All eyes on Vision

We laid out the risks and strategic rationale for investing in Vision Eye Institute in Vision upgraded to Speculative Buy on 3 Mar 14 (Speculative Buy – $0.58). But now it’s time to give you the numerical case so you have something to really sink your teeth into.

There are thankfully just a few factors that contribute most of the weight to Vision’s valuation. So we’ll take a look at a range of potential outcomes, with varying assumptions as to the market size, network size, operating margins and, ultimately, how much cash the business produces.

But before we jump on that boogie board, let’s first evaluate the wave. We often hear that ‘Australia’s population is aging’; what does that really mean?

Market

In the 1950s, Australia’s fertility rate was more than three children per woman. Today, it’s less than two. Therefore, the proportion of young people in the population has been falling while the proportion of elderly has been rising, all because the ‘baby boomers’ had less children than their parents. Combine this with technology and medicine that constantly improves life expectancy, and what you have is an ‘aging population’ (see Chart 1 and 2).

As people age, they demand more specialised medical services, such as ophthalmologists. So, while people over 65 comprise only 14% of Australia's population, they account for 32% of healthcare spending.

What's more, people are spending greater sums on their vision in particular. Improved technology, cataract surgeries and new treatments for macular degeneration have helped increase average expenditure on eye care for those over 40 with vision loss from $2,762 in 2004 to over $5,000 today.

Around one in two Australians currently have a long-term eye problem, half-a-million of which are severely impaired by conditions such as cataracts or glaucoma. And that number is predicted to reach 700,000 by 2020. So Vision’s potential customer base is growing by more than 5% per year, while total spending on eye conditions is expected to increase by about 7% per year.

Medicare

We do, however, see a potential hiccup on the horizon. The Federal Government has frozen Medicare Benefits Schedule fees for many ophthalmology services – or, in some cases, even reduced them, as was recently the case for intravitreal injections. If the real costs keep rising, this effectively decreases the Medicare coverage a patient receives.

Furthermore, the Government will be increasing the Extended Medicare Safety Net threshold from $1,221.90 today (a nice round number) to $2,000 on 1 Jan 15. This means that individuals will be more out-of-pocket before they qualify for additional rebates.

The extra costs incurred by patients could reduce demand for specialist healthcare providers. However, we don’t expect this to be too much of a problem for Vision as around 90% of its revenue is non-discretionary.

Margins

Margins will contract. You heard it here first, folks. As we explained in Put Vision on your watch list (Hold – $0.72), pressure on margins is all but guaranteed to continue as doctors push for a greater share of the profits or threaten to leave the network.  

That said, it can’t go on indefinitely. There will be a certain profit sharing ratio that balances both party's negotiating power at the contract renewal.

We can’t say with certainty at what level the gross margin will stabilise but have allowed it to fall from 38% today to 33% over the next few years in our valuation. This might be on the conservative side.

Network

To an outsider, it can look like the doctors hold all the bargaining chips – and they certainly hold a few – but it’s important to remember that Vision also brings something to the table.

Vision removes the administrative burden of operating a practice and lets the doctors get on with treating the patients. Not every great cook has the aptitude, or inclination, to own a restaurant.

Furthermore, being part of a large network drives higher utilisation rates at the surgeries which then justifies investment in the latest equipment.

All in all, given that most of Vision’s doctors have already faced at least one contract renewal, and decided to stay, we expect they’re happy with the current arrangement and a little less ‘flighty’ than the earlier cohort.

Management has also said it’s on the lookout for acquisitions now that the company’s debts are under control. So long as Vision pays sensible prices, we’re all for it. For the purpose of valuation, however, we’ll assume the number of clinics remains stable at 19.  

Cash cow

In the case of Vision, the term ‘clinic’ can be used interchangeably with ‘cash cow’. Vision’s clinics generate prodigious amounts of free cash flow.

The best way to explain why is to compare Vision’s ophthalmology clinics with Sonic Healthcare’s pathology clinics. Both generate high operating cash flows – the cash the company receives from customers minus the cash they pay suppliers – however not all the operating cash flow is available to shareholders; it isn’t ‘free’.

On the one hand, Sonic’s clinics rely on lots of expensive machinery which must be regularly upgraded and repaired. Sonic is ‘capital intensive’. Vision’s clinics, on the other hand, rely mainly on doctors – they’re ‘people intensive’.

There are burdens and benefits to each. Sonic’s capital intensity gives it strong economies of scale, which is a big competitive advantage, but it needs to continually spend around 40% of its operating cash flow on upgrading equipment. Vision needs to reinvest only 17%, so more cash is available to make acquisitions, buy back shares or to pay out as dividends.

For many years, a lot of Vision’s operating cash flow was spent on interest payments to service the company’s $100m pile of debt. But, with the help of a capital raising, that debt was reduced to its present level of $30m, making more cash available to shareholders – some $16m of free cash flow, or 9.5 cents per share, over the past 12 months.  

And this is important because despite what any other ratios say, Vision’s valuation ultimately depends on the cash you get out of it – not the highly manipulable net profit figure you see on the income statement. And, priced at just 6.3 times free cash flow, Vision is cheap as chips.    

Bottom line

It wasn’t long ago that we wouldn’t have looked twice at Vision. A debt laden roll-up with doctors fleeing, falling margins and the risk of shareholder dilution wasn’t a pretty picture.

Some risks remain around doctor loyalty and margin pressure. But Vision is now a significantly more stable business, generating lots of cash and with general healthcare trends as a tailwind. The market, however, continues to value the company as though it were a train wreck, and therein lies the opportunity.

The share price is flat since 3 Mar 14 (Speculative Buy – $0.58) and we’re sticking with SPECULATIVE BUY.

Note: Our model Growth portfolio owns shares in Vision.