Vision becomes a takeover target

Value investors face an age-old conundrum. Should they invest in attractive companies that look somewhat expensive? Or should they buy less attractive companies going cheap (the 'cigar butt' approach, as Warren Buffett likes to call it)?

With Vision Eye Institute we were only hoping for a free puff and, thankfully, it may have arrived.

Pulse Health has made a takeover bid for Vision. The all-share consideration offered is 1.6 shares in Pulse for every Vision share, implying a value of $0.90 each at Pulse's current price.

Pulse and Vision sit on opposite ends of the cigar scale. Pulse operates private hospitals and day surgeries and has a clean balance sheet and stable, steadily growing revenues and margins. The company also comes with a hefty price tag – an enterprise value to earnings before interest and tax multiple of 21 times.  

Vision, on the other hand, has few tangible assets and substantial debt. The company has so little negotiating power against its own staff – the ophthalmologists performing various types of eye surgery – that they demand a larger slice of Vision's profits at each contract renewal. Vision's margins have declined year in, year out, almost without fail. But, with a 16% free cash flow yield when we first upgraded the stock on 3 Mar 14 (Speculative Buy – $0.58), this cigar butt was of the Cuban variety.

Vision's board of directors will now review the offer and it expects to provide an initial response later this week. However the board noted the 'unsolicited and opportunistic nature of the offer', which hardly screams support at this stage. 

Losing patience

Our patience has been waning with Vision. In September, the company paid a token dividend of 1.25 cents. But the company has plenty of free cash flow and few places to reinvest earnings so we weren't impressed. Shareholders had waited four years for the dividend while the company paid off its $100m debt pile to avoid breaching covenants. 

Worse still, management decided to raise $10m of fresh equity just a month later at a low price (30% below the subsequent Pulse offer). Not only did this increase the share count by 10% but the capital raising was restricted to institutional investors. It was hardly shareholder-friendly behaviour.

Vision then sold its Gold Coast clinic in July and its Southport Day Surgery will close in early 2016. It will be difficult for the company to maintain current earnings without strong growth in revenue from its other clinics.

Finally, to top it all off, chief executive Brett Coverdale recently resigned. The company is yet to find a replacement although, as Pulse was quick to point out, it's a problem readily solved by the takeover.

We were close to lowering Vision's price guide at the last review, given the increasing uncertainty and our deteriorating confidence in management. With a takeover now on the cards, we're removing the price guide until there's greater certainty about business conditions or the takeover offer.

What should you do?

There's no need to act now. When you receive the takeover documentation, keep it in a safe place but don't accept the offer just yet. The offer is expected to close on 21 August, although the date is often pushed back multiple times. There's no rush and a lot can happen between now and then so it's best to keep your options open.

If, for example, Pulse's bid is trumped by a higher one from, say, Primary Health Care – which holds a 20% stake in Vision – you wouldn't be able to accept the better deal if you have already accepted this one.

It's worth noting that Pulse's offer is conditional upon it achieving a minimum 90% shareholding. If it doesn't achieve 90% acceptance by the time the offer closes, the deal will fall through unless Pulse chooses to waive this condition. In that case, existing shareholders will retain their stock and Vision's share price will probably fall back to where it was trading before the offer. So trying to make an arbitrage profit by increasing your holding now and then selling into the offer seems too risky, despite the gap between the offer price and share price.   

If Pulse does get a 90% holding, however, it will exercise its right to compulsorily acquire all remaining shares. Pulse apparently wants all of Vision, or none of it.

We think $0.90 per share and a price-earnings ratio of 13 is a fair price for Vision and we're likely to recommend selling on the open market or accepting the offer as the close date approaches. There's a lot of water to flow under the bridge before then, so we'll keep you informed as the takeover progresses.

Primary factor

If nothing else, there's one important thing to remember about this bid. Ultimately, it will be up to Primary Health Care whether the deal lives or dies.

Vision's current share price is 11% below the offer price, which suggests the market is factoring in a significant probability that the takeover will fail. Our guess, however, is that Primary will either support the deal – although perhaps at a higher price – or up the ante and make a bid for Vision itself.

Vision's network of ophthalmologists would fit neatly into its collection of medical centres, pathology labs and new bulk-billing IVF clinics. Vision is probably more valuable under Primary's ownership than Pulse's because Primary's GPs can refer patients to Vision's clinics and ensure high patient volumes. A higher bid by Primary is a real possibility.

Then again, Primary's founder and chief executive, Edmund Bateman, retired late last year. Primary's new chief executive, Peter Gregg, may prefer to sell Vision and reinvest the funds in its GP business.

Takeovers take a while to play out, so we'll keep you up to date as it develops. If Vision's share price moves much above $0.80, though, you might want to consider selling your shareholding on the open market. You'll get cash in the bank within a few days, rather than months, and avoid any pain if the deal falls through. Of course, you'll also incur brokerage and miss out on any upside if a higher bid emerges.

Vision's share price has increased 29% since Doctor's orders: Monash vs Vision from 11 Mar 15 (Hold – $0.62) and 38% since Vision upgraded to Speculative Buy from 3 Mar 14 (Speculative Buy – $0.58).

With no advantages to accepting the offer this early, we're happy to sit on our hands for now and await developments. HOLD

Note: Staff own shares in Vision Eye Institute but they don't include the author.