Description

Thesis: Schick Technologies (SCHK, $12.00, OTC BB) is the market share leader of digital x-ray equipment for dentists in the U.S. SCHK trades at a higher P/E than most "values", but I think the stock is inexpensive given revenue growth of 37% y/y, operating margins of 30%, and an annualized ROIC of 97% last quarter. The stock is cheap because of a SEC charge relating to a restatement of the Company’s 1998 earnings. The SEC charge poses little financial risk to the company, but management has so far opted not to apply to list on the NASDAQ pending SEC resolution. SCHK has therefore traded OTC for the last five years with little attention from institutional investors. I believe SEC resolution is likely in the next six months.

Basic Stats:
Price = $12.00
Shares = 17.1 M
Market Cap = $206 M
Cash = $21 M
Enterprise Value (EV) = $185 M
LTM (FY04) Revenues = $39.4
LTM (FY04) EPS = $0.72
LTM FCF = $13.5M
Average Daily Volume = 18,000 shares.

Valuation:
LTM (FY04) P/E = 16.6 x
NTM (FY05) P/E = 17.4 x*
EV / LTM FCF = 13.7x
EV / NTM FCF = 14.9x
EV/LTM Sales = 3.4x
EV/NTM Sales =3.8x
ROIC = 97%
ROE =52%

Estimates:
I believe the following estimates are very conservative:
NTM (FY05) Revenue = $48.3 M (23% y/y)
NTM (FY05) EPS = $0.69*(assumes gross margin of 70%, operating profit of 31%, and a tax rate of 38% beginning in Q3 and Q4 )
1Q05E (June) = $10.9 M
1Q05E (June) = $0.18
NTM FCF Estimate = $12.4 M

*The company currently has a net operating loss carry-forward (NOL) and pays negligible cash taxes. I estimate the company will begin paying taxes in the December quarter of 2004 (3Q FY05).

The Market:

I believe the U.S. is now at the “tipping point” of adoption for dental digital x-ray for the following reasons:

- Digital x-ray has currently penetrated roughly 15-20% of U.S. dental offices. This compares to much higher penetration rates in Europe (60% of dentists in France today use digital x-ray equipment as a result of insurance company incentives.)

- Digital x-ray technology has been “mainstream” for more than five years. The technology is now easier to use, creates better image quality, and is now available using a wireless connection.

- Familiar dental companies are now focused on the digital x-ray opportunity. Patterson Dental Company (PDCO), the largest distributor of dental supplies and equipment to dentists in the U.S, has aggressively promoted Schick equipment in the past year. Kodak also recently purchased a French dental digital x-ray company, Trophy Radiologie, through its acquisition of PracticeWorks (PRWK) in October 2003 for $468 million.

- Most dentists plan to purchase a digital x-ray in the next 6-24 months. This information is from multiple discussions with dentists, and is general industry knowledge.

- New Tax Law Incentives and Lower Interest Rates. With the new tax law changes and lower interest rates, many dentists have financial incentive to finally buy digital x-ray equipment . For example, the initial write-off amount of certain equipment (Schick’s digital x-ray included) increased to $100,000 in 2003 from $25,000 in 2002. The maximum initial depreciation amount in year one also increased to 50% in 2003 from 30% in 2002. Many dentists are aware of these tax benefits, which have been extended through the end of 2004.

Revenue Mix: Schick’s digital x-ray equipment is sold domestically through Patterson Dental. Patterson Dental accounted for 55% of the Company’s revenues in fiscal 2004. Schick has sold exclusively through Patterson in North America under an agreement signed in April 2000. The Patterson Dental contract renews annually and is as important to Patterson Dental as it is to Schick, given digital x-ray sales help pull in Patterson Dental software sales. Patterson Dental said at Gabelli’s dental conference June 1 that it would be interested in extending the renewable one-year contract to a renewable three-year contract with Schick.

Other components of Schick’s total revenue include: International (25% of revenue, growing 90%+ y/y in the latest quarter), U.S. government, and accuDEXA (1% of revenue.)

Product Description: The majority of Schick’s revenue comes from sales of the Schick CDR sensor, an intra-oral digital sensor. Schick’s digital sensor retails for approximately $9,000 and the Company receives roughly half of this revenue when the sensor is sold through Patterson Dental in the U.S. The average U.S. dentist buys 2.5 sensors per practice. Schick has additional digital x-ray equipment offerings such as the USBCam and CDRPan. The CDRPan is selling very well in Europe, where it was introduced last quarter, but it is not currently available in the U.S. The CDRPan carries a significantly higher ASP than the digital sensor (I believe approximately $20,000.)

