At its current price, I believe that American Dental Partners (ADPI) offers an extremely highly attractive risk/reward profile.

An investment in ADPI offers exposure to a company with excellent FCF dynamics that operates in a market with exceptional secular trends and one which, although mildly impacted by the macro-environment, is largely recession resistant. Additionally, I believe its management team is superb, absolutely committed to increasing shareholder value by maximizing return on capital and growing the business at an appropriate rate.

ADPI is one of the leading dental practice management companies in the US. The company is currently affiliated with 27 dental groups in 18 states, representing 242 dental facilities, 2,104 operatories, and 498 full time equivalent dentists. The company has a strong business model/strategy that is relatively simple to understand: they achieve strong positions in attractive markets (large and growing populations with strong economic trends) by affiliating with a sizeable established group dental practice. ADPI takes control of the business aspects of the practice and aims to grow the business and improve its operations and profitability.

The company’s share price has been impacted by the (now settled) litigation with one of its affiliated practices, and is roughly 2/3^rds off its 52-week high of $29.50. Based on what I believe are conservative assumptions for 2008, the company is currently trading at 7.6x Cash EPS, 5.3x EBITDA, and 4.2x normalized free cash flow generation power (I’ll explain later). I see the current valuation as unsustainable and I believe there is likely 50%-100% upside in the stock over the next 12-18 months as the company continues to perform as it has during its 12-year history and the investment community becomes comfortable that ADPI’s litigation problems are non-recurring and that the company is solidly on track.

I’ll spend this write-up 1) explaining why the opportunity exists; 2) explaining various aspects of ADPI’s business, its market, its competitive position, and its prospects; 3) discussing expectations for 2008 and 2009; 4) estimating intrinsic value of the stock.

 

The present opportunity in ADPI is the result of the finalization of a legal settlement with a dissident affiliated practice group, Park Dental Group (PDG). I won’t go into detail regarding the litigation history with PDG, as what’s done is done, a settlement wiping out the court decision has already been signed, and I believe that the company does not face the potential of other practice groups taking similar action. However, in brief, PDG – a Minnesota based dental group practice, one of ADPI’s original affiliate practices, and formerly ADPI’s largest affiliate – sought to extricate itself from the long term service agreement it had signed back in 1997 with ADPI. In order to do so, in February 2006 PDG alleged certain breach of contract, violation of Minnesota Dental Practice Act, unjust enrichment, etc. and sought to void the service agreement between it and ADPI. In December 2007, a Minnesota court awarded PDG compensatory damages of $88.3mm and punitive damages of $42.3mm. As a result, ADPI stock crashed, hitting a low of $4.22 in the week following the decision. Shortly thereafter, ADPI announced a settlement with PDG and shares rose to the ˜$10 level at which they currently sit.

Effective February 29, the two parties entered into a definitive settlement agreement. As per the agreement, ADPI transferred to PDG the leases and associated tangible assets of 25 of the 31 PDG facilities and various trade names associated with the practice. ADPI has also forgone outstanding accounts receivables due from PDG of $2mm. Additionally, PDG has agreed to pay ADPI’s Minnesota based subsidiary PDHC $19mm for interim management services it will provide PDG for up to the first nine months of 2008 (ADPI will receive the $19mm irrespective of whether PDG chooses to retain the ADPI’s services for the entire 9 months). Of the $19mm in service fees, ADPI has already recognized $9mm to offset the non-cash settlement charges in Q407. ADPI will recognize the remaining $10mm over the first 3 quarters of 2008, or roughly $3.3mm per quarter. In total, ADPI recognized $34.6mm in litigation expenses for Q407 – the vast majority of which were non-cash charges including the estimated fair value of assets transferred to PDG, accounts receivable forgone, as well as cash professional fee charges, all partly offset by the $9mm of the interim management fee. Additionally, ADPI will recognize a $32mm gain in Q108, a result of assets transferred to PDG whose fair value is in excess to their book value.

The loss of PDG is certainly a significant event for ADPI. For 2007, PDG was generated roughly $89mm in patient revenue (21% of total), $64mm of net revenue (23% of total), $15mm in EBITDA (27% of total). Prior to the breakdown catalyzed by the negative outcome of the PDG litigation, ADPI traded above $20 for essentially all of 2007 and spent a significant amount of time in the mid-high $20 level. The question, therefore, is does the loss of a quarter of the company’s EBITDA (and the events that caused it) demonstrate such a fundamental breakdown in the company’s operations that shaving 50% of its market cap is warranted. For reference purposes, it’s worth noting that the stock has not been at such levels since early 2004 (see the attached table of summary operating results for the company’s financial performance at that time). Additionally, I believe that the pending litigation with PDG has weighed on the stock price since the suit was filed in February 2006, preventing it from trading at normalized levels ever since.

Importantly, ADPI has already secured – through its affiliation and acquisition activity in 2007 – enough new patient revenue to offset the loss caused by PDG’s defection. Compared to the $89mm in patient revenue generated by PDG in 2007, ADPI’s new affiliated practices generated $109mm in revenue in 2007. However, as the new affiliated practices have yet to be taken under ADPI’s wing, they will not be as profitable as the departed PDG operation.  ADPI is working towards fully integrating the new affiliated practices and expects to generate operational synergies through 2008-2009 that should enable the practices to achieve operating and profitability parity with existing affiliations (including PDG). In regards to the 6 former PDG practices that ADPI will retain, that will not translate (at least immediately) into ADPI keeping 20% of the practices revenues. Certain doctors in the remaining practices (about 30%) will not be practicing under ADPI’s umbrella, and they will be allowed to stay at their current offices until May 30^th (and possibly until July 31^st). Until ADPI can replace those doctors, they will not be able to generate revenue full revenue from the 6 offices it will retain.

