Vision Eye Institute and a Portfolio Shakeup

I'm happy to report that on Monday I went on a bit of a shopping spree (on stocks of course), adding some Vision Eye Institute (ASX:VEI) and topping up on my existing holdings, which I'll talk about later. Many Australians in New South Wales, Queensland or Victoria will have either heard about Vision Eye Institute or have utilised their ophthalmic services. These eye related services are broken down into three categories: consultations, refractive surgery (better known as laser eye surgery), and other surgical procedures performed in a day surgery. In the last decade, the company experienced rapid growth as it bought more clinics and attracted ophthalmologists on the east coast, but poorly structured deals eventually led to an exodus of ophthalmologists. In combination with a high debt load, the company was brought to the brink of bankruptcy but has fortunately managed to stage a recovery recently. 

Instead of rambling on for many paragraphs about why I believe VEI is an attractive investment, I thought I'd try to keep my reasoning as concise as possible this time. Many of the most successful investors such as Peter Lynch and Warren Buffett suggest that investors be must able explain why they are purchasing a stock in a succinct manner, which makes perfect sense to me. It focuses your attention on the most important factors, encourages you to be rational, and ensures that you clearly understand the rationale. Alright, here we go!

Around 90% of VEI's revenues are non-discretionary due to the essential nature of its services to its customers. This stability in revenue was demonstrated throughout the global financial crisis and the years afterward which were spent addressing the decline in ophthalmologist numbers. Better still, with the ageing population, demand for VEI's services should continue to grow at a nice 5%+ p.a over the foreseeable future. The past issues of ophthalmologists leaving appear to be largely resolved, with the number of doctors increasing from 68 in October 2013 to 77 doctors currently. With management indicating that they will recommence the search for organic growth by expanding the number of clinics/ophthalmologists, economies of scale should help boost margins and build its competitive position. The cost of interest payments has also been dramatically cut in the most recent half, which will boost profits and reduce risk. Regarding the all important price, I estimate that VEI is trading on 7x to 8x its FY14 earnings and a DCF calculation confirms that it seems cheap enough for me. Finally, with a 20% stake in VEI, Primary Healthcare (ASX:PRY) may look to acquire the whole business, perhaps providing a nice catalyst for a re-rating in VEI's share price. 

On the flip-side, I think it's also a good idea to balance out that optimism by writing down the main risks which could result in a poor investment. To my mind, the main two are the bargaining power of ophthalmologists which is putting pressure on gross margins, and the gearing level. As the most important assets of VEI's business, the ophthalmologists have been able to push for an increasingly higher share of profits. Although gross margins have fallen from more than 50% to 43% in the first half of 2014, management have warned that this margin compression will continue. Although I believe that this trend will come to a stop in the next couple of years to balance with the benefits of VEI's business model to the ophthalmologists, I could be completely wrong, in which case the earning power of VEI may not be able to justify its current valuation. Despite reductions in net debt from $105 million in 2008 to $30 million today, this is still a relatively high 40% net debt/equity ratio. Furthermore, there are very few tangible assets to back its borrowings, so shareholders and creditors are solely reliant on the continued cash flow generation of VEI to sustain that $30 million of debt. Given the banks require $3 million to be repaid this year, management need to be careful with balancing their growth and dividend intentions in order to avoid another debt debacle. 

Although I don't think VEI is going to shoot the lights out in terms of share price performance from its current level and the risks outlined above are concerning, the case for investment was still tempting enough for me to purchase 2,786 shares at $0.61 on Monday. Speaking of temptations, it was difficult to resist making one of the endless lame puns on 'vision' that I was thinking of, but if that's your thing, take a look at the VEI attempts in their older annual reports (how about the 2005 line: 'focused on the future'). 

On a less positive note, I decided to finally exit my position in Antares Energy (ASX:AZZ) at a loss of around 23% on Monday after the proposed takeover offer of US$300 million fell through. Even though a number of investors I highly respect either recommend or hold Antares, holding onto this kind of business for the medium to long term is simply outside my circle of competence and I don't feel comfortable relying on the opinions of others. I think that the initial reason for purchasing was still valid, as it appeared more likely than not that the deal would go ahead, in which case the net cash per share would have been almost double my buy price. Unfortunately, chance has an annoying habit of making rational decisions look silly from time to time, but that's just a part of investing you have to deal with. 

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In addition to the above transactions, I added $6,600 to my portfolio and used most of it to purchase existing shares so their weighting in the portfolio stayed in line with what I think is reasonable. These purchases were 331 TGA at $2.11, 482 IMF at $1.86, 7,096 BOL at $0.155, and 12,000 ACG at $0.125. Consequently, my portfolio value currently stands at just over $16,000 with around $2,000 in cash that will hopefully be invested in a new stock if my buy order gets executed soon. This means that I've more than doubled the size of my portfolio in less than a month, and to account for my additional contributions, I'll be calculating a time-weighted return (the measure used by professional fund managers to adjust for inflows and outflows). Although portfolio performance over the past few months has been disappointing, I feel much more comfortable going forward with AZZ gone and the additions of ACG, BOL, NOD and VEI. It is probably for the best that my investing ego isn't inflated so early on by excellent portfolio performance, and it's also a good reminder that the index (All Ordinaries Total Return) is a tougher benchmark to beat than most people expect. To the right are the full gory details of my portfolio. 

For those of you seeking more detailed analysis of VEI, I can once again highly recommend The 8th Wonder - who incidentally posted just after I bought shares - and Intelligent Investor Share Advisor. After completing a six week internship at Intelligent Investor Funds Management (who are the second largest shareholders of VEI according to the 2013 annual report) and the guys at Share Advisor, I can definitely vouch for their ability and integrity. And no, unfortunately I was not paid to say all that.