The digital sensor replaces the role of traditional analog film when taking an x-ray of a patient’s bite. The digital sensor is placed in the patient’s mouth where film is usually placed. The patient bites down on the sensor and is exposed to radiation via a large tube that is pressed against the patient’s cheek (this large piece of x-ray equipment already exists in all dental offices, and does not need to be replaced when using the Schick sensor.) The digital sensor captures an instant digital image of the patient’s teeth. This image is then sent via a wired or wireless connection to a nearby computer. The digital image can then be magnified and enhanced via imaging software. The image quality is of comparable or better quality to that of traditional x-ray film.

The benefits of dental digital imaging include:

-Reduced levels of radiation to the patient. Digital sensors are more sensitive to radiation than traditional analog film. The dentist can therefore reduce the level of radiation he/she must expose the patient to by up to 80%, allowing the dentist to take a greater number of x-rays and reducing patient exposure to harmful radiation.

-Cost savings. Digital development costs less than traditional analog film development. The dentist no longer needs expensive chemicals and paper, or a dark room.

-Easier storage and transportation of charts. The image can be stored electronically and e-mailed to other doctors and insurance companies, saving time and money as compared to using snail mail or courier service to transport sensitive photographic film.

-Greater diagnosis rates. Clearer and larger images enhanced by imaging software lead to greater diagnosis rates.

-Increased sales of dental procedures. Greater diagnosis rates and improved image quality (allowing the -patient to more visibility see his/her ailment) lead to increased revenue to the dentist.

Competition: Schick owns the majority of the dental digital x-ray market in the U.S. (my estimate is at least 60%.) Trophy Radiologie (French) and Sirona (German) have meaningful market share internationally. I believe Schick will be able to maintain its lead in the U.S. despite the recent entrance of Kodak (through its acquisition of Trophy) into the U.S. market and a digital x-ray offering by Patterson Dental’s largest competitor, dental distributor Henry Schien (HSIC).

Schick has a well-established brand name among dentists in the U.S., and its relationship with Patterson Dental gives Schick a competitive edge. Patterson Dental sales representatives have very close relationships with the dentists they serve, and see the dentists in person as often as once a week. Kodak, while a significant brand name, does not have this same personal relationship with the dentists. In fact, the majority of Kodak film is sold through distributor sales reps such as those from Patterson Dental. The other large distributor of dental supplies in the U.S., Henry Schein (HSIC), does not have a competitive offering in digital x-ray. Henry Schien’s Dentrix Image-ray sensor has been rumored to have technical problems.

After thorough research into private and public companies in the dental digital x-ray space, I have concluded that the players in the dental digital market include (in order of significance):

-Trophy Radiologie, S.A. (French, recently sold to Kodak (U.S., public, EK) through Kodak’s acquisition of PracticeWorks (PRWK) in October 2003.

-Sirona (German, private.)

-Henry Schien (U.S., public, HSIC.) Henry Schien’s product is called the Dentrix Image-ray sensor. The development and manufacturing of the Image-ray is outsourced to a company named SUNI (U.S., private.)

-Dentsply (U.S., public, XRAY.) Product is offered through Dentsply’s subsidiary Gendex.

-Planmeca (Finland, private.)

-Air-Techniques (U.S., private.)

-Dexis (U.S., private.)

-Lightyear (U.S., private.)

The SEC Investigation: Schick Technologies announced in 1999 that the SEC had launched an investigation into possible accounting fraud for the quarters ended June, September, and December 1998. More than four years later, on November 17, 2003 the SEC filed formal civil action against the Company. Management has so far opted not to apply to list on the NASDAQ pending SEC resolution.

The SEC charge represents little actual financial risk to the Company. I believe an injunction is the most likely penalty. David Schick’s recent resignation as CEO was a major positive step towards SEC resolution in the next six months. The Company’s former founder and CEO David Schick individually faces several more serious charges relating to the alleged accounting fraud. Jeffery Slovin, who joined the Company several years ago after the initial SEC inquiry, has replaced Mr. Schick as CEO. The SEC has not called into question the Company’s financial statements post December 1998, and I believe there is little risk to the company’s financial statements post 1998 given SEC scrutiny since that time.

Catalyst

- SEC resolution (it has been almost 5 years since the initial inquiry.)
- NASDAQ listing (the company currently satisfies all requirements to list.)
- Visibility. Gabelli & Co. recently initiated on SCHK, however, there is no other analyst coverage. Institutions own only roughly 7% of the shares outstanding.
- Earnings. The company’s growth rate may accelerate given that we are at the “tipping point” of dental digital x-ray, the company’s recent release of the CDRPan in Europe, and the pending release of the CDRPan in the U.S. The Company reports earnings for 1Q05 (June) August 12.