Monday, July 27, 2020

Modern Dental Group



Description

Modern Dental Group Limited (HK stock code: 3600) manufactures and supplies custom teeth replacements, retainers, dentures, and fixtures, and sells them to dentists and dental labs through wholly owned distributors. Since 2011, Modern Dental strategically bought out its European distributors for 2-3x earnings and acquired 11 or more of its 21 original distributors it has known since 2001— spanning various geographies.

In 2016, expansion into North America through a USD 65-70 million acquisition for MicroDental/RTFP for 22 clinics, which was previously operated by a private equity firm, required fixing. Prior to the acquisition, MicroDental lacked industry knowledge and proper management—inventory for costly rare metals and ceramics in form of porcelain powder were wasted, and MicroDental kept on expanding at a loss. It has taken Modern Dental 3 years (2016-2019) to turn around the entire situation with MicroDental.

Due to this incident, the stock price fell from listing price of hkd 6.5 to 1.1.

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. Since her arrival, 4 clinics have been shut down, and products or services which have lower margins were completely removed. As of 2020, MicroDental is now slightly profitable.

Modern Dental’s main manufacturing base is in Shen Zhen, but they recently bought a new piece of land and plan to relocate to Dong Guan, China, in 2019. Phase I saw a relocation of 1300 technical employees, from Shen Zhen to Dong Guan. Phase II will improve capacity with another 1500 technical staff, but is delayed by the Corona Virus. As of early 2020, the total number of technical staff is around 4350



Modern Dental’s products and services:

Fixed prosthetic devices— such as crowns and bridges, comprise of 70% of sales

Removable prosthetic devices—such as removable dentures (fake teeth for the elderly), comprise 20% of sales

Orthodontic, sports guards, and anti-snoring devices contributes 10% to sales – Modern Dental is the distributor for invis-align in Australia. They also have their own brand— Trio Clear Align, which is currently only in Hong Kong and Macau, but will be expanding to other countries once licenses and certifications are obtained. While Trio Clear only makes up less than 1% of sales, it is one of Modern Dental’s most promising products for future growth.

Replacements for teeth are due to aging, cavities, accidents, etc. These replacements come in the form of crowns, dentures, or fixtures. Crowns and dentures requires a specialist or technician to shape— the color is picked from a palette to match the client’s existing teeth, color, size has to be exactly right, etc.

This is not cost effective for small dental labs to produce and they would rather outsource and procure this service instead. For example, in North America, an order is made to Modern Dental—the specifications are obtained either

  1.         through biting into a mold to prepare a cast
  2.      or through an intra-oral scanner (digital copy);

 Results from CAD-CAM are either sent to local production facilities with 10 or more staff for urgent orders or specifications are sent to China. After production is tailor made-- parcel are shipped via air for immediate delivery. 

Casts of your teeth which harden to form a mold, are bulky but precise, but increase the weight and shipping cost. Intraoral scanners are adopted by 15% to 35% of most labs to reduce processing time and streamline the entire process to a digital one. Intra-oral scanners cost approximately USD 20,000-30,000 per model.


Industry/ Market Size

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.

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).


The Business/ Competitive Advantage

Modern Dental has four main processing centers which dentists send to after obtaining results from an intra-oral scanner or cast. The patient’s specifications are mainly sent to a lab in Dong Guan or Shen Zhen, China, and are shipped via a parcel to the dental lab. Urgent orders from Europe, such as France, are processed in Madagascar. There are processing labs in North America; Melbourne, Australia; and Emmerich, Germany.

The main manufacturing lab is in Dong Guan— as of now, only phase I has been completed; Phase II has been halted due to the Corona Virus. Tangible book value of Dong Guan(land, building, equipment and labs) are around USD 27 million.

Modern Dental’s operating model is not unique, but due to scale and CAD-CAM technology, they are able to facilitate dentists in reducing processing time and provide extra support for special cases.

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. Since 2011, Modern Dental has acquired more than 10 of their 21 distributors from Europe, Australia and USA which they have collaborated with since 2001.

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).

As the industry begins to use less casts, and embraces digital technology with intra-oral scanners— Modern Dental should realize economies of scale. They will be the lowest cost producer with the highest quality, coupled with proper international training facilities.

Modern Dental is no longer just business to business— the entire manufacturing process for Modern Dental has been transformed into a vertically integrated assembly line.


Ownership structure
49.26% of the company is held by the Chan family
16.74% of the company is held by the Ngai family
28.9% is free float.



Negligible impact from Buybacks

As of 2020, 962.5M of shares were outstanding. So far, buybacks are too small and negligible (1% of float) to have a significant impact on contracting shares outstanding.

