dentalcorp Stock: Dental Roll-Up Strategy Growing Too Fast (OTCMKTS:DNTCF)

As a young MBA student, one of my ‘brilliant’ ideas was to do a roll-up strategy in dental practices to capitalize on the demographic trend of baby boomer dentists retiring and needing to sell their practices. Unfortunately, I got a job in equity research soon after graduation and never pursued this concept.

However, someone else had a similar idea and they actually pursued it to fruition. dentalcorp Holdings (TSX:DNTL:CA) is a fast-growing Canadian dental practice roll-up with 545 dental practices in its network.

Although I like the concept, I am concerned that dentalcorp’s corporate structure is introducing a lot of unnecessary costs to the simple business of operating dental practices. Furthermore, dentalcorp financed its growth with cheap floating-rate term loans that are now causing the company angst due to higher interest rates.

Until I see the company focus on returns instead of growth, I recommend investors stay on the sidelines.

(Author’s note, financial figures quoted in this article are in Canadian dollars unless otherwise stated)

Company Overview

dentalcorp Holdings is Canada’s largest network of dental practices with close to 550 practices in its network. The company was started in 2011 by Graham Rosenberg, a Schulich MBA graduate (Figure 1).

The company’s business model is to be the ‘acquirer of choice’ for leading dental practice owners looking to sell or find a partner to grow (Figure 2).

dentalcorp typically looks to acquire practices with $2.0-3.0 million in revenue and $450-500k in EBITDA (15-25% margin) (Figure 3). The company believes that over 5,000 practices meet dentalcorp’s criteria within Canada, giving the company ample runway for growth.

dentalcorp’s primary investment pitch is its ability to drive revenue and cost synergies through its economies of scale, with the average practice expected to see a 10-15% increase in EBITDA margin post-acquisition (Figure 4).

Dentistry Is A Lucrative & Resilient Business

Dental services is a ~$20 billion market in Canada employing over 100,000 dentists and hygienists. Dentists provide an essential and highly recurring service insulated from economic cycles and disintermediation from technology (Figure 5).

According to dentalcorp., the average practice in its network generates $2.7 million in revenues with 22% EBITDA margins (Figure 6). So it makes sense that dentalcorp would like to consolidate this highly lucrative and recession-proof industry.

Something Doesn’t Add Up

With such an enticing story, one should expect dentalcorp’s share price to steadily increase, as the company acquires practices, squeezes out synergies, and creates shareholder value. Unfortunately, that has not been the case, as dentalcorp’s share price has been cut in half since its IPO in 2021 (Figure 7). What gives?

In my opinion, the biggest issue with dentalcorp is the fact that its financials do not match the rosy story pitched by management. For example, if we look at DNTL’s 2023 financial results, the company generated $1.43 billion in revenues and $260 million in adj. EBITDA for an EBITDA margin of only 18.2%, far below practice-level margins (Figure 8).

Investors should note that dentalcorp’s adj. EBITDA already generously backs out M&A expenses and gains/losses on disposal of non-core practices. For a serial acquirer, I believe these expenses should be included in a proper analysis since they are part of DNTL’s core acquisition-focused business model (Figure 9).

Nonetheless, the company started with a 22%+ practice-level EBITDA (Figure 6 above) and ended up with an 18% corporate EBITDA. This means instead of creating synergies and ‘adding value’ as the company’s marketing materials suggest, dentalcorp’s layers of corporate management have detracted more than 4% in EBITDA margins from the highly lucrative dentistry business.

Company Saddled With A Billion In Variable Rate Debt

While high levels of SG&A may be undesirable, the lucrative nature of dentistry should more than offset some corporate bloat. After all, there is a reason so many dentists become multi-millionaires over their careers.

However, another major issue with dentalcorp’s business model was its hyperactive growth by acquisition strategy fueled by cheap debt. To expand its network from 10 to 545 practices over the past decade, dentalcorp racked up over $1.0 billion in debts (Figure 10).

To make matters worse, instead of issuing fixed-rate bonds, dentalcorp chose to utilize floating-rate term loans and credit facilities. This worked great when short-term interest rates were at rock bottom levels, however, the same decision has come back to bite Dentalcorp as central banks have increased short-term interest rates dramatically to fight inflation. This has increased net finance expenses for dentalcorp from $68 million in 2022 to $93 million in 2023, or an increase of 37% YoY.

On a trailing 12-month basis, dentalcorp is operating at a 4.4x net debt-to-adj. EBITDA ratio, far above the company’s long-term goal of <3.0x (Figure 11).

Strategic Process With No Buyers

In a sign that dentalcorp’s prospects are not as rosy as management portrays, the company ran a strategic review process in 2022/2023 (costing a total of $7.9 million!) that concluded without a sale. According to the company, the board of directors felt that the offers the company received did not properly reflect the value of the business.

If sophisticated institutional buyers with access to dozens of investment bankers and dentalcorp’s proprietary data room could not find enough ‘value’ to bid for the company, why should retail investors feel they can value the business better?

dentalcorp Should Slow Down Acquisitions And Pay Down Debts

In my opinion, the best course of action for dentalcorp is to rein in its breakneck pace of acquisitions and run the company for cash flows to pay down debt. This will also validate the company’s pitch that it owns a portfolio of highly lucrative dental practices that can throw off lots of free cash flows.

Valuation May Be Penalized For Excessive Debt

With over $1.3 billion in debts and leases, every dollar of debt that is paid off will increase dentalcorp’s equity value, assuming the company’s valuation multiple stays constant (Figure 12)

In fact, at 8.8x Fwd EV/EBITDA, dentalcorp may be trading at a valuation discount compared to its medical practice peer, Well Health Technologies Inc. (WELL:CA), because of its excessive debt load (Figure 13). So a reduction in debt may result in an expansion in valuation multiples.

Risks To dentalcorp

In my opinion, the biggest risk to dentalcorp remains its breakneck growth rate. Judging by the $23 million in writedowns the company took in 2023 to dispose of some underperforming practices, dentalcorp may be growing too fast with insufficient due diligence on acquisitions.

Conclusion

dentalcorp is a fast-growing dental practice roll-up in Canada with over 500 dental practices in its network. The company believes it has a long runway of acquisition-led growth within Canada and beyond.

However, operating performance for the company has been disappointing, with corporate EBITDA margins below that of standalone dental practices, even after realizing dentalcorp’s supposed ‘synergies’.

Furthermore, the company relied heavily on floating-rate term loans to fund its growth. With short-term interest rates held higher for longer by the Bank of Canada, dentalcorp is feeling the squeeze.

In my opinion, dentalcorp should slow down its pace of acquisitions and generate cash flows to reduce its debt burden. This will give the company time to optimize its portfolio and may even lead to a valuation expansion.

Although I like the dental practice roll-up concept, I am initiating dentalcorp with a hold rating until I see the company focus on value instead of growth.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.