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Modern Dental Group Ltd. 3600
November 11, 2020 - 1:53pm EST by
sediment
2020 2021
Price: 1.38 EPS -0.07 0
Shares Out. (in M): 961 P/E 8 0
Market Cap (in $M): 1,298 P/FCF 8 0
Net Debt (in $M): 995 EBIT 154 0
TEV (in $M): 1,867 TEV/EBIT 11 0

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Description

 
Modern Dental is a leading global dental custom-made prosthetic device provider in a growing (5-15%), but fragmented industry. In certain countries, consolidation is poor— obtaining 1-2% of the market automatically makes you the leader.
 
Modern Dental trades at a TEV / EBIT of 8.2x (trailing 12 months). TEV / (Operating Cash Flow - Capex) is 11.4x (FCF = Net income plus D&A minus Capex) Revenue has grown at 13.5% in the last 3 years while tangible book value has grown at 34.8%. The total dental industry was a 25-29 billion market in 2019. Modern Dental focuses on abutments, implant dentistry, and orthodontics— a sector which makes up USD 4.6-5 billion of the dental market. Accidents from sports or driving, teeth decay (cavities) and teeth replacement (elderly people) brings Modern Dental a consistent and growing revenue (USD 154M in 2014 and 309M in 2019) and cash flow (USD 23M in 2014 and 44M in 2019).
 
Teeth replacement is a necessity, but out of pocket purchase for many--
 
 
4 things drive Dental demand—
 
1. Per Capita income of the specific country
2. Penetration rate -- Number of clinics and dentists for a given population
3. Government subsidies and insurance policies
4. Increasing disposable income for growing elderly base
 
 
Since 2011, Modern Dental strategically bought out its European distributors for 2-7x EBITDA and acquired 11 or more of its 21 original distributors it has known since 2001— spanning various geographies. Modern Dental’s true competitive advantage comes from pairing their fast turnover rate with impregnable distribution channel achieved through acquisitions of distributors and labs, and strategic partnerships.
 
In 2016, expansion in North America through a USD 65-70 million acquisition for MicroDental/RTFP for 22 clinics, which was previously operated by a private equity firm at a loss. MicroDental lacked proper management due to a lack of understanding of the industry—inventory for costly rare metals and ceramics in form of porcelain powder were wasted, and some clinics didn’t have enough customers to justify its existence.
 
Due to this incident of poor capital allocation, the stock price fell from listing price of hkd 6.5 to 1.1. RTFP/ Micro Dental had a significant impact on the top line, even though it was not profitable. In 2016, RTFP/Micro Dental revenue contribution was not yet included— There were 214,810 cases at an ASP of USD 165, bringing in revenue of 35M.
 
With RTFP included in the top line, in 2017, with the 22 dental labs, the number of cases more than doubled– from 214,810 cases to 528,687 cases—bringing sales to USD 88M, with an ASP of USD 167.
 
Modern Dental’s CEO, Mr. Ngai, has been flying over to North America every 2 months to fix the situation, and in 2019, they managed to hire a new CEO, Laura Kelly, who previously worked 16 years at MicroDental as V.P of sales and left to start her own company. So she's not a new face, and has come back full circle to an industry and people she knows. Since her arrival, 4 clinics have been shut down, and products or services which have lower margins are slowly being phased out. As of 2020, management has told me that MicroDental is now slightly profitable.
 
 
Management has skin in the game—
 
49.26% of the company is held by the Chan family
16.74% of the company is held by the Ngai family
 
 
 
Here are the 5 reasons why Modern Dental will prosper/flourish over the next decade—
 
 
 
1. Digitization of Dental Procedures
 
Casts of your teeth which harden to form a mold, are bulky but precise— the heavy weight of the cast being sent to a lab has a high shipping cost. Intraoral scanners are adopted by 15% to 35% of most labs to reduce processing time by going digital. Intra-oral scanners cost approximately USD 20,000-30,000 per model. As the price of intra-oral scanners goes down, and as scanning gets more precise, casting should slowly be replaced.
 
Results from CAD-CAM are either sent to Modern Dental’s 4 local production facilities (North America; Melbourne, Australia; and Emmerich, Germany, and Madagascar for France) for urgent orders.
 
Most orders which allow for a week to process are shipped to Dong Guan or Shen Zhen, China, and are shipped via a parcel to the dental lab, since labor costs are lower. With Intra-oral scans, the dental lab only has to send a scanned digital copy of the patient’s mouth, and the final product is shipped immediately within 2-3 days.
 
 
2. Lowest Cost Provider and reduction in SG&A and increase in utilization rate to boost operating margins
 
Modern Dental competes in 17 countries with over 70 sales and customer service centers and is the only multinational denture service — it is in the top 5 in terms of market share in Germany, France, Netherlands, Belgium, USA, China, Australia— despite a fragmented industry. Modern Dental's profits and market dominance are all the more amazing when you remember that the results have been achieved without significant R&D.
 
