 

On October 5, 2005, the Company’s Board of Directors approved the adoption of the DaVita Voluntary Deferral Plan. This plan is non-qualified and permits certain employees designated by the plan administrator whose annualized base salary equals or exceeds a minimum annual threshold amount as set by the Company to elect to defer all or a portion of their annual bonus payment and, as originally adopted, up to 15% of their base salary into a deferral account maintained by the Company. Total contributions to this plan in 2007 and 2006 were $1,601, and $1,296, respectively. Effective January 1, 2006, the elective deferral percentage for base salary was increased to up to 50% of a participant’s base salary. Deferred amounts are generally paid out in cash at the participant’s election either in the first or second year following retirement or in a specified future period at least three to four years after the deferral election was effective. Participants are credited with their proportional amount of annual earnings from the plan. The assets of this plan are held in a “rabbi trust” and as such are subject to the claims of the Company’s general creditors in the event of its bankruptcy.

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DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

As part of the acquisition of DVA Renal Healthcare on October 5, 2005, the Company acquired an Executive Retirement Plan for certain members of management. The plan is non-qualified and contributions to

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

the plan were made at the discretion of DVA Renal Healthcare based upon a pre-determined percentage of a participant’s base salary. Effective November 2005, all contributions to this plan were discontinued and the balance of the plan assets will be paid out upon termination of each individual participant.

 

The Company has severalmaintains a non-qualified deferred non-qualified compensation plansplan for certain key employees. Company contributions are discretionary and are deposited into a Rabbi Trust.rabbi trust. Participants in the plansplan are subject to a vesting period and typically receive annual distributions from the plan commencing one year after grant date, although in certain situations distributions are paid upon termination or retirement. Participants also have the option to direct their balances into certain investment funds and are credited with their proportional amount of earnings from the investments. The assets of this plan as held in the rabbi trust and are subject to the claims of the Company’s general creditors in the event of its bankruptcy. During 2007 and 2006, the Company contributed $15,710 and $2,430 into the plan.

The Company also maintains a non-qualified deferred compensation plan for certain employees. Company contributions to the plan are discretionary and are deposited into a rabbi trust that is not subject to general creditors claims in the event of bankruptcy by the Company. Participants in the plan are subject to a vesting period and will receive their proportionate amount of the Company’s contribution plus earnings in December of 2008. Participants are credited with their proportional amount of earnings from the investments within the plan. During 2007, the Company contributed $14,774 into this plan.

The fair value of the assets held in trust as of December 31, 2007, and 2006 totaled $16,408.$43,036 and $16,408, respectively. The assets are available for sale and as such are recorded at fair market value with changes in the fair market values being recorded in other comprehensive income. Any fair market value changes to the corresponding liability balance will be recorded as compensation expense. See Note 9 to the consolidated financial statements.

 

Most of the Company’s outstanding employee stock plan awards include a provision accelerating the vesting of the award in the event of a change of control. The Company also maintains a change of control protection program for its employees who do not have a significant number of stock awards, which has been in place since 2001, and which provides for cash bonuses to the employees in the event of a change of control which has been in place since 2001.control. Based on the shares of our common stock outstanding and the market price of ourthe Company’s stock and the outstanding shares of its common stock on December 31, 2006,2007, these cash bonuses would total approximately $231,000$234,000 if a control transaction occurred at that price and ourthe Company’s Board of Directors did not modify the program. This amount has not been accrued at December 31, 2006,2007, and willwould only be accrued upon a change of control. These compensation programs may affect the price an acquirer would be willing to pay.

 

17.16.    Contingencies

 

The majority of the Company’s revenues are from government programs and 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; and (4) retroactive applications or interpretations of governmental requirements. In addition, the Company’s revenues from commercial payors may be subject to adjustment as a result of potential claims for refunds, from commercial payors, as a result of government actions or as a result of other claims by commercial payors.

 

F-26


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

United States Attorney inquiries

In February 2007, the Company received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services, or OIG, for records relating to Epogen®, or EPO, claims submitted to Medicare. In August 2007, the Company received a subpoena from the OIG seeking similar documents. The requested documents relate to services provided from 2001 to 2004 by a number of the Company’s centers. The request and subpoena were sent from the OIG’s offices in Houston and Dallas, Texas. The Company is cooperating with the inquiry and is producing the requested records. The Company has been in contact with the United States Attorney’s Office, or U.S. Attorney’s Office, for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. There appears to be substantial overlap between this issue and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office, for the Eastern District of Missouri in St. Louis described below. To the Company’s knowledge, no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena will continue to require management’s attention and significant legal expense. Any negative findings could result in substantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs.

 

On March 4, 2005, the Company received a subpoena from the United States Attorney’s Office, or U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. The subpoena requires production of a wide range of documents relating to our operations, including documents related to, among other things, pharmaceutical and other services provided to patients, relationships with pharmaceutical companies, and financial relationships with physicians and joint ventures. The subpoena covers the period from December 1, 1996 through the present. In October 2005, the Company received a follow-up request for additional documents related to specific medical director and joint venture arrangements. In February 2006, wethe Company received an additional subpoena for documents, including certain patient records relating to the administration and billing of Epogen (EPO).EPO. In May 2007, the Company received a request for documents related to durable medical equipment (DME) and supply companies owned and operated by the Company. The Company is producing documents and providing information to the government. The Company is also cooperating, and intends to continue to cooperate, with the government’s investigation, including by

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

participating in discussions and meetings with the government. The subpoenas have been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. To the Company’s knowledge, no proceedings have been initiated against the Company at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as this to continue for a considerable period of time. Responding to the subpoenas will continue to require management’s attention and significant legal expense.

 

On October 25, 2004, the Company received a subpoena from the U.S. Attorney’s Office for the Eastern District of New York in Brooklyn. The subpoena covers the period from 1996 to present and requires the production of a wide range of documents relating to ourthe Company’s operations, including DaVita Laboratory Services. Gambro Healthcare received a similar subpoena in November 2004. The subpoena also includes specific requests for documents relating to testing for parathyroid hormone levels, (PTH),or PTH, and to products relating to vitamin D therapies. The subpoena has been issued in connection with a joint civil and criminal investigation. It is possible that criminal proceedings may be initiated against the Company in connection with this inquiry. Any negative findings could result in substantial financial penalties against the Company, and DVA Renal Healthcare, exclusion from future participation in the Medicare and Medicaid programs and criminal penalties. Other participants in the dialysis industry received a similar subpoena, including Fresenius Medical Group, Renal Care Group and DVA Renal Healthcare, which was acquired by the Company in October of 2005.Group. To the Company’s knowledge,

F-27


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

no proceedings have been initiated against the Company or DVA Renal Healthcare at this time. Although the Company cannot predict whether or when proceedings might be initiated or when these matters may be resolved, it is not unusual for investigations such as these to continue for a considerable period of time. Responding to the subpoena may continue to require management’s attention and significant legal expense.

 

In February 2001, the Civil Division of the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia contacted the Company and requested its cooperation in a review of some of its historical practices, including billing and other operating procedures and the Company’s financial relationships with physicians. The Company cooperated in this review and provided the requested records to the U.S. Attorney’s Office. In May 2002, the Company received a subpoena from the U.S. Attorney’s Office and the Philadelphia Office of the Office of Inspector General of the Department of Health and Human Services (OIG). The subpoena required an update to the information the Company provided in our response to the February 2001 request, and also sought 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 covered the period from May 1996 to May 2002. The Company provided the documents requested and cooperated with the United States Attorney’s Office and the OIG in its investigation. In January 2007, the U.S. Attorney’s Office for the Eastern District of Pennsylvania in Philadelphia informed the Company that it has decided to close its investigation of DaVita. No charges were made against the Company, no fines were assessed and no mandatory policy changes were required in connection with this investigation.

In February 2007, the Company received a request for information from the Office of Inspector General, U.S. Department of Health and Human Services for records relating to EPO claims submitted to Medicare. The claims relate to services provided from 2002 to 2004 by a number of our centers. The request was sent from the OIG’s office in Houston, Texas. The Company have been in contact with the U.S. Attorney’s Office for the Eastern District of Texas, which has stated that this is a civil inquiry related to EPO claims. We are cooperating with the inquiry and will be producing the requested records. There appears to be substantial overlap between

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

this issue, and the ongoing review of EPO utilization and claims by the U.S. Attorney’s Office for the Eastern District of Missouri in St. Louis. EPO utilization was also one of the subjects of the multi-year investigation by the U.S. Attorney’s Office for the Eastern District of Pennsylvania, which was recently closed as described herein. To the best of the Company knowledge, the government has not initiated any proceeding against it in connection with this request although the Company cannot predict whether it will receive further inquiries or whether or when a proceeding might be initiated.

Other

 

The Company has received several notices of claims from commercial payors and other third parties related to historical billing practices and claims against DVA Renal Healthcare (formerly known as Gambro Healthcare) related to historical DVA RenalGambro Healthcare billing practices and other matters covered by their settlement agreement with the Department of Justice. At least one commercial payor has filed an arbitration demand against the Company, as described below, and additional commercial payors have threatened litigation. The Company intends to defend against these claims vigorously; however, the Company may not be successful and these claims may lead to litigation and any such litigation may be resolved unfavorably. Although the ultimate outcome of these claims cannot be predicted at this time, an adverse result in excess of the Company’s established reserves, with respect to one or more of these claims could have a material adverse effect on the Company’s business, financial condition, and results of operations.operations and liquidity.

 

TheIn December 2007, the Company has received several informal inquiries from representativesentered into a Settlement Agreement with the State of New York to resolve certain billing issues that had been the subject of inquiry by the New York Attorney General’s Medicaid Fraud Control Unit, (MFCU)or MFCU. The Company had received several informal inquiries from representatives of MFCU regarding certain aspects of the EPO and other billing practices taking place atfor facilities managed by the Company in New York. The Settlement Agreement covers numerous dialysis facilities in New York for which the Company, is cooperating withthrough its subsidiaries, provides administrative services. The Company paid $1,457 in settlement, which included the MFCU’s informal inquiriesamount of the overpayments by the New York Medicaid program plus interest; no fines or penalties were assessed.

In October 2007, the Company was contacted by the Attorney General’s Office for the State of Nevada. The Attorney General’s Office informed the Company that it was conducting a criminal investigation of the Company’s operations in Nevada and has provided documents and informationthat the investigation related to the MFCU.billing of pharmaceuticals, including EPO. On February 8, 2008, the Attorney General’s Office informed the Company that the criminal investigation has been discontinued. The Attorney General’s Office further advised the Company that Nevada Medicaid intends to conduct audits of ESRD providers in Nevada, including the Company, and that such audits will relate to the issues that were the subjects of the criminal investigation. Any negative findings could result in substantial financial penalties against the Company and exclusion from future participation in the Medicare and Medicaid programs. To the best of the Company’s knowledge, no proceedings have been initiated against the Company at this time.

