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. 

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

* 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