Description

This is another quick-hitter on a recent IPO and will again, like our recently published FTCH short write-up, be lacking in content. Also like that write-up, we see scenarios under which the company is worth something in between a lot less and zero plus a little, so we’re much more focused on ensuring we’re on the right side of one or two glaring issues than we are about burying ourselves in the minutia (which, don’t get me wrong, we’re guilty of plenty of the time, as per our other recent write up on FRAN). The other couple similarities are that we’ve spent enough time understanding the legitimate bull case for this industry’s structure that I’m sure longs are going to instinctively lob a bunch of grenades in their replies – of course, the fact that folks get giddy about top down industry addressable markets helps them ignore management obfuscation of real-time negative inflections in bottom-up fundamental performance, massive and unabating cash burn, and nefarious (to put it lightly) practices, all of which this company in particular is just teaming with. Hence, some very smart people who think this industry’s market is enormous and growing (and that a somewhat perfect pricing umbrella exists within it) are providing us with an exciting commercial opportunity, but also one I find fascinating intellectually and saddening from a human and investigative journalist perspective. The last similarity to our recent write up is that we’re publishing it within less than a one-day trading window between now and the earnings release. Not that it matters too much but we do this because I don’t love when folks tell elaborate tales just to shake weak hands out of a stock and then cover without taking fundamental catalyst risk for the print. I get the premise behind that style but it doesn’t sit well for us, especially when we sense the company-in-question’s business practices may have shifted from fake-it-til-you-make-it sales aggression to something worse (at least as the FTC defines it) in real-time. 

So without further adieu, the company is Smile Direct Club. You’re terribly let down, I know, especially with the rambling intro. Not to mention Hindenburg already put out a recent and somewhat overwhelming stack of evidence that I’d from most angles recommend over what I’m about to posit, save for a few meaningful items that I can’t help myself from stating a bit more tersely and with an appropriate storyline/chronology. So maybe just read or at least skim that thing and come back to me….(long pause for a long piece)…..ok ….you back?

3 items. The lack of market focus on how the company’s manufacturing shifted in the last year (right as they were preparing for the IPO), the ensuing customer (and incipient regulatory) response which is building to a fervor pitch over the last few months and especially weeks, and finally, the ensemble of data and sources and primary research efforts employed to suggest demand is decelerating rapidly in recent months. Best told in bullet-point story format.

-        -  There is an interesting history between ALGN and SDC that I’m not going to rehash but for the part that is seemingly always left out. Yes, ALGN sold their stake and can’t compete at the retail level until 2022 and yes, SDC has an agreement to use their scanners until then. But recently ALGN was still actually making the aligners for SDC. Manufacturing largely just shifted to SDC’s own Tennessee-based facilities, incidentally right before SDC’s IPO. The significance of this cannot be overstated, as multiple former SDC execs, including the former CIO, outlined to us in detail as of last week. To put it mildly, that transition has been an unmitigated disaster, unlike what has been suggested in Citigroup’s initiation report among others apprehensively bought by the market -- Citi said the company had minor issues in the beginning of July that were amended by the end of the month. To the contrary, the manufacturing and product quality issues have ballooned to a degree that is about as alarming as any consumer blowback we’ve seen in our time investing in consumer-facing media and retail businesses over the past 15 or so years. Huge numbers of consumers are receiving aligners that don't fit. They are cracking and breaking and causing cuts and god knows what else from an actual dental, medical perspective. Indeed, things have gotten far worse, not better.