In 2016, 996M shares were outstanding. In 2019, after a miniscule 21.4M shares of buybacks, 967M shares were outstanding.


The four most important factors contributing to Modern Dental’s future prospects are:



1     Per Capita Income 
       Govt. Subsidies/insurance affecting dental penetration rate of countries 
       Growing Elderly Population

With very few exceptions, tooth replacement for your average family is an out-of-pocket expense. Certain non-economic factors, such as public healthcare schemes and private insurance policies influence the willingness to seek dental prosthetic treatment. Government subsidies and reimbursement plays a huge role in Modern Dental’s sales. Another factor is the number of dentists and per capita income. Estonia has the highest ratio of dentists compared to its entire population, yet since its per capita income is half of USA— Estonian locals don’t really have the excess income to for dental treatments— dental care account for 74% of out-of-pocket expense.

For example, South Korea has the highest penetration rate for dental implants in the world— more than 70% of the dentists in the country place implants. Since reimbursement in South Korea was gradually introduced for senior citizens in 2014, this resulted in many listed dental companies and a growing industry. With a population of 51 million, they have around 22,950 dentists. Despite a much smaller population than China or USA, subsidies have induced patients and elderly to fix their teeth.

By contrast, large economies like China and India remain heavily underpenetrated due to a lack of qualified dental professionals. For China, there are only 130 dentists per million head count. With a population of 1.4 billion people, there are only 137,000 - 140,000 dentists. You would think because of scarcity, salaries should be sky high. A dentist’s salary in China is about USD 100,000 annually before tax.

Australia has a population of 25 million and has approximately 13,250 dentists. Modern Dental has a large presence in Australia, but in 2012, the government’s dental medical care coverage called the “Chronic Disease Dental Scheme” (CDDS) was terminated. As a result, the year before implementation, Australians rushed to fix their teeth; the industry became relatively stagnant afterwards. This diminished sales right after Modern Dental acquired Southern Cross dental in 2015 was bruising to sales.

The U.S has around 300 million people and approximately 180,000- 200,000 dentists. The number of patients treated per 10,000 adult population in the US is only half that of Italy and only a third that of Spain, the largest European market.

Europe has a population of 740 million with approximately 400,000 dentists. For example, in Germany, France, and Belgium, dental prosthetic treatments are partially covered by the public healthcare schemes, but the Netherlands has only private insurances available for dental care. In addition, French and Belgian governments grant additional reimbursements for dental prosthetic treatments for underprivileged citizens.

This illustrates the considerable growth potential for Modern Dental with its huge acquisition of Micro-dental— claiming 18 clinics in the US. Penetration in other highly populated countries like the UK, India, China and Japan is also clearly below average, offering strong upside potential in coming years.

The last point would be the increasing number of elderly citizens globally—patients over 65 years old are increasing their dental expenditures by 20%, and due to quality of health, people will be living longer. In 2015, there were 901 million people who were over 60. By 2030, there will be 1.4 billion people over 60.


2       Managing 4200-4500 technicians— optimizing labor force and utilization rate

Capital expenditures on equipment and raw materials aren’t the main concern for Modern Dental. For milling and processing machinery, German suppliers such as Datron AG’s machinery sold to Modern Dental depreciates in 7-10 years.

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.

Currently EBIT margins are at 7-10%. In 2013, it was as high as 21.5%. 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.  

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. It takes more than 2 years to train a successful and competent technician. Land, building, and equipment in Dong Guan was purchased for a total of USD27M. Turnover won’t be as rampant.

However, with Phase II completed, the head count will increase from 4500 technicians up to 6000.

North America        400
Shen Zhen          2,200
Beijing                    190
Dong Guan 1       1300
Dong Guan 2       1500 (halted due to virus)


Labor costs will only increase in China and utilization rate or the efficiency of technical staff is always a concern.

Modern Dental has 6139 employees, of those employees, there are 4300 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 70-80% utilization and can be ramped up to 85-90%. Management has also mentioned about the possibility of opening a factory in Vietnam to reduce labor costs.


3      Over reliance on acquisitions-- discipline to sit on cash and not to do foolish things

Acquisitions have been a doubled edge sword. Modern Dental can’t grow with an infinite amount of acquisitions—roll ups are not sustainable. Modern Dental’s market cap, as of July 2020, is close to USD 160-195M. Since 2013, Modern Dental has made 195M of acquisitions—66% of acquisitions were great to moderate prices—Modern Dental acquired some European distributors for 2-7x ebitda.

