AMERICAN DENTAL PARTNERS INC ADPI
March 15, 2010 - 7:30pm EST by
rii136
2010 2011
Price: 13.08 EPS $0.62 $0.79
Shares Out. (in M): 15 P/E 21.3x 16.7x
Market Cap (in $M): 192 P/FCF 6.5x 7.6x
Net Debt (in $M): 102 EBIT 25 28
TEV ($): 294 TEV/EBIT 11.8x 9.2x

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Description

ADPI is a misunderstood, stable cash-cow with high returns on capital trading at under 6x EV/EBITDA and a FCF yield in excess of 15%. The company is trading at discounted levels due to a lack of transparency in its business model and financial statements, as well as misplaced lingering concerns from a large affiliate defection in early 2008 (Park Dental).  As the company continues to generate steady cashflow and pay back debt, we believe the stock could approach $20/share over the next 1-2 years with minimal downside risk.  Additional attractive acquisitions could increase the target further.

Brief Business Overview:

Business Model

ADPI is a dental practice management company that is currently affiliated with more than 500 dentists in multiple geographic clusters nationwide. ADPI affiliates provide dental services to their customers and receive payment either directly or through the customers' insurance carriers.  Patient revenue is used to pay expenses, the largest of which are salaries, as a typical practice employs a number of dentists, hygienists, administrative assistants, and office managers.  Additional expenses include lab fees, supplies and occupancy costs.  Profits from the practices are used to pay corporate overhead and are reinvested in the business, often in the form of acquisitions.    

In practice, ADPI's business model is a bit more complex: in most states, entities such as ADPI are not technically allowed to employ dentists (dental practices can only be controlled by licensed dentists who can practice dentistry).  Instead, ADPI forms dental practice management entities (100% owned) that execute agreements with dental practices to manage the non-clinical aspects of their business.   

In ADPI's model, dental practices provide dental services to their customers and receive payment for such services.  This patient revenue is first used to pay back the ADPI-owned entity for the expenses it incurs for managing the dental practice, which include everything other than the dentist salaries.  Next, the dental practice itself pays the salaries/benefits of its dentists, in compliance with state laws.  The "profit" that is leftover is then split between the ADPI owned DPM (ADPI's "service fee") and the dental practice.  Each service agreement is slightly different but in general, ADPI keeps 85% of the leftover "profit" and the dental practice keeps the remaining 15%.   Since the top-line revenue for ADPI does not include the salary dollars that go to the dentists, its revenue will be meaningfully lower than the total system-wide patient revenues.

ADPI also directly owns/manages a small number of practices in the pediatric dentistry space (most under the name Tooth Doctor).  For these entities, ADPI receives 100% of the revenue.  This is potentially an area of profitable, above-average growth for the company.

Why the business makes sense

There are several benefits for the dentist of working with ADPI.  One major one, as discussed in Skimmer's original write-up, is that dentists are frequently not good businessman.  ADPI specializes in handling the business aspects of a dental practice, and has consistently found that it can significantly improve operations and profitability, which is beneficial for all parties.  For example, ADPI is often able to do much better on collections, vendor negotiations, and recruiting.  The company also has developed proprietary software and other process improvement procedures that reduce the administrative burden on dentists and allow them to focus more on their work.

The ADPI model also has several significant advantages for the owners of the dental practice, as well as the dentists that do not have an ownership stake.  Older dentists typically have an oversized portion of their net worth tied up in their practice, and as they look to monetize this, an entity such as ADPI is typically their best (or only) option.  The dental practice owners receive an upfront cash payment for entering into this long term affiliation (essentially a "sale" of the practice although no equity is exchanged), while continuing to retain approximately 15% of the profit of the dental practice.  Because ADPI has historically grown practices it has affiliated with, owners benefit both from the upfront cash payment and also from their retention of the equity in the dental practice which entitles them to ~15% of a growing stream of cash flows.    

Dentists that do not own equity also benefit.  Owners of a dental practice can retain these younger dentists by awarding equity in the practice.  Another option is to monetize their ownership in the 15% of profit by selling this equity to these younger dentists.  Furthermore, ADPI reworks dentist compensation so younger dentists are compensated based on their production, rather than a flat salary based on seniority or other non-revenue factors. 

