SmileDirectClub (SDC) has been a company taking their industry by storm with strong revenue growth, solid gross margins, high customer satisfaction scores, and a price point on their products that makes aligners attainable to the general public. SDC was finishing up their vertical integration of manufacturing the aligners and working out the kinks to drive further gross margin improvement and driving sales into existing markets and expanding internationally before COVID-19 hit. The pandemic hit SDC hard as revenue and margins compressed significantly. During this period, SDC changed lenders from JPM to HPS Investment Partners, a private investment firm. This article will explore why SDC changed lenders for the second time in three years, what it’s cash flow looks like and how to value the company.

Revenue

2020 was expected to be a strong year for SDC. Revenue was expected to increase to $1Bn, with 70% gross margin profit and positive adjusted EBITDA by the fourth quarter. Many of these items were reasonably achievable given their growth track record, expanding in to Europe, partnering with insurance companies and Walmart, and working out the kinks in their manufacturing facilities.

When the pandemic hit, their customers hoarded cash or purchased teeth alignment correction products and services through their dentist. Products sold and average selling price dipped. The dip in average selling price is partially due to entering new markets and lowering the price to entice new customers.

There has been improvement between May and June in regards to units shipped and they expect to ship between 83M and 87M aligners in the third quarter compared to 57M shipped in April.

Kyle Wailes, CFO stated:

Turning to our results for the quarter. Revenue for the quarter was $107 million, which represents a decrease of 45% over the second quarter of 2019. This decrease was primarily driven by 53% year-over-year decrease in aligner shipments, which came in at 57,136. As discussed in our Q1 call, we shipped 10,500 orders in April and averaged approximately 23,000 shipments between May and June, very close to the 22,000 run rate that we discussed on our Q1 call. If demand over the past 30 days hold steady, in Q3, we expect to ship between 83,000 and 87,000 aligner orders. Again, this is our prediction based on demand over the past 30 days and assumes no material changes in the current COVID operating environment.

Based on their 1H20 performance with 83M shipped in 3Q and 90 in shipped in 4Q with an average selling price $1,770 (per management’s commentary in the 2Q20 conference call), the expected revenue for the year is $585MM or a decrease of ~17% year-over-year.

Investors should be happy that units sold is trending back to its normal pace (for context, the original 2020 guidance per the 4Q19 earnings deck, was for a minimum of 591M units at an ASP of $1,725). The pace is picking up but is below FY19 of 453M units and the expected ASP of $1,770 is below the $1,817 in 2Q20. There are steps taken in the right direction and both metrics improve in the next quarter, that help the stock price appreciate.

Gross Margins

An indicator that a business has a desirable product or service is when the gross margins are high. An investor can see this is not a commodity product that is highly competitive with low margins.

Dec 2017 Dec 2018 Dec 2019 TTM
GPM 54.4% 66.4% 74.7% 67.8%

Source: Seeking Alpha

The margin expansion has been strong due to shifting all the manufacturing in house. Long-term, the goal is for GPM to be in the 85% range. At that point, all the manufacturing kinks will be out and management will be able to leverage their fixed costs. I don’t think that is unreasonable given that sales are expected to continue to increase that should drive margin in volume purchasing and spending costs amongst a larger base. This will be one of the key drivers to EBITDA profitability.

GPM hit a speed bump in the second quarter due to lower overall volume, unfavorable product and the continued spending to improve automation. Unfortunately, GPM is expected to decline to the mid-60s in the third quarter, but they expect improvement as the factories are automated. Kyle Wailes, CFO stated the following in the 2Q20 conference call:

Yeah. Happy to, this is Kyle. So, David, why don’t I take that one and you can jump in as well. So to answer the first questions looking at Q3 gross margin. I would say if you look at our volumes that we’ve guided to between 83,000 and 87,000 for the quarter that’s really at the midpoint of Q1 and Q2. And so when you look at the volume based on that in addition to MCCs and refinements as a percentage of total aligner shipped trending back in line with historical norms, we would expect Q3 likely to be in the low to mid 60s. And as we return to normal volume, trending back towards that low to mid 70s but ultimately, no change to the longer term targets that we put out historically.

