Description

Investment Viewpoint: Dentalcorp (DNTL) is a high-quality, growing, cash-generative business that has been abandoned by event-driven investors after a recent strategic alternatives review ended with the company choosing not to sell the company, but instead continue to pursue its existing business strategy of rolling up the Canadian dental practice market.

At 11x 2023 FCF, DNTL represents a rare combination of a business investors should be happy to own for the very long-term, at a price that implies attractive medium-term IRRs to investors.

DNTL is recession resistant, possesses growing barriers to entry, and run by a proven owner-operator management team that is aligned with investors. The shares have been cut in half from its $14/share May 2021 IPO price, despite TTM adjusted EBITDA doubling over that period. Additionally, the shares have given back all their potential sale premium as M&A focused investors have bailed on the stock.

As the industry leader in the essential, resilient, cash-pay Canadian dental practice market, we believe DNTL deserves to trade at a premium multiple compared to smaller DSOs yet it currently trades at significant discount on an EV / EBITDA basis.

It is worth noting that Canada has among the highest dental hygiene compliance rates of any country in the world. As such, DNTL averages ~89% recurring annual patient visits. In Canada, dental services expenditure per capita have historically grown in excess of CPI during periods of high inflation, making its business somewhat recession resistant.

With a market share of 3.6% and only ~6% of the Canadian dental market consolidated (vs ~30% in the US) the company has a large multi-year untapped TAM of potential acquired growth. Highlighting DNTL’s long growth runway, at the current pace of acquisitions and assuming ~30% of Canadian practices are consolidated, there is a potential acquisition trajectory for the next 30+ years for the company.  When combined with predictable annual organic growth, which management targets at ~4% on average, this should fuel revenue growth at a low-to-mid teens CAGR over the next 3-5 years. Moderate practice and corporate scale efficiencies should help improve adjusted EBITDA margins from 18%+ to north of 20% and drive a mid-to-high teens CAGR in adjusted EBITDA over the same period. The company’s asset-light business model, with adjusted EBITDA to FCF conversion of ~60-65%, should provide adequate capital to support the company’s future growth.

Our understanding is that DNTL’s underperformance since coming public has been driven by concern over its leverage (currently at 4.4x and below its privately held comps) in a rising rate environment. We believe the fears are overblown as the company has strong and resilient cash flows and roughly 75% of its debt is now fixed. With management now moderating its pace of acquisitions and focusing on de-leveraging, the issue of leverage should move to the background, which bodes well for multiple expansion.

Based on our estimates for adjusted EBITDA of $264 and $314 million for FY23     and FY24, respectively, the stock is currently selling at an EV/EBITDA multiple of 9.8x FY23 adjusted EBITDA and 8.3x FY24 adjusted EBITDA. We believe that on an absolute basis this valuation is attractive for a business with DNTL’s predictable and consistent cash flows and mid-to-high teens profit growth.

On a relative basis, DNTL’s multiple is well below other high growth consolidators as well as US dental companies and suppliers. Moreover, the company’s valuation is significantly below the 14.6x average of the large number of M&A transactions that have taken place in the industry over the last few years. This is significant in that while the recent strategic review process did not result in a sale, we note management's comments of “several expressions of interest” and that “the debt capital markets were not constructive to doing a transaction” at this time. Moreover, the above factors, combined with the ownership of all major Canadian & US comp’s acquired by PE firms, in our minds, makes an acquisition of the company inevitable in the future in a lower or more stable rate environment.

With management now targeting de-leveraging and continued strong earnings growth over the next 12-18 months, we believe DNTL’s multiple will re-rate higher and get closer to its ~14x IPO multiple. Furthermore, we believe the shares should be valued at a multiple of 13-14x, which represents a discount to private market valuations and is more consistent with public comps. Based on our FY24 adjusted EBITDA estimate, this translates into a share price range of roughly $16.30-$18.00 per share, or an upside of about 120-140%.

Thus, we believe there are two ways for DNTL investors to win; either realize share appreciation through the combination of double-digit earnings growth and a higher re-rating of the multiple, or the company being acquired at a significant premium price.