Investment case for ADPI:

1)      ADPI is cheap based on its steady generation of free cash flow

ADPI trades at just below 6x our estimate of current EBITDA, and has modest maintenance cap ex (less than 10% of EBITDA), resulting in a FCF yield of 15.5%.  We believe this is an attractive price for a stable, defensive business that should perform well regardless of what happens with the US or global economy.  Looking forward, based on current levels of FCF generation, some debt paydown, little/no "same-store" growth, and modest multiple expansion to 7x EBITDA, we believe the stock should be worth $20 per share within the next two years.  This target soes not rely on a turnaround, improvement in the US economy, drastic multiple expansion, nor any other extraneous uncertain event to occur. 

Valuation Snapshot

 

2007*

2008*

2009**

2010P

Revenue

230

273

299

305

EBITDA

35

41

48

49

 

 

 

 

 

EV/EBITDA

7.5

5.2

5.9

5.3

FCF Yield***

 

 

15.5%

17.0%

 

 

 

 

 

*     Adjusted to exclude PDG numbers

 

 

**    Includes estimated full-year results from Christie Dental, which occurred in Q4 09

***  FCF defined as: [ebitda - maint capex] / EV

Assumes no further acquisitions in 2010

2) ADPI invests its excess cash wisely, with a history of generating high returns on acquisitions and de novo expansion

Additional acquisitions could potentially increase this target value, as ADPI has a demonstrated history of generating high returns on capital from these efforts. We estimate that from 2001-2007 the company generated a ROIC of as much as 24% on its growth capex.  This estimation was calculated by taking the cumulative incremental EBITDA less maintenance capex over the period and dividing by the cumulative growth capex.  In 2008, the figures get a bit clouded due to the Park Dental loss and Metro acquisition, so they have not been included. 

Cumulative Acquisition ROIC for ADPI 2001-07

 

2001

2002

2003

2004

2005

2006

2007

EBITDA

20.0

19.6

22.6

26.0

30.7

33.4

44.3

EBITDA-Maint. Capex

18.0

17.5

20.2

23.3

27.7

30.0

40.1

Growth Capex (ex Metro acquisition)

6.3

10.2

10.0

10.5

29.0

30.5

41.6

Cumulative ROIC through 2007*

24%

26%

25%

24%

21%

30%

 

* Defined as [sum of incremental EBITDA-Maint Capex over period] / [sum of growth capex over the period up to and including the prior year].  For example, the 2001 column represents the ROIC for the period 2001-07, and is calculated as: the increase in [EBITDA-capex] between 2007 and 2001, divided by the sum of growth capex from 2001-2006 (for 2006 we actually use an average of 2006 and 2007).

In 2009, ADPI's acquired Christie Dental for approximately 6x EBITDA.  Accounting for the use of leverage and some small efficiency gains, this should generate returns in line with historical acquisition returns. It should also be noted that the company also does a handful of smaller "de novo" add-ons each year, whereby new satellite offices are opened in geographies where the company already has a strong presence, and can thus leverage existing infrastrcuture.  This allows the company to leverage its regional economies of scale and deploy establish new offices at minimal capital costs, often resulting in very high returns on capital.

Investor Misperceptions:

So, why is ADPI priced at these levels?  We believe that there are two main reasons:

1) Overly complicated structure / financial statements

The somewhat complicated technical ownership relationship between ADPI and its affiliates creates an income statement that is not easily digested.  For example, the relationship between patient revenues and ADPI revenues is not particularly transparent.  Further, the company presents a confusing set of proforma financial statements in an attempt to reconcile the company results to account for the loss of Park Dental.  However, Park was largely replaced with the Metro Dental acquisition.  This makes historical comparisons of results challenging.  The contribution from recent acquisition of Christie Dental does not show up in the most recent income statement, leaving the ttm EBITDA of the company approximately 10% lower than its current run rate.