Operating Margin

The company is not profitable. They are spending money on automating their factories, on marketing to deepen penetration in existing markets and in new markets and hiring staff to meet demand. Since last year, management has been preaching about controlled growth. This should be appealing to investors as the company is trying to leverage its spend and reduce acquisition costs. They are doing this by monitoring spending on marketing and G&A, and focusing on developing organic leverage by increasing demand in their existing network.

Operating expenses have improved in the second quarter by leveraging their existing network, reducing marketing spend and controlling costs. Signing partnerships with Walmart and insurance companies is an example of them leveraging their marketing expense.

Source: 2Q20 Earnings Presentation

Debt

At FYE19, SDC has a $500MM revolving credit facility with an $250MM accordion feature. The interest rate was 3-month libor + 320bps. During the 2Q20 quarter, SDC refinanced their outstanding debt with a new $400MM term loan with HPS. There is also the ability to increase the loan by $100MM. The interest rate is 3-month Libor + 750bps with a 1.75% floor! There is also a 3.25% per annum PIK or cash payment! That is really expensive debt. I am assuming that SDC was going to violate their covenant or wanted a bigger facility and the Bank Group did not want to go there. A positive is there is no annual amortization and that will improve cash flow. This new debt significantly impacts the interest expense going out the door. I see this as a negative.

Cash Flow

The following is a two-year forward looking cash flow to understand if they need additional financing.

The estimates for FY20 & FY21 are:

Revenue: $585MM & $848MM

GPM: 50% & 73%

EBITDA Margin: -74% & -35%

Balance sheet working capital is in-line with the two-year average

Overall, financial performance improves in FY21 from a low year in FY20 and it will take time to regain form. I believe this is conservative as margins should improve due to manufacturing improvement, higher sales, and operating leverage. All of these items have been executed to an extent in 1H20 but are not fully in effect.

Based on these assumptions, cash will be short and they will need to access the $100MM accordion feature. Now there are many variables in the model that can change the cash flow. Two main areas are revenue growth and margin control. Management has been able to control working capital and that there can improve cash from operations.

An Analyst asked about the need to access further financing and here is the response from Kyle Wailes during the recent conference call:

Yes, so if you look at our cash position today, we’ve got about 318 million a year end. We also have a $500 million facility with JP and both of those together are really supporting the growth that we have. I will say, we will look at additional options to better support our international growth in particular because the ABS facility that we have today does not fund that international growth overall.

If you look at 2020 at the midpoint of the range, obviously, we’ve got it to about negative 63.5 million of EBITDA. That is a great proxy overall as you know for cash. We expect about a 100 million in CapEx similar to what you saw in 2019, and then working capital and percentage change in revenue trending similar also to what you saw in 2019 as well. So putting all that together and we feel good about our test.

I expect their cash flow to improve but this is something to watch as an investor. Right now their cost of capital is expensive.

Valuation

The stock price has largely trailed its forward price-to-sales ratio due to its high-growth expectations. Its PS ratios have improved from the the lows it experienced in April which tells me that investors are more optimistic.

Chart

Based on my FY21 revenue outlook of $848MM and a PS of 6.5x, the expected stock price is $14 which represents a premium over the current price of ~$12 per share. This target is based on the notion that liquidity remains intact. A higher multiple may be warranted if their revenue outlook improves and there is positive cadence when it comes to margin improvement. A lower multiple may be warranted if the term loan accordion is enacted or there is a liquidity crunch.

Conclusion

SDC has had a rocky 2020 largely due to the pandemic and some internal operating issues. Volumes have picked up recently but the margin expectation is low for 2020. Management still targets solid revenue and margin expansion that will lead to positive EBITDA in the medium-term. However, due to its poor financial performance, SDC refinanced its debt to provide additional liquidity. This should make investors skeptical because their interest rate is significantly higher and they exited their relationship with JPM. This could be due to differences in amending the current structure, and terms and conditions. This is a negative event for shareholders. Based on management commentary and historical performance, I conservatively estimated that the company may need additional cash. Management has several levers to pull to shore up liquidity; including, reducing capex and operating expenses and managing the balance sheet. I do not see a liquidity crunch as an imminent event and is highly unlikely. Its price-to-sales multiple has expanded as investors grow more confident in the business. Based on my revenue estimate and adequate liquidity, the future stock price estimate is $14 per share.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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