As fallout from the PDG litigation, several law firms have filed class action lawsuits on behalf of purchasers of ADPI stock during the year and half lead-up the PDG litigation claiming various grievances against ADPI. Personally, I think the lawsuits are spurious – merely an attempt by lawyers and certain shareholders to re-coup some losses.  Management views them as a nuisance with essentially no threat of material damage. That said, it’s a matter to be monitored.

ADPI was formed in 1995, at a time when there was significant excitement surrounding physician practice management companies. Due to a variety of factors – poor and overzealous management, difficult Medicare/Medicaid reimbursement and healthcare insurance environment, and regulatory pressures – many of the companies founded during that era failed. ADPI has, since its founding in 1995 and IPO in 1998, largely thrived, growing its business and operating performance at a steady and consistent rate. Prior to its litigation with PDG, the company faced one other major obstacle in 2001, when several Cigna Dental insurance contracts terminated and left a few ADPI affiliated groups with underutilized capacity, resulting in severe margin contraction and crimping growth for the year. However, following that hiccup the company has consistently demonstrated impressive growth, margin expansion, and has steadily increased their ROIC and ROE.

In comments contrasting their strategy and philosophy with that of their failed peers, ADPI’s long term commitment to prudent growth and favorable returns on invested capital is made clear.

“There have been many players in our business over the years. Most have failed. I mention this because in the mid to late 1990s, many investors believed the dental practice management business was an industry that could grow at very high rates. They thought this might be the next sector in health care, like pharmacy or optometry, that might consolidate. Many of these other management companies were imprudent with their investment, sacrificing returns for growth. Unfortunately, they made so many investments so quickly that once they discovered many of the investments were bad investments, it was too late. We’ve tried to balance growth and returns over the years, sometimes to the dissatisfaction of our investors when we chose returns over growth. Today, we have an investor base that I believe is supportive of our objectives: be a value add business partner to dental groups, achieve decent returns on capital and grow at reasonable rates but don’t get discouraged if we’re short of our 8%-10% same market growth target in any particular quarter but also don’t get overly excited if we exceed the 8-10% in any given quarter.” – Breht Feigh, CFO, Interview from “The Wall Street Transcript,” 10/3/05

 

The vast majority of ADPI’s business involves it operating as an affiliated partner to large, multi-specialty dental groups. Because laws in most states prohibit unlicensed entities from controlling clinical medical practices (‘Corporate Practice’ statutes), ADPI and its licensed partner (i.e. the dentists serving at the affiliate practice), typically create a professional corporation to manage the clinical practices of a group (owned and controlled by the dentists) and a business entity (owned and controlled by ADPI) that owns the facilities and equipment of the practice and manages all non-clinical elements of the practice.

ADPI neither operates simply as a ‘roll-up’ of various dental group practices nor is its function as a business partner merely as a source of liquidity for doctors who wish to sell their practices. To be sure, ADPI supplies much of what a private equity shop or a simple ‘roll-up’ of various medical practices could: capital for its affiliated practices, facility and equipment infrastructure, and employment management of non-clinical staff (ADPI generally employs the hygienists, dental assistants and administrative staff at each dental facility, depending on state laws). However, it is ADPI’s deep experience and expertise in adding value to dental groups that set ADPI apart and enable it to grow and improve operating performance at its affiliated practices. Examples of services (essentially all of which are proprietary) ADPI provides its affiliated practices include: IT systems; organizational planning and development; recruiting and retention; training programs; quality assurance initiatives; facility development and management; employee benefits administration; procuring supplies and other necessary resources; financial planning, reporting, and analysis; marketing and payor relations; patient financing through ADPI’s proprietary dentalpaymentplan (a private-label patient financing program in collaboration with a leading national bank). Through working with practices of all sizes in a variety of markets, ADPI has been able to refine its application of these various services.

 

There are three major trends affecting the US dental market. Two major consequences will emerge from these trends, both of which are extremely favorable to ADPI: 1) an increasingly skewed supply/demand imbalance which will sustain a favorable pricing environment for dental care; 2) numerous practices looking for a business partner, presenting ADPI with very attractive affiliation/acquisition opportunities:

The trends are:

1)             The market for dental care in the United States is growing strongly:

Overall, the market for dental care in the United States is growing strongly. Based on Centers for Medicare & Medicaid Service statistics, expenditures for dental care grew at a 7% CAGR from 1990-2006 to $91 billion, and are expected to grow at a 7% CAGR through 2010 to $163 billion. Growth is being driven by four broad trends: growing enrollment in dental plans; an aging population; an increasing emphasis and adoption of various cosmetic dentistry; dental fees rising faster than the rate of inflation.

2)             There is a growing tendency towards group practices within the dental industry:

Unlike most other sectors within medical care, dental care still remains dominated by practices owned and operated by solo practitioners. In 2004, 64% of the 160,000 dentists in the US worked in single dentist practices. However, the dynamic is shifting and group practices are on the rise. The percentage of graduating dentists who began their careers as solo dentists has dropped from 31% in 1999 to 20% in 2005. Employment, rather than launching one’s own practice, has become the rule rather than the exception for newly minted dentists. This trend is being driven by two broad trends: financial motivations (students are graduating from medical schools with ever increasing debt loads, essentially ruling out their starting individual practices) and lifestyle motivations (dentists are increasingly interested in the flexibility that a group practice allows). The latter trend is strengthened by the shifting gender mix amongst dentists – females are nearing parity with males as a percentage of graduating dentists.