2)  Belief that there is a high risk that another large-scale 'defection' occurs:

As a matter of brief review, PDG was one of ADPI's original affiliates and in 2006 it sought to void its service agreement with ADPI.  The case went to trial and in December of 2007 the two sides settled with ADPI terminating the service agreement (effective December 31, 2007), transferring 25 of 31 PDG facilities to PDG, and entering into a transition services agreement through September 30, 2008 to provide management services for $19 million.  The two companies then officially separated. 

Based on conversations with several people involved in the Park Dental / ADPI situation, as well as the satisfaction level we noticed at ADPI affiliates, we believe that the risk of another Park Dental defection occurring is extremely low.  As part of our research process, we spoke to several large affiliates, including owners, dentists, and lower-level employees at ADPI affiliated practices.  This included individuals with direct knowledge of the Park Dental situation. The overwhelming consensus from our calls is that ADPI is a strong partner and a good employer, that Park Dental was an exception to an otherwise satisfied partner base, and that the Park Dental defection was a combination of several factors, including:

-          Personality conflict.  The former owner of Park Dental has been widely reputed to be a 'difficult' personality, which led to multiple clashes at the practice level and with senior management. This does not appear exist with any of their other large practices as far as we can tell.

-          Poor contract construction.  ADPI did not draw up as fail-proof of a contract as it should have, which allowed Park Dental some flexibility to exit.  This was one of the first deals that ADPI did, and the shortcomings in that contract have since been closed.

-          Adverse legal verdict: ADPI has blamed some of the outcome of Park Dental on the fact that it went to a jury.  In subsequent contracts ADPI has specified arbitration to resolve contract disputes.

At the current stock price, ADPI represents a strong value investment opportunity with modest downside.  While nobody likes to go to the dentist, value investors should take another look at American Dental Partners.

 

 

Catalyst

1) Continue to execute with no affiliate defections

2) Potential IPO of Smile Dental later this year

3) FCF generation, debt paydown, continue to deploy capital at attractive return

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    Description

    ADPI is a misunderstood, stable cash-cow with high returns on capital trading at under 6x EV/EBITDA and a FCF yield in excess of 15%. The company is trading at discounted levels due to a lack of transparency in its business model and financial statements, as well as misplaced lingering concerns from a large affiliate defection in early 2008 (Park Dental).  As the company continues to generate steady cashflow and pay back debt, we believe the stock could approach $20/share over the next 1-2 years with minimal downside risk.  Additional attractive acquisitions could increase the target further.

    Brief Business Overview:

    Business Model

    ADPI is a dental practice management company that is currently affiliated with more than 500 dentists in multiple geographic clusters nationwide. ADPI affiliates provide dental services to their customers and receive payment either directly or through the customers' insurance carriers.  Patient revenue is used to pay expenses, the largest of which are salaries, as a typical practice employs a number of dentists, hygienists, administrative assistants, and office managers.  Additional expenses include lab fees, supplies and occupancy costs.  Profits from the practices are used to pay corporate overhead and are reinvested in the business, often in the form of acquisitions.    

    In practice, ADPI's business model is a bit more complex: in most states, entities such as ADPI are not technically allowed to employ dentists (dental practices can only be controlled by licensed dentists who can practice dentistry).  Instead, ADPI forms dental practice management entities (100% owned) that execute agreements with dental practices to manage the non-clinical aspects of their business.   

    In ADPI's model, dental practices provide dental services to their customers and receive payment for such services.  This patient revenue is first used to pay back the ADPI-owned entity for the expenses it incurs for managing the dental practice, which include everything other than the dentist salaries.  Next, the dental practice itself pays the salaries/benefits of its dentists, in compliance with state laws.  The "profit" that is leftover is then split between the ADPI owned DPM (ADPI's "service fee") and the dental practice.  Each service agreement is slightly different but in general, ADPI keeps 85% of the leftover "profit" and the dental practice keeps the remaining 15%.   Since the top-line revenue for ADPI does not include the salary dollars that go to the dentists, its revenue will be meaningfully lower than the total system-wide patient revenues.

    ADPI also directly owns/manages a small number of practices in the pediatric dentistry space (most under the name Tooth Doctor).  For these entities, ADPI receives 100% of the revenue.  This is potentially an area of profitable, above-average growth for the company.