On August 28, 2007, Sheet Metal Workers National Health Fund and Glenn Randle filed a complaint in the MFCU has not indicated an intentionUnited States District Court for the Central District of California against the Company. The complaint also names as defendants Amgen, Inc. and Fresenius Medical Care Holdings, Inc. The complaint is styled as a class action and alleges four claims against the Company, including violations of the federal RICO statute, California’s unfair competition law, California’s false advertising law and for unjust enrichment. The complaint’s principal allegations against the Company are that the defendants engaged in a scheme to do so, althoughunlawfully promote the administration of EPO to hemodialysis patients intravenously, as opposed to subcutaneously, and to over-utilize EPO. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the certification of this matter as a class action. At this time, the Company cannot predict whether it will receive further inquiriesthe ultimate outcome of this matter or whetherthe potential range of damages, if any.

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the Western District of Louisiana against Gambro AB, DVA Renal Healthcare (formerly Gambro Healthcare) and related entities. The plaintiff sought to bring its claims as a class action on behalf of itself and all

F-28


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

entities that paid any of the defendants for health care goods and services from on or when proceedings might be initiated.about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying Gambro Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against the Company and DVA Renal Healthcare. The Company intends to vigorously defend against these claims. The Company also intends to vigorously oppose the certification of this matter as a class action. At this time, the Company cannot predict the ultimate outcome of this matter or the potential range of damages, if any.

 

In June 2004, DVA RenalGambro Healthcare was served with a complaint filed in the Superior Court of California by one of its former employees who worked for its California acute services program. The complaint, which is styled as a class action, alleges, among other things, that DVA Renal Healthcare (formerly Gambro Healthcare) failed to provide overtime wages, defined rest periods and meal periods, or compensation in lieu of such provisions and failed to comply with certain other California labor code requirements. The Company is evaluating the claims and intends to vigorously defend itself in the matter.against this claim. The Company also intends to vigorously oppose the certification of this matter as a class action. Although the ultimate outcome of these claims cannot be predicted, the Company does not expect that an unfavorable result, if any, would have a material adverse effect on the Company’s business, financial condition, liquidity or results of operations.

 

On August 8, 2005, Blue Cross/Blue Shield of Louisiana filed a complaint in the United States District Court for the Western District of Louisiana against Gambro AB, DVA Renal Healthcare and related entities. The plaintiff sought to bring its claims as a class action on behalf of itself and all entities that paid any of the defendants for health care goods and services from on or about January 1991 through at least December 2004. The complaint alleged, among other things, damages resulting from facts and circumstances underlying DVA Renal Healthcare’s December 2004 settlement agreement with the Department of Justice and certain agencies of the United States Government. In March 2006, the case was dismissed and the plaintiff was compelled to seek arbitration to resolve the matter. In November 2006, the plaintiff filed a demand for class arbitration against the Company and DVA Renal Healthcare. At this time, the Company cannot estimate the potential range of damages, if any. The Company is investigating these claims and continues to vigorously defend itself in the matter.

DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

In addition to the foregoing, the Company is subject to claims and suits, in the ordinary course of business, including from time to time, contractual disputes and professional and general liability claims.claims, as well as audits and investigations by various government entities, in the ordinary course of business. The Company believes that the ultimate resolution of any such pending proceedings, whether the underlying claims are covered by insurance or not, will not have a material adverse effect on its financial condition, results of operations or cash flows.

 

17.  Shareholders’ equity and stock-based compensation

Authorized capital stock of the Company

On May 29, 2007, DaVita’s stockholders approved an amendment to its Amended and Restated Certificate of Incorporation to increase the number of shares of authorized common stock from 195,000,000 to 450,000,000 shares.

Stock-based compensation

Effective January 1, 2006, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 123(R)Share-Based Payment, which requires the measurement and recognition of cost for all stock-based awards made to employees and directors, including stock options, stock appreciation rights, stock units and discounted employee stock purchases. Under this standard, the Company’s stock-based compensation awards are measured at estimated grant-date fair value and recognized as compensation expense over their requisite service periods. SFAS No. 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion (APB) No. 25Accounting for Stock Issued to Employees, under which the Company did not recognize compensation expense for most of its stock options. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the application of SFAS No. 123(R), and the Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

The Company implemented SFAS No. 123(R) using the modified prospective transition method. In accordance with this method, our consolidated financial statements for periods prior to fiscal year 2006 have not

F-29


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

been restated to reflect this change. The standard also requires that tax benefits realized from stock award exercise gains in excess of stock-based compensation expense recognized for financial statement purposes be reported on a prospective basis as cash flows from financing activities rather than as operating cash flows. The Company also elected to use the method available under FASB Staff Position FSP No. 123(R)-3Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, which provides an alternative method for calculating historical excess tax benefits from the method described in SFAS No. 123(R) for stock-based compensation awards.

Under SFAS No. 123(R), stock-based compensation recognized during a period is based on the estimated grant-date fair value of the portion of each stock-based award vesting during that period, adjusted for expected forfeitures. Stock-based compensation recognized in the Company’s consolidated financial statements for the years ended December 31, 2007 and 2006 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, December 31, 2005 and stock-based awards granted in 2006 and 2007. The Company previously recognized the effect of stock unit forfeitures as they occurred, and the effect of transitioning to recognition of expense based on expected forfeitures was insignificant. Shares issued upon exercise of stock awards are generally issued from shares in treasury.

Prior to 2006, the Company accounted for stock-based compensation in accordance with APB No. 25Accounting for Stock Issued to Employees, as allowed under SFAS No. 123Accounting for Stock-based Compensation. Under APB No. 25, stock option grants to employees did not result in an expense if the exercise price was at least equal to the market price at the date of grant. However, under APB No. 25 the Company did recognize compensation expense for stock units, which were valued at the closing stock price on the date of grant and amortized over their respective vesting periods, and for modifications to stock awards as required under FASB Interpretation No. 44Accounting for Certain Transactions Involving Stock Compensation.

Stock-based compensation plans and agreements

On May 29, 2007, the Company’s stockholders approved an amendment and restatement of the Company’s Employee Stock Purchase Plan to increase the number of shares of common stock available for issuance under that plan by 800,001 shares, and approved an amendment and restatement of the Company’s 2002 Equity Compensation Plan to increase the number of shares of common stock available for issuance under that plan by 6,000,000 shares and, among other things, to remove certain available share recycling features, to change the limit on the maximum number of shares of common stock that may be subject to awards granted to any single recipient in any consecutive twenty-four month period so that such limit applies only to awards of stock options and stock appreciation rights, and to provide additional exceptions from the three year minimum vesting period generally applicable to grants of restricted stock units and other full share awards.

The Company’s stock-based compensation plans and agreements are described below.

2002 Plan.    The DaVita Inc. 2002 Equity Compensation Plan as amended on May 29, 2007 (the 2002 Plan) provides for grants of stock-based awards to employees, directors and other individuals providing services to the Company, except that incentive stock options may only be awarded to employees. The 2002 Plan mandates a maximum award term of five years, and stipulates that stock options and stock appreciation rights be granted with prices not less than the fair market value on the date of grant. The 2002 Plan further requires that full share awards such as restricted stock units reduce shares available under the 2002 Plan at a rate of 3.0:1. The Company’s nonqualified stock options, stock appreciation rights and stock units awarded under the 2002 Plan generally vest over 48 to 60 months from the date of grant. At December 31, 2007, there were 9,703,821 stock options and stock-settled stock appreciation rights and 204,345 stock units outstanding and 10,945,124 shares available for future grants under the 2002 Plan.

F-30


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

1999 Plan.    The 1999 Non-Executive Officer and Non-Director Equity Compensation Plan (the 1999 Plan) provides for grants of stock options to employees and other individuals providing services, other than executive officers and members of the Board of Directors. The Company awards nonqualified stock options under the 1999 Plan which are generally issued with exercise prices equal to the market price of the stock on the date of grant, vest over 48 to 52 months from the date of grant and bear maximum award terms of five years. At December 31, 2007, there were 269,651 stock options outstanding and 305,274 shares available for future grants under the 1999 Plan.

Predecessor plans.    Upon shareholder approval of the 2002 Plan on April 11, 2002, the following predecessor plans were terminated, except with respect to options then outstanding: the 1994 Equity Compensation Plan, the 1995 Equity Compensation Plan, the 1997 Equity Compensation Plan, and the 1999 Equity Compensation Plan. Shares available for future grants under these predecessor plans were transferred to the 2002 Plan upon its approval, and cancelled predecessor plan awards become available for new awards under the 2002 Plan. Stock options granted under these terminated plans were generally issued with exercise prices equal to the market price of the stock on the date of grant, vested over four years from the date of grant, and bore maximum award terms of five to 10 years. The RTC Plan, a special purpose option plan related to the merger between the Company and Renal Treatment Centers, Inc. in 1998, was terminated in 1999. At December 31, 2007, there were 567,069 stock options outstanding under these terminated plans.

Deferred stock unit agreements.    During 2001 through 2003, the Company made nonqualified stock unit awards to members of the Board of Directors and certain key executive officers under stand-alone contractual deferred stock unit agreements. These awards vest over one to four years and are settled in stock when they vest or at a later date at the election of the recipient. At December 31, 2007, 63,636 stock units remained outstanding under these agreements.

A combined summary of the status of awards under these stock-based compensation plans and agreements, including base shares for stock appreciation rights and shares subject to stock option and stock unit awards, is as follows:

   Year ended December 31, 2007
   Stock options and stock appreciation rights  Stock units
   Awards  Weighted
average
exercise
price
  Weighted
average
remaining
contractual life
  Awards  Weighted
average
remaining
contractual life

Outstanding at beginning of year

   9,779,805  $38.06     437,735  

Granted

   3,918,328  $53.22     38,643  

Exercised

   (2,448,579) $24.49     (120,175) 

Forfeited

   (709,013) $48.72     (88,222) 
                

Outstanding at end of period

   10,540,541  $46.13  3.3   267,981  2.4
                  

Awards exercisable at end of period

   3,075,862  $36.52  2.5   44,881  1.3
                  

Weighted-average fair value of awards granted during 2007

  $13.89      $54.69  
              

Weighted-average fair value of awards granted during 2006

  $13.38      $51.72  
              

F-31


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Range of exercise prices

  Awards
outstanding
  Weighted
average
exercise
price
  Awards
exercisable
  Weighted
average
exercise
price

$ 0.00–$ 0.00

  267,981  $—    44,881  $—  

$ 0.01–$10.00

  556,519   4.31  556,519   4.31

$10.01–$20.00

  142,114   14.55  142,114   14.55

$20.01–$30.00

  422,470   27.97  260,785   27.81

$30.01–$40.00

  576,367   31.24  140,218   32.27

$40.01–$50.00

  3,746,418   47.93  1,484,495   47.06

$50.01–$60.00

  5,048,153   53.37  486,065   53.28

$60.01–$70.00

  48,500   61.24  5,666   60.21
              

Total

  10,808,522  $44.99  3,120,743  $36.00
              

For the years ended December 31, 2007, 2006, and 2005, the aggregate intrinsic value of stock awards exercised was $86,283, $109,562 and $104,000, respectively. At December 31, 2007, the aggregate intrinsic value of stock awards outstanding was $123,390 and the aggregate intrinsic value exercisable was $63,603.