3)             The existing base of US dentists is aging:

Currently, ˜30% of dentists are older than 54, while another ˜32% are between 45-54 (the average age of dentists today is 49). As a large number of American dentists face retirement age and consider selling their practices, ADPI, which pays ˜.6x revenue for smaller practices, offers a valuable source of liquidity for these doctors. This trend, therefore, should enable ADPI ample growth opportunities and allow it to select the most attractive practices. A further offshoot of the aging trend is the shortage of dental services that is likely to be available looking out over the next 12-15 years (or further). Current trends are such that dental school graduates will severely lag retirees at least until 2020. The consequence will be increasing occupancy resulting in higher productivity per hour and patient fees that should continue to climb significantly faster than inflation. I recommend this NYT article from October as providing some statistical, as well as anecdotal, evidence of this trend (it also touches upon the Medicaid trend I discuss later in the write-up).

http://www.nytimes.com/2007/10/11/business/11decay.html?_r=1&scp=1&sq=dentists+shortage&st=nyt&oref=slogin)

 

I’ve presented below a table with various operating results and business metrics going back to 2001. On a whole, I think the table demonstrates the strength of ADPI’s business and the focus of its management team. Across the board, metrics have improved on a stable and consistent basis.

 

											6 year
	2001	2002	2003	2004	2005	2006	2007		2006 (PF)	2007 (PF)	CAGR
Operating data:
Net revenue	$        141.6	$        146.8	$        163.7	$        178.6	$        196.9	$        217.9	$        278.8		$        217.9	$        278.8	12.0%
y/y growth rate	2.8%	3.7%	11.5%	9.1%	10.3%	10.7%	27.9%		10.7%	27.9%
Amortization expense	$            4.0	$            4.0	$            4.2	$            4.4	$            5.0	$            5.4	$            7.0		$            5.4	$            7.0
Earnings from operations	$            9.6	$          10.5	$          13.0	$          15.7	$          18.7	$          20.2	$          (6.4)		$          21.8	$          30.4	21.1%
y/y growth rate	-34.7%	9.3%	23.3%	20.9%	19.0%	8.0%	-131.5%		16.4%	39.7%
Earings from operations margin	6.8%	7.2%	7.9%	8.8%	9.5%	9.3%	-2.3%		10.0%	10.9%
Net earnings	$            3.3	$            4.7	$            6.2	$            8.5	$          10.3	$          11.1	$          (7.7)		$          12.1	$          15.5	29.6%
Net earnings margin	2.3%	3.2%	3.8%	4.8%	5.2%	5.1%	-2.8%		5.5%	5.6%
Cash net earnings	$            5.7	$            7.2	$            8.7	$          11.2	$          13.3	$          14.4	$          (3.4)		$          15.3	$          19.5	22.8%
Diluted EPS	$          0.30	$          0.42	$          0.54	$          0.70	$          0.81	$          0.86	$        (0.58)		$          0.94	$          1.16	25.4%
Cash diluted EPS	$          0.51	$          0.65	$          0.76	$          0.92	$          1.05	$          1.11	$        (0.26)		$          1.19	$          1.47	19.3%
Capitalization data:
Debt/total capitalization	48%	43%	37%	25%	24%	23%	55%		23%	55%
Return on invested capital	12%	12%	15%	17%	19%	18%	0%		18%	18%
Return on equity	9%	11%	12%	14%	14%	13%	-3%		13%	17%
Affiliated dental group data:
Patient revenue	$        207.7	$        217.0	$        245.6	$        272.4	$        303.0	$        337.4	$        418.5		$        337.4	$        418.5	12.4%
y/y growth rate	6.6%	4.5%	13.2%	10.9%	11.2%	11.4%	24.0%		11.4%	24.0%
Same market revenue growth	3%	2%	6%	10%	8%	10%	10%		10%	10%
Number of dental facilities	154	168	171	177	187	209	261		209	261	9.2%
Number of operatories	1,360	1,462	1,520	1,583	1,761	1,944	2,357		1,944	2,357	9.6%
Number of dentists	358	383	396	398	435	470	611		470	611	9.3%
Patient revenue per facility	$ 1,340,000	$ 1,348,000	$ 1,449,000	$ 1,565,000	$ 1,665,000	$ 1,704,000	$ 1,781,000		$ 1,704,000	$ 1,781,000	4.9%
Patient revenue per operatory	$    151,000	$    154,000	$    165,000	$    176,000	$    181,000	$    182,000	$    195,000		$    182,000	$    195,000	4.4%
Patient revenue per dentist	$    568,000	$    586,000	$    631,000	$    686,000	$    727,000	$    746,000	$    774,000		$    746,000	$    774,000	5.3%

 

A note about return on return on invested capital:

In the above table, ROIC is calculated by dividing EBITA by average debt plus stockholders equity. That is the formula the company uses for its internal ROIC analysis. If we calculate ROIC by dividing (EBITDA – maintenance CAPEX) by (average gross carrying amount of intangible assets + average PP&E + average goodwill + NWC), ADPI generated ROIC of 16.5% in 2007 and 16.7% in 2006. If we exclude goodwill, the company generated ROIC of 20.2% in 2007 and 18.1% in 2006. Either way ROIC is calculated, I think the company’s return on capital is extremely attractive, especially given the company’s highly replicable business model. In that way, ADPI is very much a Buffett style business – a company with excellent FCF dynamics that has plenty of opportunity to continue to reinvest capital at very attractive returns.