    Why the business makes sense

    There are several benefits for the dentist of working with ADPI.  One major one, as discussed in Skimmer's original write-up, is that dentists are frequently not good businessman.  ADPI specializes in handling the business aspects of a dental practice, and has consistently found that it can significantly improve operations and profitability, which is beneficial for all parties.  For example, ADPI is often able to do much better on collections, vendor negotiations, and recruiting.  The company also has developed proprietary software and other process improvement procedures that reduce the administrative burden on dentists and allow them to focus more on their work.

    The ADPI model also has several significant advantages for the owners of the dental practice, as well as the dentists that do not have an ownership stake.  Older dentists typically have an oversized portion of their net worth tied up in their practice, and as they look to monetize this, an entity such as ADPI is typically their best (or only) option.  The dental practice owners receive an upfront cash payment for entering into this long term affiliation (essentially a "sale" of the practice although no equity is exchanged), while continuing to retain approximately 15% of the profit of the dental practice.  Because ADPI has historically grown practices it has affiliated with, owners benefit both from the upfront cash payment and also from their retention of the equity in the dental practice which entitles them to ~15% of a growing stream of cash flows.    

    Dentists that do not own equity also benefit.  Owners of a dental practice can retain these younger dentists by awarding equity in the practice.  Another option is to monetize their ownership in the 15% of profit by selling this equity to these younger dentists.  Furthermore, ADPI reworks dentist compensation so younger dentists are compensated based on their production, rather than a flat salary based on seniority or other non-revenue factors. 

    Investment case for ADPI:

    1)      ADPI is cheap based on its steady generation of free cash flow

    ADPI trades at just below 6x our estimate of current EBITDA, and has modest maintenance cap ex (less than 10% of EBITDA), resulting in a FCF yield of 15.5%.  We believe this is an attractive price for a stable, defensive business that should perform well regardless of what happens with the US or global economy.  Looking forward, based on current levels of FCF generation, some debt paydown, little/no "same-store" growth, and modest multiple expansion to 7x EBITDA, we believe the stock should be worth $20 per share within the next two years.  This target soes not rely on a turnaround, improvement in the US economy, drastic multiple expansion, nor any other extraneous uncertain event to occur. 

    Valuation Snapshot

     

    2007*

    2008*

    2009**

    2010P

    Revenue

    230

    273

    299

    305

    EBITDA

    35

    41

    48

    49

     

     

     

     

     

    EV/EBITDA

    7.5

    5.2

    5.9

    5.3

    FCF Yield***

     

     

    15.5%

    17.0%

     

     

     

     

     

    *     Adjusted to exclude PDG numbers

     

     

    **    Includes estimated full-year results from Christie Dental, which occurred in Q4 09

    ***  FCF defined as: [ebitda - maint capex] / EV

    Assumes no further acquisitions in 2010

    2) ADPI invests its excess cash wisely, with a history of generating high returns on acquisitions and de novo expansion

    Additional acquisitions could potentially increase this target value, as ADPI has a demonstrated history of generating high returns on capital from these efforts. We estimate that from 2001-2007 the company generated a ROIC of as much as 24% on its growth capex.  This estimation was calculated by taking the cumulative incremental EBITDA less maintenance capex over the period and dividing by the cumulative growth capex.  In 2008, the figures get a bit clouded due to the Park Dental loss and Metro acquisition, so they have not been included. 

    Cumulative Acquisition ROIC for ADPI 2001-07

     

    2001

    2002

    2003

    2004

    2005

    2006

    2007

    EBITDA

    20.0

    19.6

    22.6

    26.0

    30.7

    33.4

    44.3

    EBITDA-Maint. Capex

    18.0

    17.5

    20.2

    23.3

    27.7

    30.0

    40.1

    Growth Capex (ex Metro acquisition)

    6.3

    10.2

    10.0

    10.5

    29.0

    30.5

    41.6

    Cumulative ROIC through 2007*

    24%

    26%

    25%

    24%

    21%

    30%

     

    * Defined as [sum of incremental EBITDA-Maint Capex over period] / [sum of growth capex over the period up to and including the prior year].  For example, the 2001 column represents the ROIC for the period 2001-07, and is calculated as: the increase in [EBITDA-capex] between 2007 and 2001, divided by the sum of growth capex from 2001-2006 (for 2006 we actually use an average of 2006 and 2007).