 In 2016, management was desperate to make a big acquisition to improve Modern Dental’s presence in the United States. This acquisition includes 22 dental labs, stretching from East Coast to West Coast, with labs even in Canada (Ontario and Vancouver). Modern Dental paid USD 65M for a RTFP from a private equity which had poorly managed, and was hemorrhaging cash at an annual loss of 10M.The last 33% or 65M, was for MicroDental/ RTFP, was painful and while it expanded their reach, required a lot of fixing.

Micro-dental was previously owned by private equity, hence the poor management due to a lack of understanding of the industry. They thought that if there was a fixed cost, if there were additional sales at a low price beyond the fixed cost, they would make a profit. It doesn’t work that way.

MicroDental was employing the wrong strategy- the company divided into different sectors based on quality and income. New CEO Laura Kelly is fixated only on high margin products while gradually phasing out low margin offerings. Laura Kelly was appointed as the new CEO; she previously worked for Micro-Dental as vice-president of sales for 17 years and founded her own company which was acquired by Dental Services Group. She understands the culture and knows what is like to start a company, but whether the culture can be changed and whether she can instill financial discipline is yet to be seen. She has appointed Robert Kreyer— an experienced technician, to be the director of implants and advanced dentures.

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.

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.

RTFP/ Micro Dental was purchased in 2016, and had a significant impact on the top line, even though it was not profitable. In 2016, RTFP/Micro Dental’s revenue contribution was not included—there were 214,810 cases at an ASP of USD 165, bringing in a revenue of 35M. With RTFP, 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.


 As of 2019, MicroDental has finally broken even with a marginal profit.

The acquisition of MicroDental has diluted the financial performance of Modern Dental in terms of operating and profit margins and has dampened return of capital. It was a bitter lesson learned by the management of Modern Dental. Since then, Modern Dental has slowed down the pace of its M&A activities and has held a much more cautious approach.



4      Quality Control and expansion of Trios Clear Align

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%.

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 Clear aligner, and Straumann are jumping on this opportunity. 

The standard price for Trio Clear 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, USD 100M can be added to the topline.


If these 4 conditions above are resolved, below are the following facts as to why Modern Dental would be a good investment:

--    Adequate valuation for suitable growth: Modern Dental trades at a P/E of 8.9x and 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%.

--    High ROIC: 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. Return on capital is currently 5%, 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%.

--    Teeth replacement a basic necessity: People will always need dentures and fixtures. The process of building a home has not changed materially in decades. Neither of these statements is likely to change in the next year, the next 5 years, or even the next 20 years. There is minimal technological or obsolescence risk. Also, since each individual requires a customized fitting, there is minimal inventory except for raw materials such as rare earth metals and ceramics.

--   Dominant in its markets: Modern Dental competes in 17 countries with over 70 sales and customer service centers and is the only multinational denture service —including Modern Dental Laboratory in Hong Kong (50% market share), Elysee, Permadental, Labocast in Europe, MicroDental and Modern Dental USA in North America, Yangzhijing in China, and Southern Cross Dental in Australia. It is in the top 5 in terms of market share despite the 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.


Capital Structure/Debt

A working capital of USD50M had been maintained for2015-2019. Leverage is now more conservatively financed— debt to equity has been decreased from 130% in 2014 to 50% in 2020.
Retained earnings has doubled from 62M in 2014 to 132M in 2019, while tangible book value hasn’t changed much at 250-270M despite large purchases of land, dental equipment, and hiring of staff. PPE has jumped from 17M to 88M from 2014 to 2019, but debt has held equity growth.

Modern Dental does not plan to carry out large scale re-financing on all bank loans of the Group.  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 unused 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.


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. 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 USD 400-500 million (currently, June 2020, HKD1.4B or USD179M) 14x underlying operating earnings (hkd250M or USD32-35M). Modern Dental now has the scale in America, but they have to fix the inherited poor management from the previous private equity owners, and they are dominant in Europe in Australia. 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 13% CAGR). 

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 X-ray scan, curing guns, etc, or they are dental clinics. Based on a share count of 962.5million, this would result in hkd$3.6 per share. Consistent buybacks and reduction in debt makes Modern Dental have a 61% upside, but intrinsic value may grow if operations in America improve and when utilization rates improve after phase 2 of the Dong Guan factory in China is open.
  

Catalysts
-        Huge Runway for attacking the clear aligner market for the aesthetically pleasing 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.
-        My base case assumptions is that some type of efficiencies of scale will start to take effect and affect the bottom line. Further increase in sales, capacity, and margin expansion is possible after Phase II of the Dong Guan factory is in operation.
-        Modern Dental has stable revenue from developed markets – N.A, Europe, and Australia.
-     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.
-         Leveraging a marketing and distribution network that serves over 200,000 dentists.




HKEX announcements
https://www.trioclear.com.au/

No comments:

Post a Comment