A note about debt/total capitalization:

Here’s a comment from the CFO addressing the company’s targeted 40% debt/total capitalization ratio. I think what we see, again, is a management team with a very clear focus on generating superior returns on capital through prudent capital allocation and balance sheet management:

 

“Greg [Serrao – CEO of ADPI] and I both have finance backgrounds. We believe the dental profession, given its relative stability, can support a prudent level of leverage in order to boost equity returns and we clearly realize that our lenders and equity investors have certain return expectations. Long term, we would like to see our debt to total capital around 40%. With this amount of leverage, we believe our long-term, blended pre-tax cost of capital is 18%.” – Breht Feigh, CFO, Interview from “The Wall Street Transcript,” 10/3/05

Cash EPS equals net earnings plus the after-tax impact of the amortization of ADPI’s intangible assets. Because laws restrict ADPI from actually buying dental practices, the company’s transactions are not regarded as outright purchases and therefore the intangible assets created are not treated as goodwill. Accordingly, ADPI amortizes the intangible assets and runs the expense through its income statement. Because in almost any other analogous situation the intangible assets would be regarded as goodwill, investors, sells-side analysts, and the company itself add back the after-tax amortization expense for comparable company analysis purposes.

 

Seasonality of the business:

The dental practice is a somewhat seasonal business, with the first half of the year meaningfully stronger than the second half, and the third quarter (when both dentists and patients tend to be on vacation) typically the weakest. I’ve presented below some figures to show this dynamic.

 

		Doctor Productivty per Hour					Annualized ROE					Annualized ROIC
		Q1	Q2	Q3	Q4		Q1	Q2	Q3	Q4		Q1	Q2	Q3	Q4
2006		na	na	na	na		14%	15%	12%	13%		19%	21%	17%	18%
2007		$      457	$      468	$      434	$      438		16%	17%	11%	13%		22%	23%	16%	16%

 

The meaningful differences in ROE and ROIC between the quarters also illustrates the fixed cost nature of the business – relatively light seasonality on a revenue basis is magnified on an EBIT basis. The fixed costs of the business are many: office occupancy, IT costs, regional ADPI managers and other corporate expenses, non-dentist staff (administrative and clinical assistants, hygienist) that ADPI employs, etc. Long-term, management is confident in their ability to take advantage of the various elements of operating leverage inherent in the business. Historically, revenues have grown at a faster clip than expenses which has resulted in consistently improving margins. So long as ADPI is able to achieve its 8-10% targeted growth rate, management expects expenses will continue to grow at a slower rate than revenues.

In regards to the decline in annualized ROE and ROIC from 2006-2007 in Q3 and Q4, that is largely due to the Metro Dentalcare deal, and to a lesser extent ADPI’s other recent sizeable transaction. Having paid a relatively high multiple for Metro and its expected growth and margin improvement not yet kicked in, for the time being ROIC and ROE have been impacted mildly. As the company fully integrates the new practices and improves their performance, I expect the figures to continue their steady upward trajectory.

 

Economic sensitivity of the business:

Dentistry is not a particularly economically sensitive business. People have to take care of their teeth and will assumingly prioritize that ahead of discretionary spending. That said, a certain percentage of the dental business is discretionary in nature – particularly the cosmetic dentistry element of it. As one can see, same market growth was hurt during the slow economy of 2001-2003 – although ADPI had company specific problems that exacerbated the macro-oriented challenges. Although management hasn’t quantified how a recession would impact their business as it is now, they have said that “[W]e're not going to be immune to an economic downturn totally. And it will take a little bit of the cream off the growth rate. But we will be stable and we will grow” (Greg Serrao, CEO, Q305 Conference Call).In this very uncertain macro-environment, I think the characteristics and trends of the dental business are extremely attractive.

 

 

As discussed, with the exception of Arizona Tooth Doctor for Kids, the structure of ADPI’s relationships with its affiliated practices are 40-year service agreements in which ADPI is responsible for managing all administrative and non-clinical aspects of the dental practice. Because ADPI does not own or control the affiliated dental groups, the company does not consolidate the financial statements of the professional corporations (owned by the dentists) into its own financial reports. Therefore, the company does not report in its (GAAP) financial statements total patient revenue received by its affiliated practices; rather it reports the net revenue that is passed through to ADPI from the practices. 

Under all service agreements, the affiliated practices reimburse ADPI for actual expenses incurred on their behalf in connection with the operation and administration of the dental facilities. Additionally, the practices pay service fees to ADPI for management services provided and capital committed. There are 4 variations on the service fees paid to ADPI (dependent, in part, on the laws of the states in which the practice operates):

 

1)             Fixed monthly fee set at an annual meeting (16% of 2007 business service fees)

2)             Fixed monthly fee equal to the prior year service fee plus a performance fee based upon y/y improvements in patient revenue less expenses (25% of 2007 business service fees)

3)             Variable monthly fee basis on a percentage of patient revenue less expenses (58% of 2007 business service fees)

4)             Fixed monthly fee equal to the prior year service fee plus a performance fee based upon improvements in patient revenue less expenses over the planned amount set at the annual meeting (less than 1% of 2007 business service fees)

 

Accordingly, the actual patient revenue – a non-GAAP figure that the company provides – is a very important measure in assessing operating performance and margins.