Estimated fair value of stock-based compensation awards

The Company has estimated the grant-date fair value of stock option and stock-settled stock appreciation rights awards using the Black-Scholes-Merton valuation model and stock unit awards at intrinsic value on the date of grant. The following assumptions were used in estimating these values and determining the total stock-based compensation attributable to the current period:

Expected term of the awards:    The expected term of awards granted represents the period of time that they are expected to remain outstanding from the date of grant. The Company determines the expected term of its stock awards based on its historical experience with similar awards, considering the Company’s historical exercise and post-vesting termination patterns, and the terms expected by peer companies in near industries.

Expected volatility:    Expected volatility represents the volatility anticipated over the expected term of the award. The Company determines the expected volatility for its awards based on the volatility of the price of its common stock over the most recent retrospective period commensurate with the expected term of the award, considering the volatility expectations implied by the market price of its exchange-traded options and the volatilities expected by peer companies in near industries.

Expected dividend yield:    The Company has not paid dividends on its common stock and does not currently expect to pay dividends during the term of stock awards granted.

Risk-free interest rate:    The Company bases the expected risk-free interest rate on the implied yield currently available on stripped interest coupons of U.S. Treasury issues with a remaining term equivalent to the expected term of the award.

F-32


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

A summary of the weighted average valuation inputs described above used for estimating the grant-date fair value of stock options and stock-settled stock appreciation rights granted in the periods indicated is as follows:

   Year ended December 31, 
   2007  2006  2005 
         pro-forma 

Expected term

  3.7 years  3.5 years  3.2 years 

Expected volatility

  25% 25% 27%

Expected dividend yield

  0.0% 0.0% 0.0%

Risk-free interest rate

  4.4% 5.0% 4.1%

The Company estimates expected forfeitures based upon historical experience with separate groups of employees that have exhibited similar forfeiture behavior in the past. Stock-based compensation expense is recorded only for awards that are expected to vest.

Employee stock purchase plan

The Employee Stock Purchase Plan as amended on May 29, 2007 entitles qualifying employees to purchase up to $25 of the Company’s common stock during each calendar year. The amounts used to purchase stock are accumulated through payroll withholdings or through optional lump sum payments made in advance of the first day of the purchase right period. This compensatory plan allows employees to purchase stock for the lesser of 100% of the fair market value on the first day of the purchase right period or 85% of the fair market value on the last day of the purchase right period. Purchase right periods begin on January 1 and July 1, and end on December 31. Payroll withholdings and lump-sum payments related to the plan, included in accrued compensation and benefits, were $4,711, $5,991, and $3,264 at December 31, 2007, 2006 and 2005, respectively. Subsequent to December 31, 2007, 2006 and 2005, 98,353, 123,920 and 80,442 shares, respectively, were issued to satisfy obligations under the plan. At December 31, 2007, there were 1,156,305 shares available for future grants under this plan.

The fair value of employees’ purchase rights was estimated as of the beginning dates of the purchase right periods using the Black-Scholes-Merton valuation model with the following weighted average assumptions for purchase right periods in 2007, 2006 and 2005, respectively: expected volatility of 23%, 23% and 27%; risk-free interest rate of 4.9%, 4.9% and 3.2%, and no dividends. Using these assumptions, the weighted average estimated fair value of these purchase rights was $13.96, $12.35 and $10.64 for 2007, 2006 and 2005, respectively.

Stock-based compensation expense and proceeds

For the years ended December 31, 2007 and 2006, the Company recognized $34,149 and $26,389, respectively, in stock-based compensation expense for stock options, stock appreciation rights, stock units and employee stock plan purchases, which is primarily included in general and administrative expenses in continuing operations. The estimated tax benefits recorded for this stock-based compensation in 2007 and 2006 were $12,820 and $9,678, respectively. As of December 31, 2007, there was $78,605 of total estimated unrecognized compensation cost related to nonvested stock-based compensation arrangements under the Company’s equity compensation and stock purchase plans. The Company expects to recognize this cost over a weighted average remaining period of 1.6 years.

During the years ended December 31, 2007, 2006 and 2005, the Company received $54,697, $37,877 and $42,144 in cash proceeds from stock option exercises and $32,788, $40,375 and $38,484 in total actual tax benefits upon the exercise of stock awards, respectively.

F-33


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Pro forma 2006 comparison under SFAS No. 123(R) and APB No. 25

The following table presents the impact of the adoption of SFAS No. 123(R) on selected items from the Company’s consolidated financial statements for the year ended December 31, 2006:

   Year ended December 31, 2006 
   As reported
under
SFAS No. 123(R)
  If reported
under

APB No. 25
 
      proforma 

Consolidated statement of income:

   

Operating income

  $739,432  $761,752 

Income from continuing operations before income taxes

  $475,759  $498,079 

Income from continuing operations

  $289,329  $303,554 

Net income

  $289,691  $303,916 

Basic earnings per share from continuing operations

  $2.79  $2.93 

Basic earnings per share

  $2.80  $2.94 

Diluted earnings per share from continuing operations

  $2.73  $2.86 

Diluted earnings per share

  $2.74  $2.86 

Consolidated statement of cash flows:

   

Net cash provided by operating activities

  $519,571  $556,822 

Net cash used in financing activities

  $(329,117) $(366,368)

F-34


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Pro forma 2005 results under SFAS No. 123

The weighted average grant-date fair value of stock awards granted in 2005 was $12.94. If the Company had adopted the fair value-based compensation expense provisions of SFAS No. 123 upon the issuance of that standard, net earnings and net earnings per share would have been adjusted to the pro forma amounts indicated below (shares in 000’s):

   Year ended
December 31,
2005
 

Net income:

  

As reported

  $228,643 

Add: Stock-based employee compensation expense included in reported net income, net of tax

   2,112 

Deduct: Total stock-based employee compensation expense under the fair value-based method, net of tax

   (12,180)
     

Pro forma net income

  $218,575 
     

Pro forma basic earnings per share:

  

Pro forma net income for basic earnings per share calculation

  $218,575 
     

Weighted average shares outstanding

   100,713 

Vested stock units

   49 
     

Weighted average shares for basic earnings per share calculation

   100,762 
     

Basic net income per share—Pro forma

  $2.17 
     

Basic net income per share—As reported

  $2.27 
     

Pro forma diluted earnings per share:

  

Pro forma net income for diluted earnings per share calculation

  $218,575 
     

Weighted average shares outstanding

   100,713 

Vested stock units

   49 

Assumed incremental shares from stock plans

   3,167 
     

Weighted average shares for diluted earnings per share calculation

   103,929 
     

Diluted net income per share—Pro forma

  $2.10 
     

Diluted net income per share—As reported

  $2.20 
     

Other equity transactions

During 2007, the Company repurchased 111,300 shares of its common stock for $6,350. As of December 31, 2007, the total outstanding Board authorizations for share repurchases were approximately $243,000.

Shareholder rights plan

The Company’s Board of Directors approved a shareholder rights plan on November 14, 2002. This plan is designed to assure that DaVita’s shareholders receive fair treatment in the event of any proposed takeover of DaVita.

F-35


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Pursuant to this plan, the Board approved the declaration of a dividend distribution of one common stock purchase right for each outstanding share of its common stock payable on December 10, 2002 to holders of record of DaVita common stock on November 29, 2002. This rights distribution was not taxable to DaVita shareholders. As a result of the stock split that occurred during the second quarter of 2004, two-thirds of a right are now attached to each share of the Company’s common stock. Two-thirds of a right will also attach to each newly issued or reissued share of common stock. These rights will become exercisable if a person or group acquires, or announces a tender offer for, 15% or more of DaVita’s outstanding common stock. The triggering person’s stock purchase rights will become void at that time and will not become exercisable.

Each right initially entitles its holder to purchase one share of common stock from the Company at a price of $125.00. If the rights become exercisable, and subject to adjustment for authorized shares available, each purchase right will then entitle its holder to purchase $125.00 of common stock at a price per share equal to 50% of the average daily closing price of the Company’s common stock for the immediately preceding 30 consecutive trading days. If DaVita is acquired in a merger or other business combination transaction after the rights become exercisable, provisions will be made to allow the holder of each right to purchase $125.00 of common stock from the acquiring company at a price equal to 50% of the average daily closing price of that company’s common stock for the immediately preceding 30 consecutive trading days.

The Board of Directors may elect to redeem the rights at $0.01 per purchase right at any time prior to, or exchange common stock for the rights at an exchange ratio of one share per right at any time after, a person or group acquires or announces a tender offer for 15% or more of DaVita’s outstanding common stock. The exercise price, number of shares, redemption price or exchange ratio associated with each right may be adjusted as appropriate upon the occurrence of certain events, including any stock split, stock dividend or similar transaction. These purchase rights will expire no later than November 14, 2012.

Charter documents & Delaware law

The Company’s charter documents include provisions that may deter hostile takeovers, delay or prevent changes of control or changes in management, or limit the ability of stockholders to approve transactions that they may otherwise determine to be in their best interests. These include provisions prohibiting stockholders from acting by written consent, requiring 90 days advance notice of stockholder proposals or nominations to the Board of Directors and granting the 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.

The Company is also subject to Section 203 of the Delaware General Corporation Law that, subject to exceptions, would prohibit the Company from engaging in any business combinations with any interested stockholder, as defined in that section, for a period of three years following the date on which that stockholder became an interested stockholder. These restrictions may discourage, delay or prevent a change in the control of the Company.

F-36


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

18.    Other comprehensive income

Charges and credits to other comprehensive income have been as follows:

   2005 
   Before tax
amount
  Tax (expense)
benefit
  Net-of-tax
amount
 

Unrealized gains on interest rate swaps

  $27,530  $(10,709) $16,821 

Less reclassification of net swap realized gains into net income

   (6,129)  2,384   (3,745)
             

Net swap activity

  $21,401  $(8,325) $13,076 
             

   2006 
   Before tax
amount
  Tax (expense)
benefit
  Net-of-tax
amount
 

Unrealized gains on interest rate swaps

  $12,869  $(5,007) $7,862 

Less reclassification of net swap realized gains into net income

   (15,828)  6,157   (9,671)
             

Net swap activity

  $(2,959) $1,150  $(1,809)
             

   2007 
   Before tax
amount
  Tax (expense)
benefit
  Net-of-tax
amount
 

Unrealized losses on interest rate swaps

  $(11,733) $4,564  $(7,169)

Less reclassification of net swap realized gains into net income

   (14,498)  5,640   (8,858)
             

Net swap activity

   (26,231)  10,204   (16,027)
             

Unrealized gains on investments

   6,892   (2,681)  4,211 

Less reclassification of net investment realized gains into net income

   (6,042)  2,350   (3,692)
             

Net investment activity

   850   (331)  519 
             

Total

  $(25,381) $9,873  $(15,508)
             

Changes in accumulated other comprehensive income have been as follows:

   Interest rate
swaps
  Investment
securities
  Accumulated
other
comprehen-
sive income
 

Balance December 31, 2005

  $14,806   —    $14,806 

Net activity

   (1,809)  —     (1,809)
             

Balance December 31, 2006

   12,997   —     12,997 

Net activity

   (16,027)  519   (15,508)
             

Balance December 31, 2007

  $(3,030) $519  $(2,511)
             

F-37


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

19.    Acquisitions and divestitures

Acquisitions

The total acquisition amounts were as follows:

   Year ended December 31
   2007  2006  2005

Cash paid, net of cash acquired

  $127,094  $85,658  $3,202,404

Deferred purchase price and other acquisition obligations

   1,195   585   9,331
            

Aggregate purchase cost

  $128,289  $86,243  $3,211,735
            

Cash adjustments for previous acquisitions including DVA Renal Healthcare

  $—    $846  $—  
            

Number of chronic dialysis centers acquired (before divestitures)

   16   26   609
            

Routine Acquisitions

During 2007, 2006, and 2005, the Company acquired dialysis businesses, other than DVA Renal Healthcare, consisting of 16 centers, 26 centers and 54 centers for a total of $57,783, $86,243 and $168,240, respectively, in cash and deferred purchase price obligations. In 2007 the Company also purchased 85% of HomeChoice Partners (HCP) pursuant to a stock purchase agreement for $70,506 in cash and deferred purchase price obligations, subject to further contingent price adjustments. HCP provides infusion therapy services to patients with acute or chronic conditions that can be treated at home or at an ambulatory infusion site. The assets and liabilities for all acquisitions were recorded at their estimated fair market values at the dates of the acquisitions and are included in the Company’s financial statements and operating results from the designated effective dates of the acquisitions.

