LOOKING A GIFT HORSE IN THE MOUTH? SMILEDIRECTCLUB SDC-NYSE

SmileDirectClub (SDC -NASDAQ) is a direct-to-consumer business model that provides a lost-cost alternative to braces—no orthodontists!! You bypass the doctor!

Nobody enjoys wearing braces. Nobody enjoys paying for braces.  

Source: SmileDirectClub Website

BUT IS THIS A GOOD INVESTMENT? At the end of the day I say—short term maybe yes, but long term, I’m not so sure.

SDC’s stock has had a violent ride in its short history—trading at $21 on IPO day lst fall, and bottoming just under $4 due to many factors, one of which certainly was the coronavirus. 

I was intrigued by their story because they’re growing quickly, and are now at US$ 1 billion in revenue, have net cash and are only trading 2x sales.

Plus, their major competitor, ALGN-NYSE, had an incredible stock run from $20 – $400 in the last decade–a 20-bagger, or 2000% increase! Is there room enough for TWO large players in this space?

But they are also burning cash quickly, and their accounting shows they recognize most of their revenue up front, and collect monthly payments from customers afterwards…which is a real risk that gets paid in this coronavirus environment.

 

QUICK FACTS

 

Trading Symbols:                                     SDC

Share Price Today:                                 $5.50

Shares Outstanding:                              382 million

Market Capitalization:                           $2.1 billion

Net CASH:                                                $110 million

Enterprise Value:                                    $2.0 billion

2020 Revenue Consensus                      $998 million

2020 P/S                                                 2.0

2021 Revenue Consensus                      $1,317 million

2021 P/S                                                   1.5x

 

SmileDirect offers a clear-plastic insert that is worn 22 hours a day, with treatments lasting 5-10 months. Over that time the aligner gradually moves the teeth to their optimal location. Clear plastic, so no stigma of braces and they’re made with 3D printers. Cheap!

SmileDirectClub sells their product to an older population than what you typically think for braces: approximately 5% of its customers are 19 or under, 65% between 20 and 40 years old, and 10% are above 50.

They operate via stand-alone stores as well as from kiosks in third-party drug stores like CVS and Walgreens. 

All of their stores, apart from those in Hong-Kong, have been closed since March and will remain closed until at least May 6th.

 

A Different Business Model than Align

 

SmileDirectClub is different than their primary public company competitor – Align Technology (ALGN – NASDAQ).

Align was the first public company in the space and their stock performance has been nothing short of incredible. 

Align sells their product directly to orthodontists and dentists while SmileDirectClub has quite a different model. 

Rather then being a component provider (the aligner) to independent orthodontists and dentists, SmileDirectClub provides a vertically integrated solution. 

This has its pros and cons. On the plus side, SmileDirectClub has control over marketing, manufacturing, order fulfillment, financing, and patient monitoring.

They are the only company that can provide an end to end solution.

The biggest con here is the financing. Because SmileDirectClub provides customers with a financing program that is in-house, they are also on the hook for defaults. 

The financing program generally has a small upfront payment – $250 – so SDC relies on customers monthly payments. That payment plan is $85 per month.

Before COVID-19 the default rate was around 10%. You have to think that this will increase over the coming months. I suspect that concerns around defaults have been what has weighed on the stock.

But the financing is part of the attraction of the product, as is its comparably low cost.

 

A Cheaper Solution

 

Traditional orthodontics are expensive. This makes them prohibitive to many customers.

The price tag on orthodontics is $5,000 to $8,000.  These costs are high because of the need to visit the dentist multiple times. A set of braces can require up to 15 dental appointments.

SmileDirectClub offers similar result for $1,895. It is a 60% or more cheaper option. They just use 3D printers. There are no visits to the office. All of their treatment done remotely – using teledentistry.

This again has pros and cons.

The pro is the cost. Patients meet with their doctor over the phone or computer. Meetings are at least once every 90 days. Patients upload photos for the doctor to assess.

