Potential Buyout – 25% Upside
The setup was previously covered here. Several months ago dentalcorp was approached by an interested party and launched a strategic review. An interesting nuance was that the largest shareholder L Catterton, a private equity firm with 40% ownership, wasn’t included in the special committee, hinting that it might be one of the potential buyers. A couple of recent developments have strengthened the likelihood of an imminent company sale.
Last week dentalcorp released annual results, which among other things indicated the continuation of strategic review as well as changes in executive compensation. Prior to DNTL’s IPO, the company had a management loan program, which allowed executives to borrow money from DNTL for the purchase of DNTL shares. The agreement entailed that if DNTL’s stock price reaches C$28/share by 2026 (vs $9.26/share now), half of the loans will be forgiven. As of Dec’22, the receivables from this program stood at C$78m. In the recent earnings release, the terms of this loan program were amended, but interestingly only for the company’s president and CFO. The amended terms foresee that if DNTL is sold in 2023, half of the president’s and CFO’s loans will be forgiven. Moreover, if either CFO or president is terminated without cause in connection to change of control events after 2023, the full loan amount will get forgiven. Each of them has C$12.8m of these loans outstanding. This is a pretty massive incentive for both execs compared to their annual salary of C$0.5m each. The timing of these changes in light of the ongoing strategic review strongly suggests that DNTL might already be in the late stages of sale negotiations
The buyout interest for dentalcorp is not surprising – Canadian dental industry has been in consolidation mode for a while now and the increase in PE buyout activity gave it an additional boost. DNTL currently trades at 10.3x TTM pro forma EBITDA (including incremental full-period EBITDA from acquisitions completed over the last year). There are no directly comparable public peers. Certain private industry transactions were done at higher multiples, such as US Oral Surgery Management (Nov’21, 14-15x LTM EBITDA), and Affordable Care (Jun’21, 17x LTM EBITDA), however, these peers focused on higher margin dental surgery/implantation businesses as opposed to more standard dental care practices. At 12x pro forma EBITDA, DNTL would be worth $11.22/share – 26% upside from current prices.
The announced operating results were strong with revenue and EBITDA up by 21% YoY both in the Q4 and full-year earnings (half of the growth comes from acquisitions). Outlook was also positive as DNTL expects Q1 2023 revenue to increase by 23% YoY and EBITDA margins to continue expanding.
The restructured loan program also forgives the executives’ loans after the second, third and fourth anniversary:
Each HoldCo may redeem a specified face amount of the Preferred Shares on specified dates for nominal consideration ($6.4 million face amount on the second anniversary of issuance; $3.2 million face amount of its Preferred Shares on the third anniversary of issuance; and $3.2 million face amount on the fourth anniversary of issuance).
So they can either sell the company in 2023 and have half of the $12.8mm forgiven, or wait 4 years and have ALL of the $12.8mm forgiven?
If I understand correctly, they would have to wait for two years. Anyways, it doesn’t mean much as the president and CFO are not running the show here. DNTL’s board members run it. While L Catterton and DNTL’s founder/chair/CEO are not on the special committee, they have a very strong influence in the company, and a number of recent developments suggest that the sale option is being seriously explored. The recent comp changes only strengthened the thesis.
The incentives here echo the words of Munger and Greenblatt in a big way.
While I find the specific terms confusing, the big picture is they appear greatly incentivized to sell.
Nonetheless, according to TIKR the the Net Debt/EBITDA is 6.45 (anything > 4 seems aggressive to me), and total debt to total assets is ~40%, certainly at the higher end of acceptable.
I really like the way they (CEO and President) are incentivized to sell and basically get out of the way, and it seems very likely that that’s what happens. However, if that doesn’t transpire this looks an expensive and leveraged business with a relatively high cost of capital (“At year end approximately 50% of the Company’s outstanding debt was at a blended interest rate of 6.5%.”).
Hard to pass over this, but just as hard to invest in an unprofitable leveraged business too!