The initial purchase cost allocations for acquired businesses are recorded at fair values based upon the best information available to management and are finalized when identified pre-acquisition contingencies have been resolved and other information arranged to be obtained has been received, but in no case in excess of one year from the acquisition date. Certain specific assets and liabilities including certain identified intangibles, relating to the acquisition of HCP remain outstanding that require the Company to obtain additional information in order to properly assess and finalize the potential impact, if any, to the consolidated financial statements. The Company does not expect the impact of such additional adjustments to be material. Any additional valuation adjustments that would need to be recorded will be offset with a corresponding adjustment to goodwill. Adjustments to purchase accounting for prior acquisitions and payments for acquisitions in process have been included in the periods recognized.

The aggregate purchase cost allocations for routine dialysis and other related businesses were as follows:

   Year ended December 31, 
   2007  2006  2005 

Tangible assets, principally leasehold improvements and equipment

  $20,085  $7,623  $17,381 

Amortizable intangible assets

   12,271   8,584   15,631 

Goodwill

   105,609   79,948   139,485 

Liabilities assumed

   (9,676)  (9,912)  (4,257)
             

Aggregate purchase cost

  $128,289  $86,243  $168,240 
             

F-38


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Amortizable intangible assets acquired during 2007, 2006 and 2005 had weighted-average estimated useful lives of eight, ten and ten years, respectively. The total amount of goodwill deductible for tax purposes associated with these acquisitions for 2007, 2006, and 2005 was approximately $106,000, $80,000 and $140,000, respectively.

Acquisition of DVA Renal Healthcare, Inc.

On October 5, 2005, the Company acquired all of the outstanding common stock of DVA Renal Healthcare, Inc. under a stock purchase agreement dated December 6, 2004, for $3,060,000. DVA Renal Healthcare was one of the largest dialysis service providers in the United States. The Company acquired DVA Renal Healthcare in an effort to more effectively offer chronic kidney disease services and technologies in a cost efficient manner. The purchase price reflects (i) the cash purchase price of approximately $1,800,000 for all of the outstanding common stock of DVA Renal Healthcare and (ii) the assumption and payment of approximately $1,260,000 of DVA Renal Healthcare indebtedness. The Company also incurred approximately $30,000 in acquisition-related costs. The operating results of DVA Renal Healthcare, Inc. are included in the Company’s consolidated financial statements from October 1, 2005.

The original allocations of purchase cost were recorded at fair value based upon the best information available to management at that time. The fair values of property and equipment and amortizable intangible assets and liabilities were valued by an independent third party. During 2006, the Company completed the final valuations of certain assets, properties and leasehold improvements, settlements liabilities and contingencies that were previously unresolved. During 2007, the Company allocated certain income tax adjustments to goodwill after the purchase cost allocations had been finalized. These valuation adjustments were not material to the consolidated financial statements and were recorded with a corresponding adjustment to goodwill. See Note 10 to the consolidated financial statements.

The final aggregate purchase cost allocation for DVA Renal Healthcare was as follows:

Current assets

  $490,090 

Property and equipment, net

   313,315 

Other long-term assets and intangible assets

   148,875 

Goodwill

   2,546,565 

Current liabilities assumed

   (272,420)

Alliance and Product Supply agreement and other intangible liabilities

   (168,287)

Other long-term liabilities

   (14,643)
     

Aggregate purchase costs

  $3,043,495 
     

Total consideration paid to purchase DVA Renal Healthcare also included imputed interest of $2,818, which is included in debt expense.

The centers acquired from Gambro Healthcare are subject to a five-year Corporate Integrity Agreement in connection with its December 2004 settlement with the U.S. Government that imposes significant specific compliance operating and reporting requirements, and requires an annual audit by an independent reporting organization.

In conjunction with the acquisition, the Company entered into an Alliance and Product Supply Agreement (the Product Supply Agreement) with Gambro AB and Gambro Renal Products, Inc (Gambro Renal Products).

F-39


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

The Product Supply Agreement has an initial term of seven years and will automatically renew for three additional one-year periods if the Company has not negotiated the terms of an extension during the initial term. Because the Product Supply Agreement results in higher costs for most of the products covered by the Product Supply Agreement than would be otherwise available to the Company, the Product Supply Agreement represented an intangible liability initially valued at $162,100 as of the acquisition date.

The Product Supply Agreement committed the Company to purchase a significant majority of its hemodialysis products, supplies and equipment at fixed prices through 2015. The agreement was amended on August 25, 2006 (the Amended Product Supply Agreement) to reduce the Company’s purchase obligations for certain hemodialysis product supplies and equipment and to allow for the termination of purchase obligations for certain equipment then affected by an import ban issued by the U.S. Food and Drug Administration (FDA) if the import ban was not lifted by June 30, 2007.

As a result of the reductions in the amount of purchase obligations required under the Amended Product Supply Agreement, the Company recorded a net valuation gain of $37,968 during 2006. This valuation gain represents the difference in the amortized original fair value between the Product Supply Agreement and that of the Amended Product Supply Agreement, as of the effective date of the amendment.

On July 2, 2007, the Company notified Gambro Renal Products that it was electing to be permanently relieved of its obligation under the Amended Product Supply Agreement to purchase dialysis machines (the Affected Products) because the Affected Products remained subject to the FDA import ban after June 30, 2007. All other purchase obligations under the Amended Product Supply Agreement, which continues to require the Company to purchase a significant majority of its hemodialysis non-equipment product supplies, such as dialyzers, at fixed prices, remain in place.

As a result of the termination of the Company’s purchase obligations for the Affected Products, the Company recorded a net valuation gain of $55,275 in the second quarter of 2007. This valuation gain represents the difference in the amortized original fair value of the Amended Product Supply Agreement and that of the Amended Product Supply Agreement as adjusted for the termination of the Affected Products as of June 30, 2007.

During 2007 and 2006, the Company purchased $90,696 and $146,408 of hemodialysis product supplies from Gambro Renal Products, representing 2% and 4%, respectively, of the Company’s total operating costs.

Discontinued operations

In accordance with a consent order issued by the Federal Trade Commission on October 4, 2005, the Company was required to divest a total of 69 outpatient dialysis centers and to terminate two management services agreements in order to complete the acquisition of DVA Renal Healthcare. In conjunction with the consent order, on October 6, 2005, the Company and DVA Renal Healthcare completed the sale of 70 outpatient dialysis centers to Renal Advantage Inc., formerly known as RenalAmerica, Inc. and also completed the sale of one other center to a separate physician group, and terminated the two management services agreements. In addition, effective January 1, 2006, the Company completed the sale of three additional centers to Renal Advantage, Inc. that were pending state regulatory approval in Illinois. The Company received total cash consideration of approximately $330,000 for all of the centers divested and used approximately $13,000 to purchase the minority interest ownership of a joint venture, to distribute a minority owner’s share of the sale proceeds, and to pay related transaction costs. The Company also paid income taxes of approximately $85,000 on these divestitures in the first quarter of 2006. As part of this transaction, Renal Advantage assumed specific

F-40


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

liabilities related to the centers, and all other liabilities were retained by the Company. In 2005, the Company recorded a gain of approximately $8,064, net of tax, related to the divestiture of its historical DaVita centers. Included in the gain on divestitures is the recognition of a $26,500 tax valuation allowance benefit resulting from the utilization of prior years’ capital losses offsetting the taxable gain on sale, and income tax expense of $27,133 relating to the write-off of book goodwill not deductible for tax purposes. In 2006, the Company recorded a loss of $311, net of tax, related to the divesture of its three centers. The loss on disposal of these centers includes an income tax expense totaling $1,274, of which $900 was related to the write off of book goodwill not deductible for tax purposes. In 2006, the company also recorded a net gain of $673 as an adjustment to the previously reported gain on disposal of discontinued operations.

The results of operations of the historical DaVita outpatient dialysis centers and the held for sale centers, are reflected as discontinued operations for 2005.

The results from discontinued operations were as follows:

   Year Ended
December 31,
2005
   

Net operating revenues

  $98,454

Income before income taxes

   21,534

Income tax

   8,377
    

Income from discontinued operations

  $13,157
    

Net assets of discontinued operations sold were as follows:

   2006 

Current assets

  $—   

Other current assets held for sale

   15,129 

Property and equipment, net

   —   

Amortizable intangibles, net

   —   

Goodwill and other purchase price adjustments

   667 

Other current liabilities and minority interest

   (351)
     

Net assets from discontinued operations

  $15,445 
     

Pro forma financial information

The following summary, prepared on a pro forma basis, combines the results of operations as if all acquisitions in 2007 and 2006 had been consummated as of the beginning of 2006, after including the impact of certain adjustments such as amortization of intangibles, interest expense on acquisition financing and income tax effects.

   Year ended December 31,
   2007  2006
   (unaudited)

Pro forma net revenues

  $5,333,587  $5,009,650

Pro forma net income

   392,465   306,783

Pro forma income from continuing operations

   392,465   306,421

Pro forma basic net income per share

   3.71   2.96

Pro forma diluted net income per share

   3.65   2.90

Pro forma basic income from continuing operations

   3.71   2.96

Pro forma diluted income from continuing operations

   3.65   2.90

F-41


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

20.    Concentrations

 

Approximately 65%64% of the Company’s total dialysis revenue in 2007, 65% in 2006 and 60% in 2005 and 60% 2004 are from government-based programs, principally Medicare and Medicaid. Accounts receivable from Medicare and Medicaid were approximately $236,000 and $250,000, respectively as of December 31, 20062007 and 2005.2006. No other single payor accounted for more than 5% of total accounts receivable.

 

A significant physician-prescribed pharmaceutical administered during dialysis, EPO, is provided by a sole supplier and accounted for approximately one-fourthslightly more than one-fifth of net operating revenues. Although the Company currently receives discounted prices for EPO, the supplier has unilateral pricing discretion and in the future the Company may not be able to achieve the same cost levels historically obtained.