DNTL Has A Leadership Industry Position With A Significant Multi-Year TAM And Large Pipeline: Dentalcorp is the largest dental service organization (DSO) and provider of dental services in Canada. The business has a network of 536 practices performing various dentistry, hygiene, and orthodontics services via its network of 1,850+ dentists, 2,400+ hygienists, and 5,500+ auxiliary dental health professionals. The company was founded in 2011 (with a predecessor company formed in 2018) with its first dental practice acquisition by current CEO and Chairman Graham Rosenberg, who has a background in finance and private equity. The company IPO’d in May 2021 at $14/share. Private equity firm L Catterton, which had helped finance the company, owns 37.3% of the company. CEO Rosenberg owns 5.2% and management/insiders have a 6.6% ownership stake.

Since 2011 the company has rapidly grown its network of dental practices across Canada from 10 in FY11 to its current level of 500+ through its strategy of acquiring and growing various small and mid-size dental practices.

Note: * The company completed the sale of 13 standalone orthodontic practices

The company operates in the highly fragmented $18 billion Canadian dental market with about 15,000 practices throughout Canada. Despite DNTL’s market leadership position, the company has a market share of only ~3.6%. Even when DNTL’s market share is included, the top 5 competitors in the industry only have a ~6.7% share of the market, leaving 93.3% of the industry as independent practices. By comparison, in the US, roughly 30% of the market is consolidated. Thus, this gives DNTL a significant white space of available growth to acquire additional dental practices. Highlighting DNTL’s large TAM and long growth runway, at the current pace of acquisitions and assuming ~30% of Canadian practices are consolidated, there is a potential acquisition trajectory for the next 30+ years.

Post acquisition, dentists enter into 5-to-7-year service agreements (to date ~96% resign after their original agreement ends) and are compensated in line with industry practices receiving ~40% of what they bill. The service agreements also include clauses for profit/loss sharing above/below certain targets. There are a number of reasons why it is an attractive proposition for Canadian dentists to sell their practice and partner with DNTL, which include:

• Dentists can focus exclusively on their clinical practice and provide optimal clinical care to their patients,
• Relieves dentists from the administrative burden of running a practice,
• Potential succession planning solution as dentists near retirement,
• DNTL manages the talent cycle (recruitment, training, and development, HR management, day-to-day management, finance operations, etc.),
• Access to capital for practice monetization or growth,
• Protection against increasing regulation burden,
• Dentists receive a share of growth (20% of the growth above a baseline EBITDA metric),
• The company’s marketplace purchasing portal is a one-stop-shop for supplies and receiving favorable pricing,
• New service offerings, such as orthodontics and implants,
• Technology automates patient relationship management.

The company’s criteria when selecting dentists are those dental practices that possess the following:

• $2.0-$2.3M in revenue
• $450-$500k in EBITDA
• Diverse pool of revenue producers (2+ dentists, 2+ hygienists)
• Average age of dentists late 40’s-early 50’s with long runway
• Exemplary clinical reputation and strong practice standards
• Attractive location (geography and facility type)

The company has a robust and growing pipeline with ~180+ opportunities in more advanced stages of negotiation.

After ramping up the pace of its acquisitions during FY22, where it acquired $59 million of EBITDA, in 2023 the company is slowing down its acquisition pace to about $20-25 million. We believe this change is due to a reduction in industry valuations, which will take some time for dentists to get comfortable with, along with a focus on delivering its balance sheet. With the late issue weighing on DNTL’s multiple, success in reducing its leverage ratio should be a catalyst to a re-rating higher.

Attractive, Predictable & Resilient Industry Fundamentals: The Canadian dental industry has a number of attractive attributes. It is an essential medical service, and Canadians have among the highest dental hygiene compliance rates of any country in the world. About 80% of Canadians have a regular dentist, ~75% of the overall population sees a dentist every year, ~90% of children see a dentist every year, and ~75% of Canadians have dental insurance.

Additionally, provincial governments provide annual dental fee increases, which closely track the Canadian CPI. When combined, these fee increases have averaged slightly more than inflation. We view this dynamic as similar to any company that can leverage a significant pricing power advantage to support long-term growth. The following chart illustrates this point, showing the historical correlation along with our estimate of ~5% for FY24 based on consensus Canadian CPI estimates.

Illustrated in the following chart, Canadian dental service expenditures on a per capita basis have a very long record of consistent and predictable growth. Moreover, Canada dental services expenditure per capita has historically grown in excess of CPI during periods of high inflation, making its business somewhat recession resistant.