The percentage of revenue retained by the dental firms can vary depending on the performance of the underlying affiliated practices. The percentage of total patient revenue retained by the PC’s (and correspondingly that percentage passed onto ADPI) fluctuates depending on such factors as the amount of dental revenue relative to hygiene revenue, the mix within dental revenue (specialty services versus general services), and the overall profitability of the PCs.

With regards to the composition of payors amongst ADPI’s patients, a general a shift has been occurring in the dental benefits market from capitated managed care plans to PPO and dental referral plans. ADPI management is fairly confident in its ability to reach agreements with providers that are beneficial for its affiliated practices and ADPI; management views the shift to PPO and referral plans as a positive for the company.  The company has been very aggressive trying to reduce the ‘discounts’ offered insurers in PPO and referral plans, and improved reimbursement rates have consistently contributed to same market revenue growth.

 

	2007	2006	2005	2004	2003	2002	2001
Fee-for-service	28%	31%	34%	37%	40%	45%	47%
PPO and dental referral plans	60%	52%	48%	43%	37%	29%	25%
Capitated managed care plans	12%	17%	18%	20%	23%	26%	28%

 

 

There are two aspects to address vis-à-vis the competitive environment.

 

1)             Competition for providing the actual dental services:

To this I can’t speak in great detail. People go to one dentist over another for a host of reasons. However, in general, dentists these days find themselves with ample work. As discussed, demand for dental care has increased dramatically; simultaneously, the number of working dentists in the US is on a decline on an absolute basis, and more dramatically, as a ratio of population/dentists. Additionally, it should be noted in the majority of cases, ADPI’s affiliate practices are the leading affiliate practice in its respective area, often without significant competition from other large group practices.

 

Currently, there is only one other publicly traded dental management company, Birner Dental Management Services (BDMS). However, there are a slew of private companies in the space (Bright Now, Aspen Dental, Midwest Dental, Western Dental, etc.), many of which private equity has taken an interest in – and financed – in recent years. According to management, there are about 20 competing dental management companies in their current service areas. The principal factors of competition between dental management companies are their affiliation models, the number and reputation of their existing affiliated practices, their management expertise, the quality of support services provided to the affiliated practices and their financial track record.

Within the industry, ADPI has a very strong reputation, and it appears that the litigation process with PDG has not marred this. Evidence of its reputation (as well as a large contributor to it) is ADPI’s affiliations with well-respected, nationally recognized practices such as Forward Dental in Wisconsin, Western New York Dental Group, Riverside Dental Group in California, and University Dental Associates in North Carolina, and Metro Dentalcare in Minnesota.

Importantly, ADPI maintains that it faces minimal competition from other dental practice management companies in regards to attracting affiliated practices. The primarily reason for this is the distinction between ADPI’s business model and that of most of its peers: whereas ADPI’s affiliation strategy is focused towards medically-oriented dental practice groups, most other practice management companies have a retail-oriented focus. According to ADPI management, medically oriented practices tend to have practice locations in professional medical setting, have higher fees relative to their communities, and attract patients through patient referrals and insurance programs. Conversely, retail-oriented dental practices tend to be in retail settings, have lower fees and attract patients through advertising.

I believe that aside from the threat of PE players willing to buy practices at premium multiples, ADPI is extremely well positioned to attract excellent practices and that a number of aspects of its business provide significant competitive advantages towards attracting the top practices to its ranks.

First, the company has more than a 10-year history of impacting very positively the performance of its affiliated practices. The table showing summary affiliate practice business metrics since 2001 is demonstrative of this. The specific example of ADPI’s affiliation with PDG (one of ADPI’s original affiliations) is illustrative as well. When PDG affiliated with ADPI in 1997, PDG generated $39mm in revenue, of which only $7.8mm (20%) was available to doctors practicing in the group. In 2007, PDG generated $89mm in revenue (8.6% CAGR) with ˜$25mm (28% of revenue – 12.4% CAGR) available to doctors practicing in the group. Over the period, ADPI decreased its fee from ˜17% to ˜16% of revenue. Such success ADPI has replicated with many of its other affiliated practices. The 2007 annual report includes some figures on individual practices as well letters from dentists at some of ADPI’s major affiliated practices – both testify to ADPI’s achievements as a truly value added partner.

Second, ADPI has unique affiliation model: once the affiliation is completed, a joint policy board – which manages the group and sets strategic and financial goals and initiatives for the practice –  is created with equal representation from the practice group and ADPI. This allows doctors to retain substantial decision making control over their practice.

Lastly, ADPI’s IT systems provide a further competitive advantage – both in attracting the best affiliate practices and in growing the profitability of those practices. In 2002, ADPI initiated the development of ‘Improvis,’ its proprietary practice management software platform, and has been continually developing the system since. ADPI decided to build their own system – rather than rely on third party software – because no commercially available software system accommodated the needs of large group practices, and because they believed it to be operationally advantageous to retain control over the design, development, and ongoing support of the system. Along with substantially enhancing its administrative capabilities to improve efficiencies (scheduling, billing, staffing functions, etc.), the company is working towards fully integrating Improvis with more advanced functionality –  electronic dental records, digital radiography, intra/extra oral digital imaging – that will further optimize clinical operations at ADPI affiliate practices, aiding productivity and expanding margins. As of the end of 2007, Improvis was installed in 93 of the ADPI’s dental facilities, and the company expects to make an additional 100 installations in 2008. ADPI has also developed a propriety management system designed specifically for orthodontics practices.