 

19.21.    Other commitments

 

The Company has obligations to purchase the third-party interests held by third parties in several of its joint ventures.ventures and non-wholly-owned subsidiaries. These obligations are in the form of put provisions, in joint venture agreements, and are exercisable at the third-party owners’ discretion. If these put provisions are exercised, the Company would be required to purchase the third-party owners’ interests at either the appraised fair market value or a predetermined multiple of cash flow or earnings, which is intended to approximate fair value. As of December 31, 2006,2007, the Company’s potential obligations under these put provisions totaled approximately $192,000$330,000 of which approximately $100,000$131,000 were exercisable within one year. Additionally, the Company has certain other potential commitments to provide operating capital to several minority-ownednoncontrolling-owned centers and to third-party centers that the Company operates under administrative service agreements of approximately $11,000.$18,000.

 

The Company is obligated under mandatorily redeemable instruments in connection with certain consolidated joint ventures. Future distributions may be required for the minority partner’s interests in limited-life entities which dissolve after terms of ten to fifty years. As of December 31, 2006,2007, such distributions would be valued below the related minority interests balances in the consolidated balance sheet.

 

Other than operating leases, disclosed in Note 1514 to the Consolidated Financial Statements,consolidated financial statements, and the letters of credit and the interest rate swap agreements, disclosed in Note 1413 to the Consolidated Financial Statements,consolidated financial statements, or as described above the Company has no off balance sheet financing arrangements as of December 31, 2006.

DAVITA INC.2007.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

20.    Florida laboratory

During 2006, 2005, and 2004, the Company recognized a total of $0, $3,771, and $8,293 respectively, in prior years’ Medicare lab recoveries that were previously in dispute related to lab services that were performed in 2001 and 2002. As of December 31, 2006, there are no significant unresolved Medicare lab billing issues. In total the Company has recognized $94,842 in Medicare lab recoveries related to prior years’ billings previously in dispute.

21.22.    Fair values of financial instruments

 

Financial instruments consist primarily of cash, accounts receivable, notes receivable, assets available for sale, accounts payable, accrued compensation and benefits, other accrued liabilities, interest rate swap agreements and debt. The balances of the non-debt financial instruments excluding assets available for sale see(see Note 16,9) are presented in the consolidated financial statements at December 31, 20062007 and 20052006 at their approximate fair values due to the short-term nature of their settlements. Borrowings under the Company’s credit facility,Senior Secured Credit Facilities, of which $2,385,125$1,935,125 was outstanding as of December 31, 2006,2007, reflect fair value as they are subject to fees and adjustable rates competitively determined in the marketplace. The fair value of the Company’s senior and senior subordinated notes were approximately $1,362,400$1,745,250 at December 31, 20062007 based upon quoted market prices. The fair valuevalues of the interest rate swaps were an asseta net liability of approximately $29,544$511 as of December 31, 2006 and $30,756 as of December 31, 2005,2007, which is recorded primarily in other long-term assets.liabilities.

 

22.    Supplemental cash flow informationF-42

The table below provides supplemental cash flow information:

   Year ended December 31,

   2006

  2005

  2004

Cash paid:

            

Income taxes

  $209,982  $82,275  $95,943

Interest

   271,711   86,035   48,822

Non-cash investing and financing activities:

            

Fixed assets acquired under capital lease obligations

   —     —     1,295

Contributions to consolidated partnerships

   13,568   11,326   9,167

Refinancing charges

   —     8,170   —  

Liabilities assumed in conjunction with common stock acquisitions

   —     300,462   13,991

23.    Selected quarterly financial data (unaudited)

  2006

  2005

  December 31

 September 30

 June 30

  March 31

  December 31

 September 30

 June 30

 March 31

Net operating revenues

 $1,272,617 $1,237,041 $1,207,816  $1,163,188  $1,133,315 $644,892 $617,085 $578,626

Operating income

  188,511  217,094  171,752   162,075   158,782  105,298  102,431  98,860

Income from continuing operations

  74,129  93,091  64,329   57,780   56,411  50,914  48,127  51,970

Discontinued operations, net of tax

  —    1,765  (1,092)  (311)  7,738  4,303  4,816  4,364

Net income

  74,129  94,856  63,237   57,469   64,149  55,217  52,943  56,334

Basic earnings per share from continuing operations

  0.71  0.90  0.62   0.56   0.55  0.50  0.48  0.52

Basic earnings per share

  0.71  0.91  0.61   0.56   0.63  0.55  0.53  0.57

Diluted earnings per share from continuing operations

  0.70  0.88  0.61   0.55   0.54  0.49  0.46  0.50

Diluted earnings per share

 $0.70 $0.90 $0.60  $0.55  $0.61 $0.53 $0.51 $0.55


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

23.    Supplemental cash flow information

The table below provides supplemental cash flow information:

   Year ended December 31,
   2007  2006  2005

Cash paid:

      

Income taxes

  $205,955  $209,982  $82,275

Interest

   245,325   271,711   86,035

Non-cash investing and financing activities:

      

Fixed assets acquired under capital lease obligations

   2,769   —     —  

Contributions to consolidated partnerships

   14,735   13,568   11,326

Refinancing charges

   —     —     8,170

Liabilities assumed in conjunction with common stock acquisitions

   1,653   —     300,462

24.    Selected quarterly financial data (unaudited)

  2007 2006 
  December 31 September 30 June 30 March 31 December 31 September 30 June 30  March 31 

Net operating revenues

 $1,354,869 $1,318,381 $1,312,735 $1,278,166 $1,272,617 $1,237,041 $1,207,816  $1,163,188 

Operating income

  195,263  212,412  261,217  193,317  188,511  217,094  171,752   162,075 

Income from continuing operations

  85,717  94,455  125,024  76,582  74,129  93,091  64,329   57,780 

Discontinued operations, net of tax

  —    —    —    —    —    1,765  (1,092)  (311)

Net income

  85,717  94,455  125,024  76,582  74,129  94,856  63,237   57,469 

Basic earnings per share from continuing operations

  0.80  0.89  1.19  0.73  0.71  0.90  0.62   0.56 

Basic earnings per share

  0.80  0.89  1.19  0.73  0.71  0.91  0.61   0.56 

Diluted earnings per share from continuing operations

  0.79  0.88  1.17  0.72  0.70  0.88  0.61   0.55 

Diluted earnings per share

 $0.79 $0.88 $1.17 $0.72 $0.70 $0.90 $0.60  $0.55 

25.    Condensed consolidating financial statements

 

The following information is presented in accordance with Rule 3-10 of Regulation S-X. The operating and investing activities of the separate legal entities included in the Company’s 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 senior notes and the senior subordinated notes were issued by the Company and are guaranteed by substantially all of the Company’sits direct and indirect wholly-owned subsidiaries. Each of the guarantor subsidiaries has guaranteed the notes on a joint and several, full and unconditional basis. Non-wholly-owned subsidiaries, joint ventures, partnerships and third parties are not guarantors of these obligations.

 

F-43


DAVITA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

Condensed Consolidating Statements of Income

 

  DaVita Inc. Guarantor
Subsidiaries
 Non-
Guarantor
Subsidiaries
 Consolidating
Adjustments
 Consolidated
Total
 

For the year ended December 31, 2007

      

Net operating revenues

  $365,728  $4,534,153  $754,163  $(389,893) $5,264,151 

Operating expenses

   208,042   3,921,146   617,159   (389,893)  4,356,457 

Minority interests and equity income, net

   —     —     —     45,485   45,485 
                

Operating income

   157,686   613,004   137,004   (45,485)  862,209 

Debt (expense)

   (259,745)  (256,050)  (4,002)  262,650   (257,147)

Other income, net

   284,038   —     1,072   (262,650)  22,460 

Income tax expense (benefit)

   70,972   175,854   (1,082)  —     245,744 

Equity earnings in subsidiaries

   270,771   88,565   —     (359,336)  —   
                

Net income

  $381,778  $269,665  $135,156  $(404,821) $381,778 
  DaVita Inc.

 

Guarantor

Subsidiaries


 

Non-Guarantor

Subsidiaries


 

Consolidating

Adjustments


 

Consolidated

Total


                 
For the year ended December 31, 2006                  

Net operating revenues

  $347,087  $4,263,363  $639,690  $(369,478) $4,880,662   $351,566  $4,263,363  $639,690  $(373,957) $4,880,662 

Operating expenses

   196,367   3,751,164   527,344   (369,478)  4,105,397    200,846   3,751,164   527,344   (373,957)  4,105,397 

Minority interests and equity income, net

   —     —     —     35,833   35,833    —     —     —     35,833   35,833 
  


 


 


 


 


Operating income

   150,720   512,199   112,346   (35,833)  739,432 

Debt (expense), refinancing charges and swap gains, net

   16,441   (291,095)  (2,052)  —     (276,706)

Other income, net

   11,559   —     1,474   —     13,033 

Income tax expense

   70,201   116,183   46   —     186,430 

Discontinued operations, net of tax

   —     362   —     362 

Equity earnings in subsidiaries

   181,172   75,889   —     (257,061)  —   
  


 


 


 


 


Net income

  $289,691  $181,172  $111,722  $(292,894) $289,691 
  


 


 


 


 


For the year ended December 31, 2005            

Net operating revenues

  $224,501  $2,541,928  $451,141  $(243,652) $2,973,918 

Operating expenses

   122,021   2,263,234   344,855   (243,652)  2,486,458 

Minority interests and equity income, net

    22,089   22,089 
  


 


 


 


 


Operating income

   102,480   278,694   106,286   (22,089)  465,371    150,720   512,199   112,346   (35,833)  739,432 

Debt (expense)

   (32,851)  (108,144)  (2,213)  (143,208)   (280,288)  (291,095)  (2,052)  296,729   (276,706)

Other income, net

   8,934   8,934    308,288   —     1,474   (296,729)  13,033 

Income tax expense

   29,461   93,537   677   123,675    70,201   116,183   46   —     186,430 

Discontinued operations, net of tax

    15,179   6,042   21,221    —     362   —      362 

Equity earnings in subsidiaries

   179,541   87,349   (266,890)  —      181,172   75,889   —     (257,061)  —   
  


 


 


 


 


                

Net income

  $228,643  $179,541  $109,438  $(288,979) $228,643   $289,691  $181,172  $111,722  $(292,894) $289,691 
  


 


 


 


 


                

For the year ended December 31, 2004

   

For the year ended December 31, 2005

      

Net operating revenues

  $177,370  $1,913,372  $279,578  $(192,990) $2,177,330   $224,501  $2,541,928  $451,141  $(243,652) $2,973,918 

Operating expenses

   109,256   1,645,549   222,140   (192,990)  1,783,955    122,021   2,263,234   344,855   (243,652)  2,486,458 

Minority interests and equity income, net

    12,249   12,249       22,089   22,089 
  


 


 


 


 


                

Operating income

   68,114   267,823   57,438   (12,249)  381,126    102,480   278,694   106,286   (22,089)  465,371 

Debt (expense) and refinancing charges, net

   12,082   (62,633)  (1,860)  (52,411)

Debt (expense), refinancing charges, and swap gains, net

   (141,487)  (108,144)  (2,495)  108,918   (143,208)

Other income, net

   4,125   4,125    117,570    282   (108,918)  8,934 

Income tax expense

   32,776   94,935   621   128,332    29,461   93,537   677    123,675 

Discontinued operations, net of tax

   —     11,106   6,640   17,746    —     15,179   6,042    21,221 

Equity earnings in subsidiaries

   170,709   49,348   (220,057)  —      179,541   87,349    (266,890)  —   
  


 


 


 


 


                

Net income

  $222,254  $170,709  $61,597  $(232,306) $222,254   $228,643  $179,541  $109,438  $(288,979) $228,643 
  


 


 


 


 


                

F-44


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Condensed Consolidating Balance Sheets

 

  DaVita Inc.

