Two reopening stocks to get your teeth into
I’m normally good with dental appointments but confess to ignoring a few recent reminders from my dentist for a check-up. Like many, I was put off by COVID uncertainty.
Restrictions in March 2020 limited dental services. Routine examinations and treatments were deferred and many dental practices temporarily closed or only offered emergency treatments.
Most dental practices reopened in May 2020 when restrictions eased but COVID fears and consumer uncertainty hurt industry revenue. Cancelling or deferring an annual dental check-up was easy for those worried about losing their job or COVID health risks.
Listed dental groups have reported a rebound in activity in the second half of 2020. The market expects the recovery to strengthen, judging by share-price rallies in key dental stocks.
I’ve been scouring the market for “re-openers” – stocks that will benefit when vaccines arrive and life returns to some kind of normality.
Obvious candidates are travel, tourism and education stocks, but the market has already priced in a recovery, even though the risk of local COVID outbreaks remains high.
Dental stocks rarely feature in discussions about “reopener” stocks. ASX has few dental stocks and dentistry demand after COVID is not high on investor radars.
I suspect there will be a bigger rebound in dental demand in FY22 when people become confident the worst of the pandemic is over.
Also, there’s more to dental stocks than rising demand for their services. I’m as interested in the supply side: the number of new practices that can be bought at lower prices.
Like many healthcare services, dentistry has had its share of industry aggregators over the years. Cashed-up corporates buy small dental practices and try to consolidate a fragmented industry. Done well, this strategy creates economies of scale and can build wealth quickly.
Too often, the strategy ends in tears. This market has a long history of industry aggregators that destroyed shareholder wealth. They overpaid for firms, underestimated the challenges of integrating them, and were left with unhappy practitioners in their network.
Smiles Inclusive, a dental aggregator, was the latest disaster. It listed on ASX in April 2018 and once said it wanted to be “the Flight Centre or Specsavers of dentistry”.
In February 2020, the ASX suspended Smiles Inclusive from trading after concerns about its financial health and continuous-disclosure obligations. Several dentists left the group and some were reportedly locked out of their practice. ASIC threatened legal action.
I’ve followed dental stocks on and off for years. Dental practices, it seems, are much harder to acquire and integrate into a corporate model than the market realises. Investors crave rapid growth through roll-ups, but rarely is it sustainable. Steady growth is best.
The upside of Smiles’ demise is less corporate competition to buy dental practices. The market’s best listed dental operator, 1300 Smiles, says there are now more opportunities to buy practices at a fair value because the market is no longer overheated.
Managing director Dr Daryl Holmes said in his November 2020 AGM address: “The (dentistry) landscape has changed to a startling degree. … There are now fewer big players actively pursuing acquisitions in the dental industry than at any time in the last decade.”
That’s good for 1300 Smiles and its listed peer Pacific Smiles Group. The key to roll-up strategies is not overpaying for practices. Smiles’ problems could lead to fewer corporates buying small dental practices and fewer dentists selling to newcomers.
Dentistry is highly fragmented. IBISWorld estimates 16,142 dental practices in Australia deliver a combined $10.1 billion of revenue. Many are owned by baby-boomer dentists who will look to sell their business and fully or semi-retire in the next five years.
COVID might hasten their exit. Volatile trading conditions, rising compliance costs and higher operating expenses strengthen the argument for sensible industry consolidation.
Industry incumbents such as 1300 Smiles should have a good few years ahead thanks to less competition for acquisitions and a rebound in consumer demand.
At current prices, I prefer 1300 Smiles to Pacific Smiles Group, which has rallied in the past six months and looks fully priced. Dental-products firm SDI is another beneficiary of a dental recovery.
Pacific Smiles Group (PSQ)
1300 Smiles (ONT)
The Townsville-based dental chain has been a steady performer for years. Since its $15-million float on ASX in 2005, 1300 Smiles has grown into a $145-million company.
Its network has 34 dental practices in Queensland and New South Wales. 1300 Smiles usually acquires a few practices each year – a measured approach that has worked well for the company and for dental firms that join the business, over a long period.
The market knock on 1300 Smiles is that its acquisition strategy has been too conservative. Some fund managers I know wanted 1300 Smiles to make more acquisitions each year and drive faster earnings growth and higher valuations. The company’s conservative approach looks like a masterstroke after so many roll-up implosions.
1300 Smiles said there was an “enormous rebound” in business activity after the peak of COVID disruption in April and May 2020. “Revenue has rebounded to new levels well above those of the previous year. This rebound became apparent in June 2020 and has continued.”
1300 Smiles in 2019 missed out on acquiring the Australian business of NZ-listed Abano Healthcare Limited (Maven Dental). But it’s been quietly acquiring small practices, most recently in Bundaberg in Queensland.
The company said: “In the current environment, we expect we will complete a bigger proportion of all potential acquisitions because it is now less likely we will face competition from other buyers who might be willing to pay more than we think a given practice is worth.”
1300 Smiles has rallied from a 52-week low of $4.69 to $6.80. The three-year annualised total shareholder return to January is about 5%, Morningstar data shows.
I doubt the market has fully priced in 1300 Smiles’ rebound in activity or its potential to acquire more practices in the next few years, at reasonable prices.
1300 Smiles (ONT)
SDI makes and distributes dental-restorative materials and whitening systems. Its products are sold in more than 100 countries, making SDI Australia’s largest dental-products manufacturer.
Established in 1972, SDI was known for its Riva restoratives (fillings) that dentists use on teeth to stop decay. In the past decade, its product mix has shifted more to whitening and teeth-aesthetics products. Amalgams used for fillings were only 13% of its sales in FY20.
COVID halted SDI’s record sales momentum in the first half of FY20. Government restrictions on dentistry limited demand for SDI procedures. Full-year sales were up 15% to $67 million.
SDI has done a good job during the pandemic. Its management and directors took big pay cuts, inventory was rationalised and operating expenses fell.
SDI was profitable in the second half of FY20 despite awful industry conditions and dentists providing only emergency treatments for a time.
In a December update, SDI said it had a strong first quarter for FY21 in most of its regions, even though its UK sales were savaged (thanks to rampant COVID there).
The company said its product-mix strategy was on track with continued growth in whitening and aesthetics, and decline in amalgams. Whitening products have good long-term growth prospects as younger people invest in domestic dentistry to brighten their smile.
SDI said it would be debt free by December – another good sign. Recent product launches are performing well and the company expects to release 1-2 new products each year.
However, the market paid little attention to the trading update. SDI shares have edged lower this year. From a 52-week high of $1.05 in February 2020, SDI fell to 65 cents. It has recovered to 75 cents, lagging other dental-related stocks.
Like many thinly traded micro-cap stocks, SDI is not well covered by brokers and has a low market profile. That’s a shame: SDI has been around a long time, built a global business and is leveraged to a recovery in dental services (and products) in the next 18 months.
SDI and 1300 SMILES suit experienced, long-term investors who understand the features, benefits and risks of micro-cap investing.