         During the most recent conference call management stated that competition for affiliate practices remains minimal – the company’s only real competition being the doctors’ decision of whether they want a business partner. In regards to valuation for deals, for the small and mid-sized transactions that ADPI traditionally seeks – deal multiples are at normal levels (ADPI has historically paid, on average, ˜5.2 EBIT for its affiliated practices). However, larger practices – such as Metro Dental that ADPI affiliated with in September 2007 – have drawn significant interest from PE firms, pushing up multiples in the space. ADPI is unwilling to pay such premium valuations unless unique characteristics of the practice will enable them to meet their 18% target ROIC.

 

ADPI’s method of growth is two-fold:

 

ADPI has a stated goal of increasing the patient revenue of its affiliated practices at 8-10% per year. The table of summary operating metrics shows that the company has achieved this goal in each of the last 4-years.

ADPI achieves the 8-10% revenue growth through a combination of factors: increasing provider hours and doctor productivity per hour, improved reimbursement rates, adding dentists and services to existing groups, de-novo offices, and in-market affiliations. Historically, same market revenue growth excluding the impact of same-market affiliations has been in the 3-7% level, with the three year average at 5%. Based on historical affiliation/acquisition multiples, management estimates that achieving 3% in in-market affiliation growth for 2008 will require $6-$7mm of capital allocated to in-market affiliations.

Management feels very comfortable that the 8-10% goal allows them to grow at a rate than keeps their return on capital targets in check. Although API could ratchet up CAPEX to generate higher same-market growth rates, management is unwilling to do so at the expense of generating their target return on capital. Of course, to the extent they can grow faster while also generating the desired returns, they are happy to do so:

 

“We have historically found to grow above those levels required significant capital investment without the corresponding return on capital we would like. But we would grow above 8% to 10% if the investment of capital could yield immediately an appropriate return on the capital which it does on these roll-ins and in market affiliations. So I guess what I’m saying is growth above 8% to 10% is a positive thing from our perspective as long as the return on capital is consistent with our goals.” – (Greg Serrao, CEO, Q206 Conference Call)

 

Going forwards, ADPI’s existing affiliate base should be able to maintain the 8-10% annual clip, owing both to the strength of ADPI’s affiliated practices in the markets as well to the secular population and economic growth these markets enjoy. Although I haven’t been able to get recent numbers, as of a couple years ago, the markets ADPI was currently in had total populations of 46mm people. At that time, ADPI’s active patient base was 1.1-1.2mm, or ˜2.5% market share within their existing markets. The numbers today have likely increased, but there is obviously still tremendous opportunity ahead for ADPI to grow locally in its existing markets.

 

2)             Adding affiliate practices:

The opportunities for ADPI to continue its expansion into new markets is vast. In addition to growing its existing affiliate base, ADPI has ranked 316 Metropolitan Statistical Areas that management believes offer strong prospects based on population, job growth, and income levels. The company has decided to focus on the top 125 of those markets, and is currently in about 40 of them. Management certainly doesn’t have plans to conquer all of those areas in the near term, but the snap-shop does provide an idea of the long-term growth opportunities the lie ahead for ADPI.

The company has already said that the volume of affiliations for 2008 will be significantly below that of prior years, largely due to capital restraints. Their current lending agreement (amended in February) allows them only $15mm to spend for affiliations next year (irrespective of operating cash flows). Additionally, management has said that their focus for 2008 growth spending will largely be devoted towards de-novo offices and tuck in in-market affiliations for existing practices. De-novo offices are the result of an existing office facing overwhelming capacity. ADPI looks for a location a mile or two from the exiting site, sets up an office, and a partner from the original office moves in, with a full book of business from day one. The result is a quick turn to profitability of the de-novo office. De-novos are currently the company’s most attractive capital allocation platform (from a ROIC perspective) and enable ADPI to effectively leverage the regional and local resources devoted to its existing affiliated practices.  

To the extent ADPI does seek new affiliated practices, I believe we can count on management remaining extremely prudent. Management has made it clear – both to the investment community and to its affiliated practices – that return on capital is their top priority for the company when considering transactions, and that they will remain firm in their extremely disciplined capital allocation philosophy:

 

“[W]e believe our cost of capital would be 18% based on our feeling that 40% of our capital will be debt, 60% will be equity. And then when you figure out what the cost of capital is we blended at 18%. So if we're paying more than a six multiple, obviously, we're already paying above our cost of capital, not to say that we wouldn't do that. But it would be hard because how do you get it back in line? So our focus has been really always around cost of capital and that discipline remains. And for the dental practices that want to be part of American Dental Partners, I think they appreciate the discipline because if you overpay for something, that means the next day you need to do something extraordinary, cut costs or do stuff like that and nobody likes that game.” – Breht Feight, CFO, Q306 Conference Call

 

Historically, ADPI has paid very attractive prices for its affiliated practices, averaging out around 5.2x EBIT. Recently, however, the company paid a higher price, ˜10x EBITDA, for Metro Dentalcare. ADPI paid $85mm for Metro, which has 90 dentists, 34 dental offices, and was expected to generate $70mm in annual revenue. Management believes there is tremendous opportunity with Metro, as its revenues are growing at 20% annually (twice the rate of the average ADPI affiliate) and has EBITDA margins of 12% vs. 16% for the average ADPI affiliate. Management believes that by implementing ADPI’s operational systems they can expand Metro’s margins substantially. Management comments indicate they do believe Metro will meet their ROIC threshold.