  

Guarantor

Subsidiaries


  

Non-Guarantor

Subsidiaries


  

Consolidating

Adjustments


 

Consolidated

Total


  DaVita Inc.  Guarantor
Subsidiaries
  Non-
Guarantor
Subsidiaries
  Consolidating
Adjustments
 Consolidated
Total

As of December 31, 2006

            

As of December 31, 2007

         

Cash and cash equivalents

  $299,430     $10,772   $310,202  $443,157  $   $3,889  $   $447,046

Accounts receivable, net

     $809,028   123,357    932,385     786,765   141,184    927,949

Other current assets

   6,660   448,421   11,828    466,909   26,528   557,357   17,370    601,255
  

  

  

  


 

               

Total current assets

   306,090   1,257,449   145,957    1,709,496   469,685   1,344,122   162,443    1,976,250

Property and equipment, net

   30,130   689,039   130,797    849,966   19,317   766,596   153,413    939,326

Amortizable intangible, net

   59,371   142,394   1,956    203,721   55,629   126,202   1,211    183,042

Investments in subsidiaries

   3,904,797   388,919   —    $(4,293,716)  —     4,286,853   427,436     (4,714,289) 

Receivables from subsidiaries

   812,201      30,928   (843,129)  —     698,868     61,015   (759,883) 

Other long-term assets and investments

   25,190   14,650   20,940    60,780   22,729   16,052   38,628    77,409

Goodwill

      3,444,224   223,629    3,667,853   49,791   3,476,124   242,018    3,767,933
  

  

  

  


 

               

Total assets

  $5,137,779  $5,936,675  $554,207  $(5,136,845) $6,491,816  $5,602,872  $6,156,532  $658,728  $(5,474,172) $6,943,960
  

  

  

  


 

               

Current liabilities

  $166,440  $915,554  $30,178   $1,112,172  $182,419  $856,638  $47,439  $   $1,086,496

Payables to parent

      843,129   —    $(843,129)  —       759,883     (759,883) 

Long-term debt and other long-term liabilities

   3,725,415   273,195   12,751    4,011,361   3,688,203   272,448   14,006    3,974,697

Minority interests

         —     122,359   122,359         150,517   150,517

Shareholders’ equity

   1,245,924   3,904,797   511,278   (4,416,075)  1,245,924   1,732,250   4,267,523   597,283   (4,864,806)  1,732,250
  

  

  

  


 

               

Total liabilities and shareholders’ equity

  $5,137,779  $5,936,675  $554,207  $(5,136,845) $6,491,816  $5,602,872  $6,156,532  $658,728  $(5,474,172) $6,943,960
  

  

  

  


 

               

As of December 31, 2005

            

As of December 31, 2006

         

Cash and cash equivalents

  $431,811         $431,811  $299,430    $10,772   $310,202

Accounts receivable, net

     $749,288  $104,272    853,560    $809,028   123,357    932,385

Other current assets

   5,877   350,035   13,125    369,037   6,660   448,421   11,828    466,909
  

  

  

  


 

               

Total current assets

   437,688   1,099,323   117,397    1,654,408   306,090   1,257,449   145,957    1,709,496

Property and equipment, net

   34,319   611,828   103,931    750,078   30,130   689,039   130,797    849,966

Amortizable intangible assets, net

   73,407   158,980   3,557    235,944   59,371   142,394   1,956    203,721

Investments in subsidiaries

   3,616,683   333,106     $(3,949,789)  —     3,904,797   388,919   —    $(4,293,716)  —  

Receivables from subsidiaries

   1,038,182      8,486   (1,046,668)  —     812,201     30,928   (843,129)  —  

Other long-term assets and investments

   30,273   4,933   9,743    44,949   25,190   14,650   20,940    60,780

Goodwill

      3,399,112   195,271    3,594,383     3,444,224   223,629    3,667,853
  

  

  

  


 

               

Total assets

  $5,230,552  $5,607,282  $438,385  $(4,996,457) $6,279,762  $5,137,779  $5,936,675  $554,207  $(5,136,845) $6,491,816
  

  

  

  


 

               

Current liabilities

  $285,956  $691,172  $12,605   $989,733  $166,440  $915,554  $30,178   $1,112,172

Payables to parent

      1,046,668   —    $(1,046,668)  —       843,129   —    $(843,129)  —  

Long-term debt and other long-term liabilities

   4,093,987   252,759   4,035    4,350,781   3,725,415   273,195   12,751    4,011,361

Minority interests

         —     88,639   88,639       —     122,359   122,359

Shareholders’ equity

   850,609   3,616,683   421,745   (4,038,428)  850,609   1,245,924   3,904,797   511,278   (4,416,075)  1,245,924
  

  

  

  


 

               

Total liabilities and shareholders’ equity

  $5,230,552  $5,607,282  $438,385  $(4,996,457) $6,279,762  $5,137,779  $5,936,675  $554,207  $(5,136,845) $6,491,816
  

  

  

  


 

               

F-45


DAVITA INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(dollars in thousands, except per share data)

 

Condensed Consolidating Statements of Cash Flows

   DaVita Inc.  Guarantor
Subsidiaries
  Non- Guarantor
Subsidiaries
  Consolidating
Adjustments
  Consolidated
Total
 

For the year ended December 31, 2007

      

Cash flows from operating activities

      

Net income

  $381,778  $269,665  $135,156  $(404,821) $381,778 

Changes in operating assets and liabilities and non cash items included in net income

   (285,992)  105,895   (73,466)  404,821   151,258 
                     

Net cash provided by operating activities

   95,786   375,560   61,690   —     533,036 
                     

Cash flows from investing activities

      —    

Additions of property and equipment

   (3,501)  (220,264)  (48,447)  —     (272,212)

Acquisitions

   (69,701)  (57,393)  —     —     (127,094)

Proceeds from discontinued operations

   —     12,289   —     —     12,289 

Other items

   (19,811)  (82,317)  62,673   —     (39,455)
                     

Net cash (used in) provided by investing activities

   (93,013)  (347,685)  14,226   —     (426,472)
                     

Cash flows from financing activities

      —    

Long-term debt

   (49,961)  2,212   447   —     (47,302)

Intercompany borrowing

   113,333   (30,087)  (83,246)  —     —   

Other items

   77,582   —     —     —     77,582 
                     

Net cash provided by (used in) financing activities

   140,954   (27,875)  (82,799)  —     30,280 
                     

Net increase (decrease) in cash

   143,727   —     (6,883)  —     136,844 

Cash at the beginning of the year

   299,430   —     10,772    310,202 
                     

Cash at the end of the year

  $443,157  $—    $3,889  $—    $447,046 
                     

For the year ended December 31, 2006

      

Cash flows from operating activities

      

Net income

  $289,691  $181,172  $111,722  $(292,894) $289,691 

Changes in operating assets and liabilities and non cash items included in net income

   (327,844)  370,840   (106,010)  292,894   229,880 
                     

Net cash (used in) provided by operating activities

   (38,153)  552,012   5,712   —     519,571 
                     

Cash flows from investing activities

      

Additions of property and equipment

   (2,582)  (211,953)  (48,173)  —     (262,708)

Acquisitions

   —     (85,153)  (1,351)  —     (86,504)

Proceeds from discontinued operations

   12,742   9,437   —     —     22,179 

Other items

   —     (59,606)  74,576   —     14,970 
                     

Net cash provided by (used in) investing activities

   10,160   (347,275)  25,052   —     (312,063)
                     

Cash flows from financing activities

      

Long-term debt

   (408,211)  (1,198)  2,450   —     (406,959)

Intercompany borrowing

   238,246   (203,539)  (34,707)  —     —   

Other items

   77,842   —     —     —     77,842 
                     

Net cash used in financing activities

   (92,123)  (204,737)  (32,257)  —     (329,117)
                     

Net decrease in cash

   (120,116)  —     (1,493)  —     (121,609)

Cash at the beginning of the year

   419,546   —     12,265   —     431,811 
                     

Cash at the end of the year

  $299,430  $—    $10,772  $—    $310,202 
                     

For the year ended December 31, 2005

      

Cash flows from operating activities

      

Net income

  $228,643  $179,541  $109,438  $(288,979) $228,643 

Changes in operating assets and liabilities and non cash items included in net income

   79,506   14,071   (125,645)  288,979   256,911 
                     

Net cash provided by (used in) operating activities

   308,149   193,612   (16,207)  —     485,554 
                     

Cash flows from investing activities

      

Additions of property and equipment

   (11,780)  (101,978)  (47,607)  —     (161,365)

Acquisitions

   (3,035,434)  (166,970)  —     —     (3,202,404)

Proceeds from discontinued operations

   151,587   147,262   —     —     298,849 

Other items

   —     (68,146)  87,703   —     19,557 
                     

Net cash (used in) provided by investing activities

   (2,895,627)  (189,832)  40,096   —     (3,045,363)
                     

Cash flows from financing activities

      

Long-term debt

   2,776,738   (4,180)  1,048   —     2,773,606 

Intercompany borrowing

   12,272   400   (12,672)  —     —   

Other items

   (33,965)  —     —     —     (33,965)
                     

Net cash provided by (used in) financing activities

   2,755,045   (3,780)  (11,624)  —     2,739,641 
                     

Net increase in cash

   167,567   —     12,265   —     179,832 

Cash at the beginning of the year

   251,979   —     —     —     251,979 
                     

Cash at the end of the year

  $419,546  $—    $12,265  $—    $431,811 
                     

 

  DaVita Inc.