Scale is coupled with quality control—
 
Modern Dental’s denture and fixture quality is top notch at a reasonable price; when patients need a cast, denture, or crown made, there are a lot of errors due to technicians or faulty hardware or software.
 
Modern Dental claims to have a re-make rate of 3%, while the industry is at 8-10%.
 
Why is reducing SG&A crucial to higher operating margins and the major catalyst to improving the prospects of the company?
 
Gross Margins are 47-51%, yet operating margins for the past few years are at a horrendous 6-9%. This is due to SG&A jumping from 27% to 38-40% from the previous acquisitions for Europe and America.
 
In 2020, 15% of staff was laid off in the U.S, while there 8-10% of staff were terminated for China.
 
Currently EBIT margins are at 7-10%. In 2013, it was as high as 21.53%. This is because SG&A is at 38% in 2019, in 2013, SG&A was only 30.5%. Therefore, controlling the headcount and making sure utilization rate is of the utmost importance— acquisitions can only improve the top line, while scrupulous management can improve cash flows and the bottom line. This consolidation naturally brings an increase in assets and head count, and Modern Dental is eliminating any excess staff or assets from the process, which should bring up return on capital. EBIT margins can potentially be as high as 30-35%, with ROIC up to 15% if things are on track. 
 
Why is utilization rate important?
 
Modern Dental has 6139 employees, of those employees, 4300 are technicians. Each technician has the capability to produce 1.8 cases per day. In 2019, 1,807,754 cases were manufactured; these cases represent USD 310M of revenue. Of this revenue, more than 60% comes from a stable base from Europe and USA, with higher ASPs (USD 165-215) and EBIT margins. China brings growth and scale, but the ASP is significantly lower USD 88 (half of Europe’s ASP).
 
Assuming 4300 technicians x 1.8 cases / day, that’s approximately 7,740 cases per day.
If technicians work 260-275 days a year, 7,740 x 275 = 2,128,500 cases.
 
My estimates are that Modern Dental is currently at 60-70% utilization and management has confirmed labs in USA as of q4 2020 will have a 70-80% utilization rate. For MicroDental, labs in New York were only 50% open, while Vancouver was only 60% open.
 
 
 
3. High ROIC- Top line improvement from acquisitions finally realized in the bottom line
 
 
From 2016 to 2019, the number of cases (sales volume) jumped from 1.39 million cases to 1.8 million. Revenue is 300-310M in 2019, of which about 40-50% or 130-140M was from organic revenues, and 50-60% or 145-175M was from acquisitions.
 
55-60% of cost of goods sold primarily consists of labor costs, while 28-33% are raw materials in the form of ceramic and alloys mainly imported from Europe and the United States. As dentists and labs employ CAD-CAM technology, less expensive materials such as ceramic blocks rather than precious alloys. Raw materials are mainly procured from Europe and USA. The prices for Cobalt chrome alloy, Zirconia, CAD blocks, porcelain powder, and gold are relatively stable.
 
Return on capital is currently 5-6%, but if we discount goodwill from U.S and European acquisitions, we can take away 167M (HKD 1.3B) from capital employed. With 20M (HKD 165M) generated, the ROIC is actually 10-11%. In the future, 15-20% is certainly possible.
 
 
 
4. A long Runway for Trios Clear Align
 
 
Malocclusion, or misalignment of teeth, affects billions of people or 60-70% of the world population. 12 million people seek treatment and 300 million people have yet to seek dental assistance. Invisible orthodontics makes up 8-11% of the entire market and grows 5-6% annually.
 
Currently Invisalign has the lion’s share of the market and are selling treatments at USD 4000-6000. Once their 25 year patent expired, incumbents such as 3M, Modern Dental’s Trio, and Straumann are jumping on this opportunity.
 
The standard price for Trios is selling at USD 1950-2800 (HK$15,000 to 20,000) depending on location and geography. Modern Dental can leverage its distribution channel and existing customer base of 20,000 dentists worldwide for cross-selling. Depending on how fast Modern Dental can leverage on this opportunity to
expand Trio’s clear aligner— Trios only makes up 5-7% of total sales and is only in Macau and Hong Kong. Once they obtain the licensing in other countries, USD 100M can be added to the topline.
 
 
 
5. Phase II opening of Dong Guan and increase in ASP in China
 
 
During this entire period, Chinese customers had the largest contribution in terms of volume, but due to a low average sales price, the revenue contribution is minimal. For example in 2019, of the 1.8 million total cases, the aggregate revenue was USD 300M. 747,000 cases came from China, but at an ASP of only USD 88, only USD 65M was contributed to total revenue. Whereas Europe, an ASP of USD 205, or 574,544 cases, produces a revenue of USD 117M.
 