    In 2009, ADPI's acquired Christie Dental for approximately 6x EBITDA.  Accounting for the use of leverage and some small efficiency gains, this should generate returns in line with historical acquisition returns. It should also be noted that the company also does a handful of smaller "de novo" add-ons each year, whereby new satellite offices are opened in geographies where the company already has a strong presence, and can thus leverage existing infrastrcuture.  This allows the company to leverage its regional economies of scale and deploy establish new offices at minimal capital costs, often resulting in very high returns on capital.

    Investor Misperceptions:

    So, why is ADPI priced at these levels?  We believe that there are two main reasons:

    1) Overly complicated structure / financial statements

    The somewhat complicated technical ownership relationship between ADPI and its affiliates creates an income statement that is not easily digested.  For example, the relationship between patient revenues and ADPI revenues is not particularly transparent.  Further, the company presents a confusing set of proforma financial statements in an attempt to reconcile the company results to account for the loss of Park Dental.  However, Park was largely replaced with the Metro Dental acquisition.  This makes historical comparisons of results challenging.  The contribution from recent acquisition of Christie Dental does not show up in the most recent income statement, leaving the ttm EBITDA of the company approximately 10% lower than its current run rate.

    2)  Belief that there is a high risk that another large-scale 'defection' occurs:

    As a matter of brief review, PDG was one of ADPI's original affiliates and in 2006 it sought to void its service agreement with ADPI.  The case went to trial and in December of 2007 the two sides settled with ADPI terminating the service agreement (effective December 31, 2007), transferring 25 of 31 PDG facilities to PDG, and entering into a transition services agreement through September 30, 2008 to provide management services for $19 million.  The two companies then officially separated. 

    Based on conversations with several people involved in the Park Dental / ADPI situation, as well as the satisfaction level we noticed at ADPI affiliates, we believe that the risk of another Park Dental defection occurring is extremely low.  As part of our research process, we spoke to several large affiliates, including owners, dentists, and lower-level employees at ADPI affiliated practices.  This included individuals with direct knowledge of the Park Dental situation. The overwhelming consensus from our calls is that ADPI is a strong partner and a good employer, that Park Dental was an exception to an otherwise satisfied partner base, and that the Park Dental defection was a combination of several factors, including:

    -          Personality conflict.  The former owner of Park Dental has been widely reputed to be a 'difficult' personality, which led to multiple clashes at the practice level and with senior management. This does not appear exist with any of their other large practices as far as we can tell.

    -          Poor contract construction.  ADPI did not draw up as fail-proof of a contract as it should have, which allowed Park Dental some flexibility to exit.  This was one of the first deals that ADPI did, and the shortcomings in that contract have since been closed.

    -          Adverse legal verdict: ADPI has blamed some of the outcome of Park Dental on the fact that it went to a jury.  In subsequent contracts ADPI has specified arbitration to resolve contract disputes.

    At the current stock price, ADPI represents a strong value investment opportunity with modest downside.  While nobody likes to go to the dentist, value investors should take another look at American Dental Partners.

     

     

    Catalyst

    1) Continue to execute with no affiliate defections

    2) Potential IPO of Smile Dental later this year

    3) FCF generation, debt paydown, continue to deploy capital at attractive return

    Messages


    SubjectAgree, good idea
    Entry03/16/2010 10:07 AM
    Membermiser861

    We agree with your thesis. We have done plenty of work on the Park issue and feel comfortable that a similar situation will not occur in the future. It has also never happened at similar practice management groups that we have spoken with. Bottom line is that this is a very stable business (worst same practice comp was -1.8% in Q1 '09 when retail was comping negative double digits) trading at just over 6X free cash flow. We think the management team is solid and the industry dynamics/demographics are extremely favorable for the foreseeable future.


    SubjectRE: Agree, good idea
    Entry03/16/2010 10:43 AM
    Memberrii136

    Thanks for the thoughts, Miser.  We agree on management.  We are hopeful that a Smile Dental IPO or other PE go-public could draw more attention to the space and result in some multiple expansion, in addition to the 15%+ returns we'll get from management just continuing to do what they are doing.