  

Guarantor

Subsidiaries


  

Non-Guarantor

Subsidiaries


  

Consolidating

Adjustments


  

Consolidated

Total


 

For the year ended December 31, 2006

                    

Cash flows from operating activities

                    

Net income

 $289,691  $181,172  $111,722  $(292,894) $289,691 

Changes in operating and intercompany assets and liabilities and non cash items included in net income

  (101,863)  167,301   (128,452)  292,894   229,880 
  


 


 


 


 


Net cash provided by (used in) operating activities

  187,828   348,473   (16,730)  —     519,571 
  


 


 


 


 


Cash flows from investing activities

                    

Additions of property and equipment

  (2,582)  (211,953)  (48,173)      (262,708)

Acquisition and divestitures, net

  —     (85,153)  (1,351)      (86,504)

Proceeds from discontinued operations

  12,742   9,437           22,179 

Other items

      (59,606)  74,576       14,970 
  


 


 


 


 


Net cash provided by (used in) investing activities

  10,160   (347,275)  25,052       (312,063)
  


 


 


 


 


Cash flows from financing activities

                    

Long-term debt

  (408,211)  (1,198)  2,450       (406,959)

Other items

  77,842               77,842 
  


 


 


 


 


Net cash (used in) provided by financing activities

  (330,369)  (1,198)  2,450       (329,117)
  


 


 


 


 


Net (decrease) increase in cash

  (132,381)  —     10,772   —     (121,609)

Cash at the beginning of the year

  431,811               431,811 
  


 


 


 


 


Cash at the end of the year

 $299,430  $—    $10,772  $—    $310,202 
  


 


 


 


 


For the year ended December 31, 2005

                    

Cash flows from operating activities

                    

Net income

 $228,643  $179,541  $109,438  $(288,979) $228,643 

Changes in operating and intercompany assets and liabilities and non cash items included in net income

  104,043   14,471   (150,582)  288,979   256,911 
  


 


 


 


 


Net cash provided by (used in) operating activities

  332,686   194,012   (41,144)  —     485,554 
  


 


 


 


 


Cash flows from investing activities

                    

Additions of property and equipment

  (11,780)  (101,978)  (47,607)      (161,365)

Acquisitions

  (3,035,434)  (166,970)          (3,202,404)

Proceeds from discontinued operations

  151,587   147,262           298,849 

Other items

      (68,146)  87,703       19,557 
  


 


 


 


 


Net cash (used in) provided by investing activities

  (2,895,627)  (189,832)  40,096       (3,045,363)
  


 


 


 


 


Cash flows from financing activities

                    

Long-term debt

  2,776,738   (4,180)  1,048       2,773,606 

Other items

  (33,965)              (33,965)
  


 


 


 


 


Net cash provided by (used in) financing activities

  2,742,773   (4,180)  1,048       2,739,641 
  


 


 


 


 


Net increase in cash

  179,832   —     —     —     179,832 

Cash at the beginning of the year

  251,979               251,979 
  


 


 


 


 


Cash at the end of the year

 $431,811  $—    $—    $—    $431,811 
  


 


 


 


 


For the year ended December 31, 2004

                    

Cash flows from operating activities

                    

Net income

 $222,254  $170,709  $61,597  $(232,306) $222,254 

Changes in operating and intercompany assets and liabilities and non cash items included in net income

  (173,238)  203,653   (65,030)  232,306   197,691 
  


 


 


 


 


Net cash provided by (used in) operating activities

  49,016   374,362   (3,433)  —     419,945 
  


 


 


 


 


Cash flows from investing activities

                    

Additions of property and equipment

  (4,416)  (92,478)  (31,434)      (128,328)

Acquisitions

      (264,177)  (2,088)      (266,265)

Proceeds from discontinued operations

      1,223           1,223 

Other items

      (21,587)  35,296       13,709 
  


 


 


 


 


Net cash (used in) provided by investing activities

  (4,416)  (377,019)  1,774       (379,661)
  


 


 


 


 


Cash flows from financing activities

                    

Long-term debt

  202,983   2,657   1,659       207,299 

Other items

  (57,261)              (57,261)
  


 


 


 


 


Net cash provided by financing activities

  145,722   2,657   1,659       150,038 
  


 


 


 


 


Net increase in cash

  190,322   —     —     —     190,322 

Cash at the beginning of the year

  61,657               61,657 
  


 


 


 


 


Cash at the end of the year

 $251,979  $—    $—    $—    $251,979 
  


 


 


 


 


F-46


SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, we have duly caused this Annual Report on Form 10-K to be signed on our behalf by the undersigned, thereunto duly authorized, in the City of El Segundo, State of California, on February 26, 2007.27, 2008.

 

DAVITA INC.
By: 

/s/    KENT J. THIRY        


 

Kent J. Thiry

Chairman and Chief Executive Officer

 

KNOW ALL MEN BY THESE PRESENT, that each person whose signature appears below constitutes and appoints Kent J. Thiry, Mark G. Harrison, James K. Hilger, and Joseph Schohl, and each of them his or her true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signature


 

Title


  

Date


/s/    KENT J. THIRY        


Kent J. Thiry

 

Chairman and Chief Executive Officer (Principal Executive Officer)

  February 26, 2007

/s/    MARK G. HARRISON        


Mark G. Harrison

Chief Financial Officer (Principal Financial Officer)

February 26, 200727, 2008

/s/    JAMES K. HILGER        


James K. Hilger

 

Acting Chief Financial Office (Principal Financial Officer) and Vice President and Controller (Principal Accounting Officer)

  February 26, 200727, 2008

/s/    CHARLES G. BERG        

Charles G. Berg

Director

February 27, 2008

/s/    WILLARD W. BRITTAIN        

Willard W. Brittain

Director

February 27, 2008

/s/    NANCY-ANN DEPARLEEPARLE        


Nancy-Ann DeParle

 

Director

  February 26, 200727, 2008

/s/    RPICHARDAUL B. FJ. DONTAINEIAZ        


Richard B. FontainePaul J. Diaz

 

Director

  February 26, 200727, 2008

/s/    PETER T. GRAUER        


Peter T. Grauer

 

Director

  February 26, 2007

/s/    C. RAYMOND LARKIN, JR.        


C. Raymond Larkin, Jr.

Director

February 26, 200727, 2008

/s/    JOHN M. NEHRA        


John M. Nehra

 

Director

  February 26, 200727, 2008

/s/    WILLIAM L. ROPER        


William L. Roper

 

Director

  February 26, 200727, 2008

/s/    ROGER J. VALINE        


Roger J. Valine

 

Director

  February 26, 200727, 2008

/s/    RICHARD C. VAUGHAN        


Richard C. Vaughan

 

Director

  February 26, 200727, 2008

 

II-1


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

DaVita Inc.:

 

Under date of February 26, 2007,27, 2008, we reported on the consolidated balance sheets of DaVita Inc. and subsidiaries as of December 31, 2006,2007, and 2005,2006, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006,2007, which are included in the Annual Report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule in the Annual Report on Form 10-K. The financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statement schedule based on our audits.

 

In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As discussed in Note 312 to the consolidated financial statements, DaVita Inc. and subsidiaries adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Income Tax Uncertainties, effective January 1, 2007. As discussed in Note 17 to the consolidated financial statements, DaVita Inc. and subsidiaries adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006.

 

/s/    KPMG LLP

 

Seattle, Washington

February 26, 200727, 2008

S-1


DAVITA INC.

 

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

 

Description


  

Balance at

beginning

of year


  

DVA

Renal

Healthcare

acquisition


  

Amounts

charged to

income


  

Amounts

written off


  

Balance

at end of

year


 Balance at
beginning
of year
 DVA
Renal
Healthcare
acquisition
 Amounts
charged
to income
 Amounts
written off
 Balance
at end of
year
  (in thousands) (in thousands)

Allowance for uncollectible accounts:

                    

Year ended December 31, 2004

  $52,554  —    $40,960  $35,348  $58,166

Year ended December 31, 2005

   58,166  68,925   63,666   52,159   138,598 $58,166 $68,925 $63,666 $52,159 $138,598

Year ended December 31, 2006

   138,598  —     126,203   93,044   171,757  138,598  —    126,203  93,044  171,757

Year ended December 31, 2007

 $171,757 $—   $136,682 $112,486 $195,953

S-2


EXHIBIT INDEX

 

2.1  Stock Purchase Agreement dated as of December 6, 2004, among Gambro AB, Gambro, Inc. and DaVita Inc.(14)
2.2  Amended and Restated Asset Purchase Agreement effective as of July 28, 2005, by and among DaVita Inc., Gambro Healthcare, Inc. and Renal Advantage Inc., a Delaware corporation, formerly known as RenalAmerica, Inc.(17)
3.1  Amended and Restated Certificate of Incorporation of Total Renal Care Holdings, Inc., or TRCH, dated December 4, 1995.(1)
3.2  Certificate of Amendment of Certificate of Incorporation of TRCH, dated February 26, 1998.(2)
3.3  Certificate of Amendment of Certificate of Incorporation of DaVita Inc. (formerly Total Renal Care Holdings, Inc.), dated October 5, 2000.(6)
3.4  Certificate of Amendment of Amended and Restated BylawsCertificate of Incorporation of DaVita, Inc. (formerly Total Renal Care Holdings, Inc.), as amended dated June 3, 2004.(11)May 30, 2007.(29)
3.5  Amended and Restated Bylaws for DaVita, Inc. dated as of December 14, 2006.(26)March 2, 2007.(32)
4.1  Registration Rights Agreement for the 6 5/8% Senior Notes due 2013 dated as of March 22, 2005.(3)
4.2  Registration Rights Agreement for the 7 1/4% Senior Subordinated Notes due 2015 dated as of March 22, 2005.(3)
4.3  Indenture for the 6 5/8% Senior Notes due 2013 dated as of March 22, 2005.(3)
4.4  Indenture for the 7 1/4% Senior Subordinated Notes due 2015 dated as of March 22, 2005.(3)
4.5  Supplemental Indenture, dated October 5, 2005, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and Senior Trustee.(16)
4.6  Supplemental Indenture, dated October 5, 2005, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and Senior Subordinated Trustee.(16)
4.7  Rights Agreement, dated as of November 14, 2002, between DavitaDaVita Inc. and the Bank of New York, as Rights Agent.(27)
4.8Second Supplemental Indenture (Senior), dated February 9, 2007, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and The Bank of New York Trust Company, N.A., as Trustee.(28)
4.9Second Supplemental Indenture (Senior Subordinated), dated February 9, 2007, by and among DaVita Inc., the Guarantors, the persons named as Additional Guarantors and the Bank of New York Trust Company, N.A., as Trustee.(28)
4.10Registration Rights Agreement for the 6 5/8% Senior Notes due 2013 dated as of February 23, 2007.(33)
10.1  Employment Agreement, dated as of October 18, 1999, by and between TRCH and Kent J. Thiry.(4)*
10.2  Amendment to Mr. Thiry’s Employment Agreement, dated May 20, 2000.(5)*
10.3  Second Amendment to Mr. Thiry’s Employment Agreement, dated November 28, 2000.(6)*
10.4  Third Amendment to Mr. Thiry’s Employment Agreement, dated March 31, 2005.(15)*
10.5  Employment Agreement, dated as of November 29, 1999, by and between TRCH and Gary W. Beil.(6)*
10.6  Employment Agreement, dated as of July 19, 2000, by and between TRCH and Charles J. McAllister.(6)*
10.7  Employment Agreement, dated as of June 15, 2000, by and between DaVita Inc. and Joseph Mello.(8)*
10.8  Employment Agreement effective as of June 7, 2004, by and between DaVita Inc. and Tom Kelly.(11)*