The combination of recurring patients visits/revenue and Canadian government fee increases is important because it supports healthy recurring organic growth. This is important, as organic growth has been in the eyes of many investors, the “acid test” as to the underlying strength and viability of high growth roll-ups. Given the current and projected governmental dental fee increases in FY23/24 that were previously detailed, this should support solid organic revenue growth in the mid-to-upper single digits over the next 12-18 months or more.

An additional attractive element of the Canadian dental industry is that unlike in the US, the business is a private patient cash pay at the time-of-service model. The Canadian pay model is somewhat similar to the veterinary business in the US, where patients pay dentists directly at the time of service, and then the patient submits a reimbursement claim to their insurance company. This eliminates any receivable on the books of a dentist.

Historically, the overall Canadian dental market has grown at about a 3%-4% CAGR. DNTL has guided longer-term to ~4% annual organic growth of which ~1/3^rd is price and ~1/3^rd is volume (the combination of general Canadian population growth plus incremental volume driven by DNTL). The remainder is from providing additional dental services (aligners, orthodontics, implants, etc.). For FY23, DNTL has guided to higher same practice revenue growth of 4%+ driven by a robust post-COVID rebound in patient visits and higher provincial fee increases tied to higher inflation. In Q1-FY23 DNTL got off to a good start for the year, reporting an 8.5% increase in organic same practice.

Attractive Financial Profile Characterized By Predictable Recurring Revenues, High Margins And Strong Cash Flow: Dentalcorp has an attractive financial model, characterized by predictable organic growth, high margins, low capex and low working capital requirements. DNTL’s organic revenue growth is targeted at ~4%, with a drop through of 5% on organic EBITDA growth. As illustrated below, 75%-80% of the company’s costs are variable in nature and can change commensurate with volumes.

DNTL targets acquiring dental practices at ~7x EBITDA pre-synergies. When the company acquires a new dental practice, they target taking out ~100-200 bps of cost, translating into a 10-15%+ immediate practice-level EBITDA margin expansion driven by cost synergies. Thereafter, they can increase organic growth within a new practice by putting the practice on their customer service platform and lowering purchasing costs, and adding new ancillary services within the practice over time. The average dental practice in DNTL’s network has annual revenues of ~$2.4 million, practice level EBITDA margins of ~22%+, organic growth of ~4%, and predictable cash flows.

With growth in the size of DNTL’s dental network, corporate level adjusted      EBITDA margins for the company have recently increased to 18%+. Margins are expected to be somewhat stable this year, as the company has been making investments to its IT platform intended to more efficiently scale new practices. This should translate into corporate efficiencies in adding new dental networks onto the DNTL platform. Beginning in FY24, management expects to improve corporate adjusted EBITDA margins by about 50 bps per year.

Aided by its cash pay model, the company has low working capital requirements, along with minimal cap-ex needs. As a result, historically DNTL has had an EBITDA to FCF ratio of about 60%-65%, which has allowed the company to generate strong cash flows. These strong cash flows provide the company a fair amount of capital to use for acquisitions of new dental practices.

Recently free cash flow has been running at roughly $120 million. Given the expected current pace of acquisitions (~$20-25 million of EBITDA per year), management expects to be self-funding in about a one-year time frame.

Comments From Competitor 123 Dental Support Our Favorable Investment Thesis: Recently we had the opportunity to speak with an executive from DNTL’s major competitor, 123 Dental, about the Canadian DSO market. The following are some key comments:

• “The [Canadian] government fee increases were quite significant this year and should be significant next year as well”. He said fee increases this year are in the 7-8% range and he expects them to be about 6-7% next year, which compares historically with an average of 2-3% when there are no real inflationary pressures.
• Relative to the US dental market, “the Canadian market from a reimbursement model is “better” and “more stable”.
• Labor, which is about 28-30% of revenues, had increased about 10-15% last year, but “that pressure is subsiding” and is expected to grow about 5% this year.
• He expects the rate increases to offset supplies and wage increases this year: “the margin percentage is expected to hold” this year. Regarding next year, he believes that there will be “some opportunities” for margin expansion “as the cost pressures subside and the rate increases are expected to be larger than normal”.
• The government has put in place a program to help seniors and lower income individuals have more access to dental care. While they are still discussing the fees, which they expect to be “not much lower than private insurance”, they expect “any volume to be incremental” and could be a tailwind to volume growth.
• Incremental growth opportunities are Invisalign’s and implants. Invisalign’s are “now standard of care” as dentistry is moving to digital care and more dentists are being trained on providing this service. Implant procedures are increasing and are an incremental growth opportunity as general dentists are trained for the procedure.
• DNTL is the DSO industry leader, followed by 123 Dental, with a large gap after the top two. Consolidation “will definitely continue” and is a trend “well accepted by the dentists”.
• Given the rise in interest rates, acquisition multiples have dropped “quite drastically” from ~8.5x to ~7x on average and the pace of acquisitions in the industry has slowed compared with last year. He believes it will take 6-9 months for the market to normalize back to its historical acquisition cadence. He believes this is a “short-term headwind” and “the long-term fundamentals are not affected by this”.
• The average dental practice has a ~22% margin, “which is quite positive from a cash flow perspective “and allows platforms “to be more levered”. He noted that when DNTL was a private company they had leverage “that was much higher than what they have as a public company”.
• Regarding DNTL’s strategic review ending without a sale, he believes it was due to the rise in interest rates and an increase in the cost of capital, which did not allow an acquirer to offer a high enough valuation [vs the $14 IPO price]. He also believes that in the future an acquisition of the company is not off the table in a different rate environment.
• In summary he said that the Canadian DSO space “is quite attractive, very stable in revenues, cash flow generative, and over the next few years can continue to grow at the same pace as everyone has been growing at without a lot of headwinds”.

Management’s Focus On Reducing It’s Leverage Ratio Should Be A Catalyst To The Shares Re-Rating Higher: Our understanding is that the primary reason for the underperformance of the shares is the company’s high leverage in the current higher rate environment. This leverage, which currently stands at 4.4x on a net debt to pro forma EBITDA basis, is especially concerning to Canadian investors.       Noteworthy, are two points in this regard. First, DNTL’s leverage is roughly consistent with the level when it IPO'd in May 2021. Second, our understanding is that most of the US and Canadian dental comps owned by private equity firms are levered up 6-8x. In speaking with industry participants, the reason why most comps are comfortable at these high levels of leverage is tied to the predictability of the cash flows in the business and the resiliency in the business during periods of macroeconomic softness and higher rate environments.

Given DNTL management’s background in private equity and their understanding of the stability of the business, they are comfortable operating with the current leverage. However, management has become frustrated that the underperformance of the shares does not fully recognize their success in increasing profitability and the intrinsic value they have created in about the last two years as a public company. During this time period TTM adjusted EBITDA has more than doubled, however, the share price has been cut in half. In a move to address the decline in the multiple of the shares, management has decided to moderate the pace of its acquisitions of dental practices from the aggressive pace of FY21 to a level of about $20-25 million of purchased EBITDA. The company will use the post-acquisition excess cash flows in the business to reduce its leverage. As illustrated below, management’s target is to reduce its leverage ratio to below 4x, which we believe is possible in early-to-mid 2024. Success in moving in this direction should prove to be a catalyst to the shares re-rating higher.

Management Confidence Echoed In $1 Million Insider Purchase: In reaction to the sharp decline in the share price since the company’s IPO, in the Fall of 2022 (prior to the announcement of the strategic review) senior management purchased 90,464 shares at an average price of $10.84. The following members of management purchased shares:

• Graham Lawrence Rosenberg, Founder, Chairman of the Board & CEO: Purchased 55,400 shares at prices of $9.96-$10.95 (average price of $10.77/share)
• Guy Amini, President & Corporate Secretary: Purchased 18,232 shares at $10.95/share.
• Nate Tchaplia, CFO: Purchased 18,232 shares at $10.95/share.

On the company’s Q3 conference call, CEO Rosenberg stated the following:

“The rest of the management team and I demonstrated our conviction in the outlook of our business by purchasing approximately $1 million worth of shares in the open market during the quarter. We deeply understand our business and its position in the industry, and we are very optimistic about the potential to create significant value for shareholders moving forward.”

We believe the appeal of any potential investment opportunity increases when we see management either having a large ownership position or have recently purchased shares. In the case of DNTL, both of these factors were present. Not only was management, especially CEO Rosenberg, already significant shareholders, they stepped up to the plate and purchased additional shares. We view these actions as a strong vote of confidence in the company.

