SmileDirectClub (NASDAQ: SDC) Stock Analysis

Democratizing orthodontics through first principles and offering better customer experiences.

5yr Target Price

• 2022/07/14: $15 (closing price $1.01)
• 2022/08/10: $15 (closing price $1.14)

Investment Case

SmileDirectClub (SDC) has serious bankruptcy risks in my opinion, if the macro environment continues to deteriorate. Major risks include: 1) running out of cash reserves (400 million cash while burning 100-200 million a year, with almost 1 billion in debt), 2) CEO moving on to other businesses (a serial entrepreneur currently running multiple companies), 3) significant defaults on its financing option SmilePay (no credit checks while making up 60% of their revenue, delinquency rate at 10% currently), and 4) ongoing and future lawsuits leading to bankruptcy.

Outside the major risks addressed, SDC is the best positioned players to turn the orthodontics industry on its head, much like what Uber did to the taxi industry or what Hims & Hers did to the sensitive care industry. In my opinion, they have superior price, customer experience, technology, and TAM compared to every other clear aligner company, including Invisalign. They are doing everything they can to maneuver within the macroeconomic backdrop, including introducing SDC Plus (early 2023), expanding the dental network, shutting down unprofitable international operations, and streamlining marketing channels. They still have a corner to turn, but if they do turn the corner, SDC has a chance to become a 20%+ FCF margin business growing topline 30%+ a year for decades to come and is currently trading at <1x LTM sales.

Thinking in first principles, face-to-face orthodontist care is simply no longer needed for cases of slight malocclusion, a potentially larger market than the 15 million annual case starts today. Through complementary tech (3D printing and software) advancements, virtual dentists/orthodontists can now handle larger volume of cases at a cheaper price with a shorter treatment time. This frees clinics to treat more serious oral problems, ultimately leading to positive spillover effects for consumers and dental practices alike.

*”Thinking in first principles” inspired by Ashlee Vance’s book on Elon Musk, “complementary tech” inspired by Peter Thiel’s book Zero to One, and “positive spillover effect” inspired by John List’s book Voltage.

Table of Content

• Business Overview (2022/07/22)
• Mind Map Summary (2022/07/22)
• Unit Economics (Past, Present, and Future) (2022/07/22)
• Management (2022/07/22)
• Numbers (2022/07/22)
• Others (2022/07/22)
• 2Q22 update (2022/08/10)

Business Overview

SDC is the first DTC (direct-to-consumer) clear aligners company and plans to expand its product lines into general oral care. It was able to adopt a new business model as Invisalign’s patent expired in 2017. SDC operates through 3 channels: 1) dental office (scan is done by dentists with SDC paying a fee, while the rest of the aligner), 2) SmileShops (a location either standalone or placed within other businesses like a CVS, hair saloon, or dental office, with SDC staffing), and 3) impression kits (sent directly to your home). They charge around 2000 USD, and you must pay for retainers afterward the 4-6 months treatment, costing 100 each (every 6 months). This is compared to Invisalign’s and traditional braces’ 5000-8000 USD cost, which must be done through a licensed orthodontist, and generally take twice as long or longer.

The most significant SDC’s advantages include: 1) owning the entire consumer experience from scan to treatment to retainers, 2) vertically integrated for the best unit economics and fastest improvement on product offerings compared to competitors (introduced nighttime aligners and soon to release high-end SDC Plus offerings in 2023), and 3) market share (owning 80%+ of the DTC aligner space which represents only 3% of the entire aligners market).

I would argue DTC aligners are in general better experience. SDC has successfully disassociated with the traditional pain, money, and tears that orthodontics usually come with. It’s a smile brand. Although they have garnered negative reviews just like any other DTC brand, the product has successfully helped 1.5 million+ members achieve the smile they previously couldn’t afford. Numbers don’t lie. Incremental improvements in customer care and new strategies targeting different channels will likely continue to improve the brand perception. Will need to continue to monitor website visits, conversion rates, and public reviews (Facebook, Reddit, and YouTube).