    SubjectQuestions
    Entry08/31/2010 09:09 PM
    Memberotaa212

    Thanks for a very interesting write up. Just a couple questions on the numbers: In calculating the acquisition ROIC you are including in the numerator all of the incremental EBITDA - maint. capex. Does this imply that there is negligible organic growth? Also, if the yield on EBITDA - maint. capex is 15%, doesn't that imply a 10% or so after-tax yield? The reason I ask is that if both of those things are the case, then at the price at which you wrote this up it would be a business with negligible organic growth yielding about 10%, and the upside would come from value-creating acquisitions. Alternatively, if there is organic growth the 10% yield looks more attractive but the acquisitions look less attractive. Thanks in advance.


    SubjectRE: Questions
    Entry09/01/2010 08:03 PM
    Memberrii136
    otaa,
    Thanks for the questions.  We've had a lot of internal debate recently on the right way to think about the ROIC on this business - to your point the way we did the ROIC analysis we are lumping in organic growth (and internal growth capex) with acquisition capex so it's not the best measure of the ROIC on the acquisitions. De novo additions (opening up new offices) have far and away the highest ROIC, because it's a capital light way of adding business (get some equiptment + office space + hire dentist).  Doing acquisitions at 6.5x gets a ROIC before any business improvement of about 7.5% and is much lower ROIC because of all the goodwill (buying w/ services biz usually much more expensive than building). We usually think they can get it down to about 5x proforma over the long-term after synergies / various improvements which gets the ROIC up to ~11% for acquisitions, plus they can usually then use the acquired platform to do more denovo adds which can get the ROIC to maybe the low teens.  So generally would characterize organic growth as very high ROIC and acquisition related growth as having lower but still decent (low teens) ROIC. Traditional ROIC analysis messy in our opinion because of Park Dental (a one-off disaster) and Metro dental (they overpaid and likely won't do this again, in our view, and if they do the stock is probably at 7-8x anyway).
     
    On your question of organic growth, in normal economic environment this should grow low-mid single digits a year.  In current economic environment organic growth has been flat/slightly negative, which has weighed on the stock.  We expected organic growth to pick-up a little bit, and probably overlooked how much prolonged unemployment in many of their geographies would continue to hamper their business.
     
    On the FCF Yield, we defined it in this write-up as pre-tax, which we probably should have laid out more clearly (was defined in valauation snapshot section).  While the stock was not screaming cheap at those levels, we liked the cashflow yield, the defensive nature of the business, and the prospects for growth in EBITDA.  Because of the leverage, even a small improvement in the multiple towards historical levels, given the leverage, would have resulted in a nice IRR, and we viewed worst-case as the after-tax yield while we waited.
     
    The thesis has not played out here yet, but we don't think a lot has changed here except for the stock price.  At current prices we get an after-tax FCF yield of ~14% (40m cash from ops - 5m maint capex / 250M mkt cap).  We like it at these levels and at these prices find the valuation & after-tax yield particularly compelling given the defensive nature of the business, discount to historical levels and private market comps, and nice after-tax FCF yield.  We are also encouraged by the stock buyback given the current valuation.
     
    hope this helps,
    rii
     

    SubjectRE: RE: Questions
    Entry09/02/2010 10:15 AM
    Memberotaa212
    Got it--I appreciate your answers.

    SubjectRE: RE: Questions
    Entry09/02/2010 11:44 AM
    Membermiser861
    How are you calculating market cap?

    SubjectRE: RE: RE: Questions
    Entry09/02/2010 12:39 PM
    Memberrii136
    yikes - thanks for catching that, miser.  That's what i get for rushing to answer before leaving work w/out checking my math (used EV accidentally instead of mkt cap).
     
    16M diluted x 10.85 = 173M market cap.  so 35M of cash flow from ops - maint capex divided by that mkt cap is ~20% levered FCF yield post tax.
     
    Also I believe the numbers we did the first time were pre-tax unlevered FCF yield since we used the EV - using a $13 stock price gets 208M mkt cap; so 35M on 208 would have been 17% levered, post-tax FCF yield when we wrote it up.
     
    Hope that helps,
    rii
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