 

3)             Replicating Arizona Tooth Doctor for Kids:

In December 2006, ADPI acquired the assets of Arizona’s Tooth Doctor for Kids, then employing 37 dentists and generating $20mm in annual revenue. Tooth Doctor provides dental care to children, and ˜90% of the group’s revenue is generated from health plans contracted with the Arizona Health Care Cost Containment System, the state’s Medicaid program. Approximately 640,000 children are enrolled in the state’s Medicaid program, representing nearly 40% of the state’s child population. A substantial growth opportunity for ADPI lies in replicating Tooth Doctor in other markets. Tooth Doctor represents ADPI foray into the government subsidized/covered dental market. Government pay represents ˜3% of total dental spending, and even less amongst ADPI’s affiliated practices.

Management only pursued Tooth Doctor after carefully evaluating the reimbursement structure in Arizona and coming to the conclusion that – when coupled with the higher productivity rate pediatric dentistry offers – they could develop a very profitable business in this market. Management comments illustrate their general aversion to low-reimbursement government pay practices, but their willing to pursue opportunities when and where they exist:

 

“As it relates to Tooth Doctor, one of the things, I think, that we learned in the early years is stay away from Medicaid and all these lower reimbursement plans. And I wouldn't say we've become expert on it. But we've learned a lot about reimbursement, and what drives reimbursement, and what's good reimbursement and what's bad reimbursement…[O]ne of the other things that we've learned is productivity per hour is a pretty significant measure. And what we're finding in this pediatric marketplace, especially where there is acute need, is the productivity per hour of the doctors is very strong. And so even though the reimbursement is lower than our traditional affectivity level, you still get a pretty strong productivity per hour, which leads to an attractive margin.” – Greg Serrao, CEO, Q306 Conference Call

 

In the company’s most recent conference call, management spoke excitedly about the performance of Tooth Doctor in its first year with ADPI and expressed enthusiasm about expansion plans of the model to other states. Management believes that in many markets the Medicaid opportunity is substantial and they expect many states to continue to raise reimbursement rates in attempts to attract dentists to their platforms. In many states, child dentistry is the number one issue on the state level for Medicaid dollars. I think this is a very exciting opportunity – for along with the substantial growth the model offers, management has said that Tooth Doctor has proven a more profitable business than its affiliated practice model.

Currently, management sees Texas – which recently doubled their reimbursement rates to levels ADPI views as extremely attractive – as the first market in which they will replicate Tooth Doctor. Development could begin this year, and management already has a willing partner to develop the practice with their existing affiliated group in Texas.

 

 

With all of the moving parts for 2008, I’m only going to do my best to put forth was I think are very reasonable/conservative projections for the year. Along with the removal of ˜85% of PDG patient revenues (but the maintenance of $10mm in non-recurring service fees), there is difficulty in projecting margins for the newly integrated affiliates, the timing of certain synergies, and anticipating potential litigation expense. Additionally, it’s difficult to gauge how much operating cash flow the company will devote towards de-novo facilities versus debt pay-down. ADPI management does not provide revenue or earnings guidance of any kind.

That said, I’ve modeled various scenarios as well as tried to cull out the lost PDG revenue, while keeping the contribution of the retained practices. (Management has said they will provide pro-forma results throughout 2008 to account for the removed practices – I expect this will make it easier for the investment community to understand the company’s ongoing performance). For the purposes of this write-up and the valuation, I am relying on what I consider to be the conservative scenarios. I assume a below target same market-growth rate of 6% (a combination of increased productivity and de-novo development), and I don’t anticipate any new affiliated practices (aside from the small one ADPI signed on a couple weeks ago).  Due to the negative margin impact due to the loss of PDG and Metro’s inclusion, I assume a meaningful decline in contribution margin (profits after clinical expenses), and no improvements in corporate G&A expense as a percentage of revenues. Under those circumstances, I expect ADPI to generate roughly $300mm in net revenue, $30mm in EBIT, $50mm in EBITDA (impacted by an increase in D&A from recent acquisitions), and $1.30 in cash EPS [all of these numbers are normalized to exclude the impact of possible further litigation costs]. My models show significant upside potential to all those numbers – especially on the EBIT, EBITDA and cash EPS side – from better growth rates, realization of synergies in new affiliated practices, and general expense control. For reference, the two sell side analysts who cover the company anticipate EBITDA ranging from $51.5mm-$53.9mm and Cash EPS ranging from $1.31-$1.55 (part of the substantial difference is accounted for by a discrepancy in projected interest expense, but I can’t figure out the remainder). Those analysts both preface their estimates by saying they are being conservative due to the uncertainty of the current situation.

I can offer even less precision looking out in 2009, but I would expect the numbers to continue to improve as the company continues to grow modestly and the margins at Metro and other recent affiliates improve meaningfully. Development of Tooth Doctor replicates and new affiliations could generate significant upside. In short, I think there is a significant amount of optionality embedded in the shares at their current level.

The company has said CAPEX should be about $10mm in 2008, split 65% for de-novo offices and facility relocations (in total, 8 planned for 2008) and 35% for maintenance CAPEX. The latter number is a good indication of the low capital requirements of this business (maintenance CAPEX has been about $3.5mm for the last two years as well). Were ADPI to cease seeking new affiliations/acquisitions and rely on growth purely from same-store sales (i.e. shifting its emphasis wholly to the management of its existing portfolio of practices), they would generate quite tremendous FCF. Assuming we can proxy FCF generation power at Net Income + D&A + Stock-based compensation – Maintenance CAPEX, on a normalized basis (excluding litigation expenses) the company generated roughly $23mm in 2006 and $30mm in 2007. Based on the model I used for the estimates above, I believe the company can generate another $30mm of such FCF in 2008.