Modern Dental’s relocation from Shen Zhen to Dong Guan not only increases capacity, it also helps retain employees. Shen Zhen is similar to Silicon Valley, employees jump ship too often. Modern Dental trains 700 new technicians every year, but despite benefits and incentives, they get employed by bigger companies in Shen Zhen which aren’t even in the Dental Industry. The land and equipment in Dong Guan was purchased for a total of USD27M. Turnover won’t be as rampant in Dong Guan.
 
With Phase II completed, the maximum technician head count will increase from 4500 up to 6000. If this new capacity is utilized well, and income per capita goes up, China can eventually be 50% of Modern Dental’s bottom line.
 
A new factory in Vietnam will be under renovation in September 2020, the capacity initially will be less than half of Dong Guan.
 
 
Risks
 
- Management acquiring at a crazy price and not having enough restraint from pulling the trigger
 
- Modern Dental has stable revenue from developed markets – N.A, Europe, and Australia. They are able to leverage on their distribution network and sales and dental training offices which covers 200,000 dentists internationally. However, government subsidies significantly influences demand. Regarding benefits and government subsidies, Holland, Belgium are more progressive, with promotion of intra-oral scanners, whereas France, USA, and Germany are slower and have less concern for promoting oral health. Australia use to be a big market before the government changed the regulations. 
 
- A failure to capture additional market share after aquisition and a failure to improve SG&A and utilization rate
 
- N.A and Europe each bring in 200M of revenue to the top line. China only brings in 65M despite greater unit volume. The growth opportunity in a highly fragmented market with the ability to increase pricing over the future brings another long runway for compounding. Is it possible when there are so many players? We'll see. 
 
 
Valuation:
 
Modern Dental has 10% operating earnings, and if they stopped with acquisitions and focused on cost control, especially on staff and overhead, they could easily have 20% operating margins. The acquisition of MicroDental hurt operating and profit margins, in turn causing ROIC to plummet. Since then, Modern Dental has slowed its pace of acquisitions and has held a more cautious approach. This is incredible cheap for a business with equity growing at 15%. Modern dental is mainly a B2B business, but vertical integration and acquisition of some dental labs and clinics invariably means they have to deal with clients directly and have to deal with the B2C segment.
 
Given that dentures and fixtures quality and response time are crucial to dental clinics, I believe a fair price for this business would be a market capitalization of hkd 3.5 billion or at minimum USD 400-500 million (currently, as of July 2020, HKD1.4B or USD179M) 14x underlying operating earnings (hkd250M or USD32-35M). Modern Dental is already dominant in Europe in Australia, and Hong Kong (>50% market share for HK). Modern Dental now has the scale in America, but the change in management and operations needs to be reflected in the bottom line. China has poor margins due to fierce competition, but this is compensated with growth due to increased disposable and discretionary income from a large population (the entire industry in China is growing at 10-13% CAGR).
 
Modern Dental does not plan to carry out large scale re-financing on all bank loans. Their plan is to use different bank loans facilities to gradually re-finance the outstanding bank loan due within 1 year (2021) or pay down loans using extra cash (USD 55M). Modern Dental has around USD 95-100M (HK$700-800m) bank loans and USD25M (HK205m) in lease liabilities. In addition to this there is a 20M revolving credit for contingent needs. Modern Dental is repaying this sum gradually as there is still the expenditures of phase II of Dongguan plant in the near future.
 
Modern Dental currently trades at 0.8x trailing twelve months enterprise value to revenue, at a USD 450-500M valuation, if debt and cash remain at the same level, this would be 1.7x TEV/revenue. There aren’t any comparable operators of modern dental’s scale, since they are either in the manufacturing of dental machinery such as intra-oral scanners, milling, etc. or they are dental clinics. Based on a share count of 962.5million, this would result in hkd$3.6 per share. While buybacks have been 1% of float and is negligible, management may make a greater commitment in the future. The reduction of debt brings an upside, but intrinsic value may grow if operations in America improve and when utilization rates improve after phase 2 of Dong Guan's lab opens.
 
 
 
 
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 
 
- Layoff of technicians in USA and China
 
- Increase in capacity due to DongGuan Phase II and a new factory established in Vietnam
 
- Huge Runway for attacking the Trios clear aligner market for the aesthetically concerned crowd.
 
- Once RTFP/ MicroDental becomes a cash flow contributor, assuming sales jump up from 65M to
110M; I assume that a modest 10-20M of cash flow is possible.
 
- Other contributing factors include obtaining valuable patents and signing a J.V with the Swiss
company Straumann (SWX:STMN), which produces state of the art dental implants and screws (fully
tapered, BLX, two piece, and four piece implants).
 
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