1Main Capital has recently pitched DNTL in its Q1 investor letter. Pasting the full pitch below:
“In the first quarter, the Fund initiated a position in dentalcorp Holdings (DNTL), Canada’s largest operator of dental practices, with over 1,800 dentists serving 2 million active patients across 500 locations. The company was established in 2011 by its CEO, Graham Rosenberg, who went on to partner with several institutions to accelerate growth through acquisition, before going public in 2021. Currently, Rosenberg holds a 5% stake in the company (35% voting power), while private equity firm L Catterton owns 40% (28% voting power).
Dental service organizations (DSOs), are solid businesses that own dental practices, employ medical staff, and manage operations. They benefit from a highly diversified, predominantly cash-paying customer base and are resistant to technological disruption or economic fluctuations. In fact, Canadian per capita dental expenditures have grown at 1.5x the rate of GDP over the last 45 years, increasing in 43 of those years.
DSO’s underlying business stability enables them to support high leverage, making them ideal private equity rollups. Additionally, the pool of potential acquisition targets is extensive, with roughly 95% of Canada’s 15k practices independently operated by dentists either approaching retirement or increasingly preferring to focus on patient care rather than practice management.
A typical practice generates $2.5 million in revenue and $400k in EBITDA, and is acquired for 6-8x EBITDA, with 75% paid in cash and 25% in DNTL equity. Larger, multi-location acquisitions are acquired for 8-10x EBITDA. Following acquisition, DNTL typically experiences a 10-15% increase in EBITDA due to purchasing scale, technology implementation, and operational efficiency.
Dentists who sell their practices usually sign 5-year employment agreements, with 95% renewal rates. In addition to receiving DNTL equity, dentists’ compensation is based on performance of their individual practice, where they participate in 20% of the EBITDA upside/downside from target levels.
DNTL’s resilient business model and attractive growth profile contributed to its well-received 2021 IPO, priced at $14, with investors pushing the stock price to $18+ within the year. However, the company’s stock was hit hard in 2022 due to its low float during the duration unwind, causing shares to plumet to $6. On the way down, insiders purchased $700k worth of stock on the open market at $11 per share.
In November 2022, the company announced a strategic review in response to unsolicited expressions of interest, presumably from several PE buyers familiar with and fond of the DSO model. Notably, the L Catterton directors were not part of the strategic alternatives committee, suggesting potential interest in reacquiring the company. KKR and Blackstone, both active in the DSO space, could also be logical acquirors of DNTL.
Last month, DNTL reported strong Q4 results and provided an optimistic outlook for 2023. In its earnings release, the company disclosed that certain loans given to management by the company, used to buy shares in the IPO, were modified such that they would be forgiven if the company is sold.
Based on these factors, I believe it is likely that the company will be sold for a significant premium relative to the prices at which the Fund acquired its position. However, if the business chooses to remain public, I anticipate that it will be able to acquire practices at lower multiples than those paid in the recent past, allowing it to grow its FCF per share at attractive rates. In either scenario, I believe that we will generate attractive returns.”
Full letter is here: https://static1.squarespace.com/static/5e03bb9dcc191357f10902ad/t/64368ee6b157b05bc0ccb151/1681297127076/Q1%2723+letter.pdf
Big move down last couple days with earnings due tomorrow morning as far as I can see. Given the thesis hasn’t changed, Is there any reason to avoid a starter position here?
I don’t see any news that could have triggered the sell-off. The industry seems resilient enough so really not sure what could’ve been the reason behind this drop.
The strategic review process has concluded without a sale. Management basically said that the received offers were too low. The Special Committee will be dissolved. The stock is relatively inexpensive now (8.9x PF EBITDA) and given the recent comp changes management should still be incentivized to pursue a sale in the upcoming years. However, no short-term catalysts remain on the horizon for now.
https://www.sedar.com/GetFile.do?lang=EN&docClass=7&issuerNo=00045407&issuerType=03&projectNo=03534785&docId=5422219