Ideas Lab: Pacific Smiles

How does McDonalds make its money? If you said by selling burgers and fries, you'd be wrong. As much as 80% of profits come from franchisees, where the business collects fees and high-priced rent, with margins of over 80%. 

McDonalds isn't a burger business; it's a real estate company.

Successful investing means uncovering what is true about a business and comparing it against what is thought to be true. It is about deciphering a clash of narratives.

We think we have uncovered such a situation right here on the ASX, a business that gets compared to, and priced as, an acquisitive roll-up but is actually a property business already generating decent returns.

Pacific Smiles looks like a dentistry business. There are 82 centres around the east coast carrying the Pacific Smiles brand and dentists from those centres see thousands of patients each year. 

Those dentists, however, aren't employed by Pacific Smiles; they run their own surgeries and service their own patients. Pacific Smiles isn't a dentistry business; it's a property business.

Serviced surgery

The company provides fully equipped surgical rooms and dental offices for dentists to lease. Setting up an independent dental surgery costs about $1m, a big expense for a newly minted dentist. 

On top of that, there are costs for patient and document management, inventory, marketing and administration to take care of complex insurance matters. No dentist wants to do all that. They would rather look inside patients' mouths. Cue the violins and enter, Pacific Smiles.

The company will outfit a fully equipped surgery complete with a waiting room, receptionist and dental assistant. 

It will buy and restock consumables, provide patient management systems, invoicing, marketing and administration to deal with Medicare and health insurance. Everything but the dental work itself is provided for, all for one fee.

This is an attractive deal for dentists. They can operate independently with no upfront cost, choose flexible working hours and work from many locations.

There are benefits for patients too, because surgeries can afford to be in more convenient locations like malls and office blocks and they are usually open seven days a week with extended trading hours. No independent dentist can offer that. 

Best of all, however, Pacific Smile centres have scale, so they can negotiate agreements with health insurers to provide patients with no-gap service. 

Dental economics

Because about 75% of Pacific Smiles' patients hold private health insurance, the majority walk out without paying a cent. 

It also means about half of Pacific Smiles' revenue comes directly from health insurers and it has agreements with 75% of the industry. It also has long-term agreements with Medibank and Nib, for which it operates branded dental centres.  

Pacific Smiles will typically sign up dentists to a service agreement for 1-3 years. Over that time, dentists pay a monthly service fee which is calculated as a percentage of patient fees. This means the businesses revenue is directly linked to the dentist's revenue.

The economics of each surgery are important to grasp and explain why an opportunity is present. 

When the business opens a new centre, it will build capacity for up to four dentists (four chairs), even though it takes time to fully occupy those chairs and build a patient base. 

For the first few years, a new dental centre will lose money and is a drain on aggregate profits. It will take, on average, about three years for a new centre to start generating profits. At this point, prebuilt capacity is fully utilised and returns start to look attractive. You can see this in Table 1. 

Before three years, however, expansion appears loss-making. Currently, about 35% of the company's centres are less than three years old. That's 29 centres from a total of 82 that are losing money and dragging down profitability.

Pacific Smiles thus faces a conundrum. To grow, it must invest in new capacity and face three years of losses and up to five years before showing decent growth rates. The true profitability of the business is being disguised by the decision to grow.

Rising fees

There is no doubt patient fees are rising. Since listing, same centre patient fees have risen 5.4% per year and, with growing centre numbers, patient fee growth has averaged 12% per year over a decade. Over that same time, operating profits have risen 17% per year, illustrating that the business does scale nicely. 

Yet earnings before interest, tax, depreciation and amortisation (EBITDA) of $21.5m understates potential profitability. 

Even if the business stopped growing, today's 82 centres should be able to match the long-term average per-centre profitability of $500,000, implying group operating profits of $40m. That's double last years reported EBITDA, and would suggest an EV/EBITDA multiple of less than 10. That's attractive considering the potential growth on offer. The business has outlined 250 locations for expansion. The growth runway remains long.

Double take

The raw valuation numbers don't look appealing. Pacific Smiles trades on a PER of 24 times and we know brokers and bank analysts typically compare it to 1300Smiles and Smiles Inclusive, which are traditional roll-ups: they buy established dentists and take ownership of running surgeries. 

The Pacific Smiles model is more akin to Servcorp rather than a traditional dental business. This misunderstanding is compounded by the appearance of poor profitability that reflects a deliberate decision to grow. 

For the patient investor, this is a potential opportunity. 

Management own plenty of stock and the founders remain on the board as major shareholders (although one recently sold down stock). Interestingly, the private equity firm that originally floated Pacific Smiles has bought nearly 20% of the stock on market. We've never seen that before.

The business is not impregnable - there are low barriers to entry and little to keep out determined competition - and we disapprove of management's decision to take on debt to maintain overly generous dividends. It is also capital intensive and it will take time to realise potential profitability. 

These reasons, along with low liquidity, are why Pacific Smiles didn't pass our internal review. 

For those willing to take on a little more risk or to do their own homework, here lies a decent quality business run by able management at a cheap price. We think it is sorely misunderstood and, potentially, mispriced. It might be worth a look. Just don't call it a dentist. 

Disclosure: The author owns shares in Pacific Smiles.