This is way cheaper than visits to the office. As well, it opens up a segment of the population that never had access to an orthodontist.

JP Morgan estimates that this opens up a far larger segment of the population – 60% of Americans that don’t have an orthodontist available.

But the con may be quality. There have been a number of questions raised by both shorts and industry professionals about whether the patient can be adequately treated over the phone.

Of course, SmileDirectClub is taking business away from these same doctors. Their comments need to be considered in that light.

 

Competition

 

The first public entry into the space was Align Invisibility.

A second, recent entry has been Danaher, which is a large conglomerate style business, has also entered the space.

The introduction of Danaher is good and bad – Danaher would likely not enter if they didn’t think there was a good opportunity, but they also will be good competitors.

Both of these competitors are focused more on the selling of the aligner to professionals.

There are some smaller players that are taking a more vertically integrated approach like SmileDirectClub. In particular: Candid Co, Smilelove, and SnapCorrect. Each of these competitors are smaller than SmileDirectClub and they have a decent head start against these rivals.

 

My Biggest Fear

 

The thing that concerns me most with SmileDirect is the financing that they do for their aligners and their cash position.

Basically, I see SDC as the opposite of a SaaS company. While a SaaS company signs a contract with a customer that lets them book cash up front and takes deferred revenue on their balance sheet, SDC does the opposite – they book all the revenue up front even though the cash from customers that are using their SmilePay financing option comes in over a 2 year period.

So I think they run the risk of having to reverse revenue if defaults are higher than their 9% estimate. They have accounts receivable of $346 million from SmilePay and they have been assuming a 9% default rate on that.

The way they have to account for SmilePay customers also makes things look better than they are–when they are growing–but it will do the reverse when that stops. SDC doesn’t seem to have any recurring revenue to recognize from existing customers that they are servicing because it was all recognized up front.

So over the next few quarters, SDC could see a double hit to revenue.  Revenue coming in from new aligners will be down substantially because all of their stores and kiosks are closed. And they probably will have to take some sort of hit from prior booked revenue as they revise up their default rate.

The upfront revenue recognition compared to also makes their cash position a bit more precarious–IMHO–then it appears in the financials. They have $318 million of cash at YE and $208 million of debt. They burned through about $440 million of cash last year. And even though gross margins are high – about 80% – their G&A and sales and marketing were nearly $1.1 billion, while revenue was $706 million.

MAYBE I’M BEING TOO NEGATIVE BUT….I think SDC has a lot of cash headwinds in the next few quarters and it is going to be a tight squeeze for them to get through them.

 

Conclusion

 

When SmileDirectClub IPO’d in October of last year brokerages were projecting a valuation of 7x sales.

But nothing like that multiple has occurred. Right now the stock trades at under 2x next years estimates (though these may need to be lowered still because of COVID-19’s impact).

A short report by Hindenburg research in October argued that SmileDirectClub was putting patients at risk with its teledentistry. The report also pointed to the company’s cash burn – which it referred to as “incineration”.

The stock stabilized after that but the double hit from COVID-19 – uncertainty about defaults from existing patients and the loss of new patients given the country-wide shutdown – has led to a much further decline in the stock.

Balancing that is that the company has shown it can grow their business. Revenue grew 77% year over year in 2019 and 54% year over year in the fourth quarter.

That growth has come with significant cash losses though. Cash flow drain was $330 million in 2019, which was a step up of more than $200 from 2018.

Quite honestly, the biggest positive with the company is that their stock has been decimated while the broader market has recovered. Some sort of bounce-back might be expected unless there is something really concerning on the default line.

Absent that, the case could be made that SmileDirectClub’ stock chart could revert to the mean as investors get clarity of when their locations can re-open and they can be back in business.

But there is risk here. There was already risk about the safety of the business model before COVID-19 hit. Now there is a financing risk that is tough to estimate yet. So buyer beware.