Put Vision on your watch list

A friend of mine recently had laser eye surgery to correct his comically poor eyesight. Much to his surprise, although he didn’t leave the clinic with 20/20 vision, he left able to see the world in greater detail than 97% of the population!

You may have heard similar stories or even experienced it for yourself. The ageing population, with its fading eyesight, has been met by technological leaps in laser eye surgery and the result has been a boom for the ophthalmic industry.

And yet fewer than 30 qualified ophthalmologists are being added each year to the country’s pool of about 800. Such an imbalance of supply and demand is usually an investor’s dream, particularly since most of that demand is non-discretionary, with a large proportion of industry revenues arising from patients who would go blind without treatment.

Vision Eye Institute sprung up to take advantage, buying up eye clinics around the country. Typically the company would pay a multiple of profits to buy a clinic, with contracts tying in the selling doctors for five years, with lower rates of pay and a small share of earnings.

This proved very attractive to the doctors, and sales and underlying profit before tax increased more than tenfold between 2002 and 2009, to $114m and $21m respectively, as the number of clinics on the company’s books grew from three to 23. In 2004 the company floated, at an offer price of $2.30, but most of the cash generated by the business went into buying new clinics and net debt ballooned to over $100m (see Chart 1).

Doctor's orders

The share price doubled in a year following its float, hitting $4.95 in October 2005, but the trouble began when the initial five-year contracts signed with doctors started coming up for renewal. Vision soon learned that it was the doctors, not itself, that controlled the supply of ophthalmology services.

Some doctors chose to retire rather than continue working for less (no doubt that had been part of the plan all along); others left and established new practices after a two-year non-compete period, or in some cases before; few chose to re-sign on the terms initially offered by Vision.

The company has responded in the only way open to it – by agreeing to pay the doctors a greater share of the profits. As a result, while the company has been able to maintain sales on a reduced base of clinics by absorbing more of that booming demand, underlying profits have been crunched, falling to just $13.7m in 2013 before a goodwill writeoff of $26m.

With a broken business model, disappearing profits and high debt levels – not to mention five chief executives in six years – investors were spooked, sending the share price down to a low of just 8 cents in late 2011.

Stay of execution

But Vision earned itself a stay of execution. By stabilising the fall in clinics at 19 and reallocating free cash from buying clinics to repaying debt, the company was able to raise $27m in a share offer late last year at 34 cents. The new shares diluted existing shareholders by 41%, but it also took net debt down to a much more manageable $40m.

The share price is now up to 71.5 cents, putting it on a price-earnings ratio of 12 times the underlying 5.9 cents per share the company earned in 2013 and just 9 times the 7.6 cents it’s expected to make in 2014 – a bargain if the business model can be fixed, but a potential value trap if it can’t.

Vision does at least have an ace up its sleeve. Whilst it might not control the doctors who provide its services, it does control the expensive equipment they use. A single LASIK machine can cost as much as half-a-million dollars, so a large capital-city clinic might contain $1m of plant and equipment or more.

If doctors want to set up on their own, they’ll need to borrow large sums to purchase the required technology. And while most of the earnings from consultations are now being funnelled to the doctors themselves, fees for the use of theatre equipment go directly to Vision. In 2013, 34% of its revenues came from this source (see Chart 2).

Economies of scale

Thanks to its scale, Vision can ensure high utilisation rates for this expensive equipment and the key to it adding value in this industry, and earning good profits along the way, is in maximising this utilisation. Vision’s strategy is to use many small consulting clinics to drive volume through the central operating theatres. By harnessing the demand in this way, the company may be able to make the most of its economies of scale.

With the much reduced interest bill, free cash flow should rise by at least 15% in 2014, enabling Vision to reduce debt further – although, worryingly, management has also suggested that the time may be right to make further acquisitions. We can only hope that the lessons of the past have been learnt (albeit by a different management team).

Vision holds a great deal of potential, but there’s a broad range of ways for this story to play out. Management itself has said it’s inevitable that doctors will increase their share of earnings over time. The challenge for Vision will be to use its scale to increase its pool of earnings faster than the doctors can capture it.

Given the risks, we’d need a wide margin of safety before recommending the stock but, all things being equal, we’d look to make it a Speculative Buy below 60 cents. In the meantime, HOLD.