10.9  Employment Agreement, effective as of August 16, 2004, by and between DaVita Inc. and Tom Usilton.(12)*
10.10  Amendment to Mr. Usilton’s Employment Agreement, dated February 12, 2007.(31)*
10.11Employment Agreement, effective as of November 18, 2004, by and between DaVita Inc. and Joseph Schohl.(19)*
10.1110.12  Employment Agreement, dated as of October 31, 2005, effective October 24, 2005, by and between DaVita Inc. and Dennis Kogod.(18)*
10.1210.13  Employment Agreement, effective November 2, 2005, by and between DaVita Inc. and Christopher J. Riopelle.(18)*


10.1310.14  Severance and General Release Agreement between DaVita Inc. and Lori Pelliccioni, entered into as of November 3, 2005.(18)*
10.1410.15  Amended and restated Employment Agreement effective as of February 28, 2005, by and between DaVita Inc. and Denise Fletcher.(19)*
10.1510.16Employment Agreement, effective September 22, 2005, by and between DaVita Inc. and James Hilger.(21)*
10.17Employment Agreement, effective September 1, 2006, by and between DaVita Inc. and Mark G. Harrison.(22)*
10.18Offer of Employment Letter to Mary Kowenhoven dated February 15, 2007.(28)*
10.19Employment Agreement, entered into effective July 16, 2007, by and between DaVita Inc. and Patricia Jones.(30)*
10.20Memorandum relating to Bonus Structure for Charles J. McAllister.(19)*
10.21Memorandum relating to Bonus Structure for Thomas O. Usilton.(16)*
10.22Memorandum relating to Bonus Structure for Joseph Schohl.(16)*
10.23Amended Director Compensation Philosophy and Plan.(25)*
10.24Form of Indemnity Agreement.(26)*
10.25Form of Indemnity Agreement.(19)*
10.26First Amended and Restated DaVita Inc. Executive Incentive Plan.(15)*
10.27Post-Retirement Deferred Compensation Arrangement.(19)*
10.28DaVita Voluntary Deferral Plan.(16)*
10.29Deferred Bonus Plan.ü*
10.30Deferred Bonus Plan (Prosperity Plan).ü*
10.31Amended and Restated Employee Stock Purchase Plan.(34)*
10.32DaVita Inc. Severance Plan.(35)*
10.33September 18, 2001 DaVita Inc. Change in Control Bonus Program.(23)*
10.34  Second Amended and Restated 1994 Equity Compensation Plan.(9)*
10.1610.35  First Amended and Restated 1995 Equity Compensation Plan.(9)*
10.1710.36  First Amended and Restated 1997 Equity Compensation Plan.(9)*
10.1810.37  First Amended and Restated Special Purpose Option Plan.(9)*
10.1910.38  Amended and Restated 1999 Equity Compensation Plan.(10)*
10.2010.39  First Amended and Restated Total Renal Care Holdings, Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan.(7)
10.2110.40  Amended and Restated DaVita Inc. 2002 Equity Compensation Plan.(15)*


10.2210.41  Form of Non-Qualified Stock Option Agreement for stock options grants to employees under the Company’s 2002 Equity Compensation Plan.(12)*
10.2310.42  Form of Restricted Stock Unit Agreement for restricted stock unit grants to employees under the Company’s 2002 Equity Compensation Plan.(12)*
10.2410.43Form of Stock Appreciation Rights Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.44Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan. (22)*
10.45Form of Restricted Stock Units Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.46Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.47Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan.(24)*
10.48Form of Restricted Stock Units Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.49Form of Stock Appreciation Rights Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(24)*
10.50Amended and Restated 2002 Equity Compensation Plan.(25)*
10.51Amended and Restated 2002 Equity Compensation Plan.(34)*
10.52  Credit Agreement, dated as of October 5, 2005, among DaVita Inc., the Guarantors party thereto, the Lenders party thereto, Bank of America, N.A., Wachovia Bank, National Association, Bear Stearns Corporate Lending Inc., The Bank of New York, The Bank of Nova Scotia, The Royal Bank of Scotland plc, WestLB AG, New York Branch as Co-Documentation Agents, Credit Suisse, Cayman Islands Branch, as Syndication Agent, JPMorgan Chase Bank, N.A., as Administrative Agent and Collateral Agent, JPMorgan Securities Inc., as Sole Lead Arranger and Bookrunner and Credit Suisse, Cayman Islands Branch, as Co-Arranger.(16)
10.2510.53Credit Agreement, dated as of October 5, 2005, as Amended and Restated as of February 23, 2007, by and among DaVita Inc., the Guarantors party thereto, the Lenders party thereto and JPMorgan Chase Bank, N.A.(33)
10.54Amendment Agreement, dated February 23, 2007, by and among DaVita Inc., the Guarantors party thereto, the Lenders party thereto and JPMorgan Chase Bank, N.A.(33)
10.55  Security Agreement, dated as of October 5, 2005, by DaVita Inc., the Guarantors party thereto and JPMorgan Chase Bank, N.A., as Collateral Agent.(16)
10.26Amended and Restated Agreement dated December 2, 2004, between Amgen USA Inc. and DaVita Inc.(19)**
10.27Alliance and Product Supply Agreement, dated as of October 5, 2005, among Gambro Renal Products, Inc., DaVita Inc. and Gambro AB.(16)**
10.28Freestanding Dialysis Center Agreement No. 200308359, effective January 1, 2004, between Amgen USA and Gambro Healthcare, Inc.(16)**
10.2910.56  Corporate Integrity Agreement between the Office of Inspector General of the Department of Health and Human Services and Gambro Healthcare, Inc. effective as of December 1, 2004.(16)
10.3010.57  FormAlliance and Product Supply Agreement, dated as of Indemnity Agreement.(19)*
10.31First Amended and RestatedOctober 5, 2005, among Gambro Renal Products, Inc., DaVita Inc. Executive Incentive Plan.(15)*
10.32Post-Retirement Deferred Compensation Arrangement.(19)*
10.33Memorandum relating to bonus structure for Charles J. McAllister.(19)*
10.34Memorandum Relating to Bonus Structure for Thomas O. Usilton.(16)*
10.35Memorandum Relating to Bonus Structure for Joseph Schohl.(16)*
10.36Director Compensation Philosophy and Plan.Gambro AB.(16)*
10.37DaVita Voluntary Deferral Plan.(16)*
10.38Dialysis Organization Agreement effective February 3, 2006 between Amgen USA Inc. and DaVita Inc.(20)**
10.39Employment Agreement, effective September 22, 2005, by and between DaVita Inc. and James Hilger. (21)*


10.40Form of Stock Appreciation Rights Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.41Form of Non-Qualified Stock Option Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.42Form of Restricted Stock Units Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan).(22)*
10.43Employment Agreement, effective September 1, 2006, by and between DaVita Inc. and Mark G. Harrison.(22)*
10.4410.58  Amended and Restated Alliance and Product Supply Agreement, dated as of August 25, 2006, among Gambro Renal Products, Inc., DaVita Inc.Inc, and Gambro AB.(23)**
10.4510.59  FormLetter dated March 19, 2007 from Willard W. Brittain, Jr. to Peter T. Grauer, Lead Independent Director of Non-Qualified Stock Option Agreement—Employee (DaVitathe Company. (28)
10.60Amended and Restated Agreement dated December 2, 2004, between Amgen USA Inc. 2002 Equity Compensation Plan)(24)and DaVita Inc.(19)**
10.4610.61  Form of Non-Qualified Stock OptionDialysis Organization Agreement (DaVitaeffective February 3, 2006 between Amgen USA Inc. 1999 Non-Executive Officer and Non-Director Equity Compensation Plan(24)DaVita Inc.(20)**


10.4710.62  Form of Restricted Stock Units Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan(24)*
10.48Form of Stock Appreciation Rights Agreement—Employee (DaVita Inc. 2002 Equity Compensation Plan(24)*
10.49Amended Director Compensation Philosophy and Plan(25)
10.50Amended and Restated 2002 Equity Compensation Plan(25)*
10.51September 18, 2001Dialysis Organization Agreement between DaVita Inc. Change in Control Bonus Program.(23)
10.52Form of Indemnity Agreement(26)and Amgen USA Inc. dated December 20, 2007.ü**
12.1  Computation of RatiosRatio of Earnings to Fixed Charges.ü
14.1  DaVita Inc. Corporate Governance Code of Ethics.(13)
21.1  List of our subsidiaries.ü
23.1  Consent of KPMG LLP, independent registered public accounting firm.ü
24.1  Powers of Attorney with respect to DaVita. (Included on Page II-1)
31.1  Certification of the Chief Executive Officer, dated February 26, 2007,27, 2008, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.ü
31.2  Certification of the Chief Financial Officer, dated February 26, 2007,27, 2008, pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.ü
32.1  Certification of the Chief Executive Officer, dated February 26, 2007,27, 2008, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü
32.2  Certification of the Chief Financial Officer, dated February 26, 200727, 2008, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.ü

üIncluded in this filing.
*Management contract or executive compensation plan or arrangement.
**Portions of this exhibit are subject to a request for confidential treatment and have been redacted and filed separately with the SEC.
(1)Filed on March 18, 1996 as an exhibit to the Company’s Transitional Report on Form 10-K for the transition period from June 1, 1995 to December 31, 1995.
(2)Filed on March 31, 1998 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997.
(3)Filed on March 25, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(4)Filed on November 15, 1999 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.


(5)Filed on August 14, 2000 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.
(6)Filed on March 20, 2001 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
(7)Filed on February 2, 2003 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
(8)Filed on August 15, 2001 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(9)Filed on March 29, 2000 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
(10)Filed on April 27, 2001 as an exhibit to the Definitive Proxy Statement for our 2001 Annual Meeting of Stockholders.
(11)Filed on August 5, 2004 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.
(12)Filed on November 8, 2004 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004.
(13)Filed on February 27, 2004 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
(14)Filed on December 8, 2004 as an exhibit to the Company’s Current Report on Form 8-K.
(15)Filed on May 4, 2005 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending March 31, 2005.
(16)Filed on November 8, 2005 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending September 30, 2005.


(17)Filed on October 11, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(18)Filed on November 4, 2005 as an exhibit to the Company’s Current Report on Form 8-K.
(19)Filed on March 3, 2005 as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
(20)Filed on May 8, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006.
(21)Filed on August 7, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ending June 30, 2006.
(22)Filed on July 6, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(23)Filed on November 3, 2006 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.
(24)Filed on October 18, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(25)Filed on July 31, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(26)Filed on December 20, 2006 as an exhibit to the Company’s Current Report on Form 8-K.
(27)Filed on November 19, 2002 as an exhibit to the Company’s Current Report on Form 8-K.
(28)Filed on May 3, 2007 as an exhibit to the Company’s Quarterly Report as Form 10-Q for the quarter ended March 31, 2007.
(29)Filed on August 6, 2007 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007.
(30)Filed on November 7, 2007 as an exhibit to the Company’s Quarterly Report on Form 10-Q for the third quarter ended September 30, 2007.
(31)Filed on February 16, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(32)Filed on March 8, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(33)Filed on February 28, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(34)Filed on June 4, 2007 as an exhibit to the Company’s Current Report on Form 8-K.
(35)Filed on November 7, 2007 as an exhibit to the Company’s Current Report on Form 8-K.