Two Ways For Investors To Win; Double Digit Earnings Growth And A Higher Multiple Re-Rating Or Via An Acquisition Of The Company: On November 21^st of last year DNTL issued a press release announcing the “Commencement of Strategic Review Process to Unlock Shareholder Value”. On May 12^th of this year, with the release of strong Q1 FY23 results, the company announced the conclusion of the strategic review process, saying “based on the Company’s strong outlook and prospects for future growth, as well as the fact that none of the alternatives proposed by third parties reflected the fair value of the Company  recommended that it would be in the best interests of the Company, giving due regard to the interests of the Company’s shareholders and other stakeholders, to continue to pursue its existing business strategy, which contemplates the achievement of balanced growth through organic, acquisitive and balance sheet deleveraging initiatives under the leadership of the Company’s existing senior management team.” In addition, the company announced a share repurchase program representing about 2% of the outstanding shares.

In remarks at a recent investor conference DNTL’s CEO Graham Rosenberg stated “we had several expressions of interest in and around the November time frame, undertook a comprehensive review of those opportunities, the debt capital markets were not constructive to doing a transaction….the offers and intent of the buyers were impacted by the inability to sufficiently lever up to get a transaction done”.

From the above remarks, we know multiple bidders were interested in the company. Also, given that Board member L Catterton was not included on the special committee to review the strategic alternatives, one can surmise that they were one of the interested parties. In addition to the inbound interest in the company from others, we believe the rationale for conducting the strategic review was a fair amount of frustration that management had at the time as to both the post-IPO underperformance of the shares and where the stock was valued in the public markets, despite solid growth and execution, and the valuation accorded a number of comparable transactions in the private markets. Also, we suspect that given what the company believes is a significant white space growth opportunity to consolidate the Canadian market, it would prefer to not slow its pace of acquisitions and maintain its current leverage, which it could do as a privately held company, especially under PE ownership.

The following chart highlights the significant amount of M&A activity in the dental space, especially from PE firms, as well as the multiple disparity between the value of these transactions and the ~10x FY23 EBITDA multiple that investors have accorded DNTL currently. Noteworthy, is the 16.5x multiple that DNTL’s closest competitor, 123 Dental, was acquired at just last year. Also, despite significantly increasing intrinsic value in the last ~5 years, DNTL’s multiple is well below the valuation that L Catterton paid for its stake in the company back in 2018.

Our bottom line on this subject is that not only does the above chart highlight DNTL’s undervaluation and current investment opportunity, we believe that given the ownership profile of all the largest dental platforms in both Canada and the US owned by private equity firms (except DNTL), along with the company’s leadership market share, strong, well experienced management team and its proven platform for successfully acquiring and growing dental practices, it is inevitable that sometime in the future DNTL will be acquired as well.

The Shares Are Attractive On Both An Absolute And Relative Basis, With A Multiple Re-Rating Higher Likely: Based on our estimates for adjusted EBITDA of $264 and $314 million for FY23and FY24, respectively, the stock is currently selling at an EV/EBITDA multiple of 9.8x FY23 adjusted EBITDA and 8.3x FY24 adjusted EBITDA. We believe that on an absolute basis this valuation is attractive for a business with DNTL’s predictable and consistent cash flows and mid-to-high teens growth. On a relative basis, DNTL’s multiple is well below high growth consolidators as well as US dental companies and suppliers.

Moreover, the company’s valuation is significantly below the 14.6x average of the large number of M&A transactions that have taken place in the industry over the last few years. This is significant in that as we discussed previously, while the recent strategic review process did not result in a sale, we note management's comments of “several expressions of interest” and that “the debt capital markets were not constructive to doing a transaction” at this time, along with the ownership of all major Canadian and US comps acquired by PE firm, in our minds makes an acquisition of the company inevitable in the future in a lower or more stable rate environment.

With management now targeting de-leveraging and with continued strong earnings growth over the next 12-18 months, we believe DNTL’s multiple will re-rate higher and get closer to its IPO multiple. We believe the shares should be valued at a multiple of 13-14x, which represents a discount to private market valuations and is more consistent with public comps. Based on our FY24 adjusted      EBITDA estimate, this translates into a share price range of roughly $16.30-$18.00 per share, or an upside of about 120-140%.

Conclusion: We believe there are two ways for DNTL investors to win: either realize share appreciation through the combination of double-digit earnings growth and a higher re-rating of the multiple or through the company being acquired at a significant premium price in a lower or more stable rate environment.

Catalyst

• Continued strong organic same-practice sales growth.
• Continued strong growth in adjusted EBITDA and free cash flow.
• Further growth in dental acquisition practices.
• Success in management’s goal of reducing its leverage ratio.
• Greater awareness of the company to US investors.
• A potential acquisition of the company.