Ultimately, the turning of the corner could be the mutual beneficial friendship that SDC has started with general practitioners, driving more business to these dental clinics while having professionals educate SDC customers, there are now around 600 locations, with 1200 in the pipeline, and more to come. It could also be the higher-end product releasing in early 2023 that targets the higher-income household. It could be their continued focus on the teen market (representing 70% of the market, but only 10% of SDC’s business). Or it could just be time, with conversion sometimes taking up to 2 years, clear aligner decisions are not impulse buys, and product as well as brand marketing efforts may need more time to show.

Mind Map Summary

Unit Economics (Past, Present, and Future)

Invisalign is a good proxy of what margins will be like. The P&L is rather similar, given Invisalign essentially sells to orthodontists at the same 2000 USD price. However, it is likely that Invisalign has an overall leaner structure with less customer acquisition cost (a well-established brand marketing to orthodontist channels) and less maintenance (does not own the entire customer experience). With 25-30% EBITDA margins consistently for Invisalign (aligner business ex-scanners), it is likely that SDC will achieve somewhere around the 20% margins once it reaches a stabilized growth phase. The company is currently losing money, at a rate of 40-50 million operating loss and 10-15 million capex per quarter. This amounts to 200-250 million loss in 2022 alone, and with 400 million on the balance sheet it will be quite dangerous if the losses are not contained and turned around through scaling in 2023.

Management

Management still holds over 60% of total shares outstanding (class B shares), they have a lot of skin in the game. The tone as of 1Q22 earnings call still suggests a strong commitment to the mission despite past headwinds, CEO David Katzman still knows every single detail of the business, no signs of passing on the throne.

Numbers

Key metrics

• Market size: Aligner case start per year is 15 million, about 500 million people with some form of malocclusion that SDC can address
• SDC market share: 3% of total market today
• Google trend: trending down, inconsistent with “clear aligners” search, Invisalign dominant here
• Website tracker: Organic search still down significantly from previous highs according to Semrush
• FDC official complaint: comparable to Invisalign on a complaint-to-total cases percentage basis

Valuation

• Bull case
  • Cashflow positive by 2024
  • 1.1 billion USD revenue by 2026
  • 20% FCF margins by 2026
  • 30% clear aligners market share by 2026 (10% of global aligner case starts)
  • 25x FCF multiple
  • Moderate dilution
  • TP = 24
• Base case
  • 13% clear aligners market share in 2026 (same as 2022)
  • 20x FCF multiple
  • Moderate dilution
  • TP = 10

Others

Legal matters could be problematic in the future. It has already cost SDC to limit their future SmileShop openings in Georgia and Alabama when these states passed laws to require orthodontist to be present in SmileShops. However, in the grand scheme of DTC clear aligners, SDC has prevailed in almost every circumstance. It is now a legal powerhouse that has successfully befriended the American Academy of Clear Aligners (AACA), increased its 3^rd party dental professional rating for several quarters consecutively, and double-downed on symbiosis with dental partners. The results continue to speak for itself, and it’s hard to see a reversal in regulation on a proven and widely accepted product.

2Q22 update (2022/08/10)

• David Katzman sounded motivated as ever, emphasizing “innovation led” vs. “marketing led”.
• Moving up the buyer funnel by 1-3 weeks with in-app purchase after showing customers the 3D scans and adjustments through SmileMaker platform. Could improve conversion rate (still have to do impressions or scans). The ultimate goal of allowing direct 3D printing with only smartphone software seems impossible in the near-term. However, allowing iPhone equipped with 3D scanning to provide such capabilities may not be 1-2 years away (Matterport-like approach).
• SDC Plus will launch in 4Q22, the price point of USD 3900 could boost profitability. CFO claims 30% of that goes to SDC while the rest goes to GP, which should boost GP’s willingness to adopt such programs, as it comes together with the normal 2K USD version. Should accelerate GP adoption of SDC, currently at 690 partner locations.
• Cash flow control was well executed, expect to end the year with midpoint 140 million USD in cash, with more available from the HPS credit line.
• Revenue guidance decreases mostly due to inflationary pressure on the core demographic, which could improve as the core demographic expands to higher income customers.
• No significant changes to model & TP.
• New Bull TP = 20
• New Bear TP = 9