Management commented on the Q407 conference call that so far into 2008, trends in productivity per hour have remained very strong, although they have seen some weakness in California (6% of operatories) and Arizona (10% of operatories). Q407 was a very strong quarter across all lines.

As mentioned previously, there is currently only one other publicly traded dentist management company – Birner Dental Management Systems (BDMS). See previous write-ups on the company for further details. Based in Colorado, the company’s affiliated practices are all based in Colorado, New Mexico, and Arizona. Based on its 2007 numbers, the company is currently trading at .8x patient revenue, 1.2x net revenue, 7.0x EBITDA and 14.8x cash EPS. As an aside, I think this company is also valued quite attractively and may likely be taken out by a larger player or a small-market PE firm. However, relative to ADPI I do not believe its valuation – especially in light of ADPI’s significantly better growth profile – is nearly as attractive, nor do I believe the company is run by management that is so resolutely passionate about their business.

 

Pediatrix Medical (PDX) and VCA Antech are two other strong companies focused on acquiring medical practices, neonatal/pediatric and veterinary care respectively, improving their operations, and have long-term visions of industry consolidations, very similar to ADPI.

 

		2007			2008			2009
		EPS	EBITDA		EPS	EBITDA		EPS	EBITDA
Pediatrix Medical	PDX	23.4x	13.4x		20.0x	11.5x		17.7x	10.5x
VCA Antech	WOOF	21.6x	11.9x		19.1x	10.6x		16.8x	9.7x

 

Here is a sampling of other medical service companies, representing different verticals within the industry. A number of these companies face company specific issues that have severely impacted their stock prices, resulting in trough valuations. Other companies are trading at more normalized levels.

 

		2007			2008			2009
		EPS	EBITDA		EPS	EBITDA		EPS	EBITDA
Amsurg	AMSG	16.8x	9.9x		15.2x	8.6x		13.9x	7.6x
Dialysis Corporation of America	DCAI	22.4x	8.7x		16.7x	na		12.8x	na
Quest Diagnostics	DGX	15.9x	9.2x		14.6x	8.2x		12.6x	7.4x
DaVita	DVA	14.6x	8.0x		13.8x	8.0x		12.5x	8.0x
IntegraMed America	INMD	22.7x	7.8x		na	na		na	na
IPC The Hospitalist Company	IPCM	30.5x	18.4x		19.9x	11.7x		15.3x	9.0x
Laboratory Corporation of America	LH	17.8x	9.1x		15.4x	8.2x		13.7x	7.3x
MedCath Corporation	MDTH	14.6x	5.1x		14.2x	5.5x		11.4x	4.7x
RehabCare Group	RHB	19.3x	7.2x		14.5x	6.1x		12.1x	5.1x
	Mean	17.5x	8.3x		13.8x	7.0x		11.6x	6.1x
	Median	17.8x	8.7x		14.9x	8.2x		12.7x	7.4x

 

A further benchmark for valuation are private market acquisitions of dental practices and dental management companies. In February of 2008, Merrill Lynch Private Equity acquired UK based Integrated Dental Holdings. Though terms were not disclosed, the reported purchase price was £300mm, and apparently (according to management and echoed by sells-side analysts) done at ˜12x LTM EBITDA [a news article I read pegged the companies LTM revenues as £90mm – this assumes a rather robust 3.3x revenue multiple for the company, and unless it was generating extremely generous ˜28%, the two numbers don’t tie]. Apparently, a number of private equity firms including Blackstone, Bridgepoint Capital, and Duke Street Capital were interested in acquiring the company.

(http://www.manchestereveningnews.co.uk/news/business/s/1035943_multimillion_pound_dental_deal, http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/02/17/ccdentists117.xml)

Additionally, in recent years, there have been many acquisitions in the dental services market, with most deals done in the 8x-12x range.  Typically, the larger the practice group or management company, the higher the multiple. ADPI management has commented extensively on this in various conference calls. Given ADPI’s extremely attractive affiliated practice portfolio, its proven ability to grow practices and improve their operations, its propriety IT systems, and a host of other factors addressed in this write-up, I believe that the higher end of the range is certainly appropriate.

Below are tables presenting what I believe is a very reasonable range where the company’s intrinsic value currently is. The implied valuations are based on the assigned multiples and the projections I discussed above. As I said, I think there is a lot of room for meaningful upside performance in 2008, and even more so for 2009. With that upside performance, I would expect as well multiple expansion.

 

Metric		EBITDA
$        50.0		6.0x	7.0x	8.0x	9.0x	10.0x	11.0x
		$      12.79	$      16.69	$      20.58	$      24.47	$      28.36	$      32.26
		Cash EPS
$         1.30		10.0x	12.0x	14.0x	16.0x	18.0x	20.0x
		$      13.00	$      15.60	$      18.20	$      20.80	$      23.40	$      26.00
		Normalized FCF Generation Power
$        30.0		6.0x	7.0x	8.0x	9.0x	10.0x	11.0x
		$      14.01	$      16.35	$      18.69	$      21.02	$      23.36	$      25.69

 

1)             Valuation and market appreciation of business prospects

2)             Dismissal of class action securities lawsuits

3)             Interest from financial buyer