-         - What’s exacerbating the dramatic fall-off in product quality since SDC fully took manufacturing in-house is that they’re more aggressively than ever pressing the panic button to hawk product in order to make numbers, now that they’re public. They’re doing this by not only paying the on-staff orthodontists per-accepted application, but firing folks who don’t meet quotas. While this was common practice on the margins over the last couple years, our evidence shows the magnitude of their willingness to blur these lines has widened especially in the last few months. To quickly exemplify, we spoke to several former on-staff dentists who expressed that the standard acceptance rate should be 20-30%, whereas the actual forced acceptance rate is being pushed towards 80%. This has lead to what the former CMO described as “the beginning of a consumer uproar, based on quality of patient care declining.” So we took a look at consumer reviews to see what he meant. At first glance, we didn’t know what we were missing, the reviews on google and the company’s own website looked by and large fine. But what we didn’t realize originally (and figured out once we visited stores) is that SDC incentivizes potential customers to write positive reviews after their initial screenings, before they’ve even used the product. Of the roughly 500 reviews on HiYa, most all are split between 1 and 5 with very few in the middle. But virtually all (98-99%) of the positive reviews are commentary on an initial interaction with a salesperson. In fact, of the ~500 reviews there were only 2 positive (we define positive as 4 or 5) who actually completed using the product. On the other hand, the negative reviews are, in a word, violent. When I read the Hindenburg report the citing of specific, detailed examples was helpful, but it also took away from the sheer magnitude of what is happening (a la 1200 better business buereau submissions), and the constancy of the bewildered and concerned tone of the voice. Please read them yourself. I can’t imagine any reasonable person ever using or recommending this product to anyone they remotely care about subsequent to reading them. Most important though is the cadence of negative reviews submitted, which more than doubled from the second quarter to the third, and then are on space to more than triple between the third and the fourth. All of this is bubbling into a not-too-distant legal backlash and regulatory upheaval of epic proportion, which will destroy the value of this brand enough to all-together squash the broader structural opportunity that might otherwise exist.

-        -   As we outline in our prior write-ups over the last year or so (PETS, FTCH, FRAN) we track an array of data sources which, as an ensemble, help us prognosticate changes in consumer demand. SDC is no different. The core demand drivers are deteriorating, as per web traffic, credit card, social media, and other indicators. What is different for SDC is that they’re a very recent IPO, which means with even a modicum of thoughtful planning they’ll have placed the first couple quarters in the bag (especially after having cut guidance during the pre-IPO process to ensure as much), and I’m sure they’ll be able to obscure what’s happening for some period of time.  Their window is shorter than I’d otherwise estimate for a couple reasons. One is that we’re just entering the 1^st inning of an avalanche of outcry that will bombard them in quarters to come. Not just from the dental regulatory bodies of Georgia and Alabama (recent), or the state of California outlawing their process as it stands (a few weeks ago), but opposers ranging from consumers themselves to the federal bodies put in place to protect said consumers. The other thing as that CD&R is deeply involved, which, in other instances might be viewed as a risk to betting against SDC. But they have a long-standing rep for integrity as much as they do thoughtful investing, so I have to imagine they’ll oppose the company carrying out the façade or feigning mea culpa just to bide more time. They’ll want to protect the brand enough such that even if the the equity value flirts with worthlessness they have the opportunity to do what they do well and turn this thing around. At this rate they won’t have that chance unless they move swiftly.

Oh, one last thing. I said earlier I’d never seen a company with such offensive and overwhelming consumer reviews stemming from product issues, among other misgivings. Let me amend that to say I’ve never witnessed a public company in that vein. There is one company these product reviews remind us of. The other item that reminded us of the prior company are the many interviews we’ve had with frightened former employees and feedback from the multitude of consumers forced to sign stand-still agreements just to get their money back when they didn’t receive the product (let alone the lineup of customers, I line that is going to grow exponentially, who months later are far worse off having used the product than if they’d not received it in the first place). That company too made claims that flew in the face of scientists and practitioners bidding fair-warning, and it pawned off someone else’s technology as its own, only to the embolden the magical claims said technology could achieve in its hands only. That company was Theranos.

I know. You think this is absurd. It can’t be that bad.

Let's wait and see.

Catalyst

There are innumerable items I’m not mentioning, such as a plethora of competitive entrants, further illegalization of the company’s process, the funding of growth through providing consumers credit, which, once the regulators swarm, I cannot possibly imagine consumers will actually have to pony up for, valuation (don’t get my started), corporate governance, etc. But on this one we’re not trying to convince you, we’re just telling you. It’s really bad.