Dental Industry Part 3 – Modern Dental Group (3600 HK)

 

+ Strong core business of dental prosthetic production with good cash flow generation. Possible margin improvement after factory move in 2019/2020.

+ Although listed in HK, this company mostly has stable revenue from developed markets – Europe/USA/Australia.

+ A kicker is the growth opportunity in China where the need for dental care is huge as well as the high fragmentation in the market.

+ Debt tenor recently extended, which shows prudence of liquidity management.

+ Low valuation with good potential for turn-around and multiple expansion if management can integrate acquisitions successfully.

So far acquisitions has just grown top line, nothing has feed through to the bottom line. Markets are currently in doubt of management execution on the investments.

Strange history of running core operations on land where the lessor did not have the right to lease out the land (might have been hard to understand beforehand though).

Recently started a share buy-back program (about 1% of float so far), although this is general is an acceptable way to shift out earnings to shareholders, it more looks like a way to prop up the share. The management should concentrate their efforts and cash in improving the businesses they bought.

 

Background

Modern Dental Group (hence forth called MDG) is the only listed company in the previously described segment of prosthetic producers and distributors. The company floated on the Hong Kong exchange in December 2015, offering 175m new shares and 75m secondary shares at 4.2 HKD. This brought in about 660m HKD cash to the company. The current market cap of MDG is 1.2bn HKD.

The company started growing significantly during the early 2000’s with centralized production facilities in Shenzhen, China, for dental prosthetics production. The company used third-party distributors to sell their low prices dental prosthetics. This co-operation grew over the years to a large number of distributors world-wide, selling their products to local dentists. The offshoring of prosthetic production to China has seen strong growth (as discussed in Part 2) and created good cash flow for MDG. This enabled the company to bit by bit acquire it’s distributors and smaller local labs. MDG has through acquiring these companies become a direct distributors to the dental clinics with the purpose to control the whole mid-stream segment. The goal as I interpret it, is to be able to provide a full-service offering, both low cost options from China and the higher quality products from the local labs.

As we learned in previous posts, the development of CAD/CAM technology enables the local labs (who can afford it) to fight off the low cost production in China. With machines doing most of the work, low labor cost is not as big of an advantage as in the past. This is probably the main reason MDG has been on a spending spree over the last 5 years. My guess is that MDG see the next leg of growth as consolidating the small local dental labs into bigger units where economies of scale works better with CAD/CAM. In fact MDG has already created such labs of larger scale in Hong Kong, Melbourne and Emmerich (close to the border of Netherlands). By consolidating the market MDG might be able to out-compete smaller local players.

Ownership structure

47.4% of the company is held by the Chan family

16.1% of the company is held by the Ngai family

The rest 36.5% is free float.

A family majority owner is very common in HK listed company. This is both a blessing and a curse, if it’s the right family leading the company, it could be very good with a strong owner to lead company. HK also has many cases where this has gone totally wrong and money is more or less embezzled into other non listed entities which are family controlled. Given the nature of the business in this case and that two separate families are large owners, I see this risk as minimal. It’s rather the risk of incompetent leadership which would be the largest risk. At the same time, the families have all the motivation in the world to not mis-manage their company, since they are more heavily invested than anyone else. On balance in this case I see it as a positive that this company has a strong family owner.

Fundamentals Overview

The core of this company has been the large production facilities in Shenzhen China, they have delivered solid cash-flow (some 150m HKD per year back in 2014) and continues to do so. Although exactly how much is not fully visible anymore, since income is now mixed together with all the acquisitions done (more on that later). The company has some 780m HKD in debt, which recently has been refinanced (at a cost) at a longer tenor (5 years). Being prudent and taking up longer term financing, even if it costs more, I see as a positive and responsible management. I would not want to see debt levels escalate, now at 2.45x EBITDA.

As we can see above, Europe is the largest market, followed by the U.S. Unfortunately profit contribution and margins per region is not available, but from my readings Europe together with Hong Kong (included in Greater China) are the two regions which contributes most to the bottom line.

Revenue and Net Income

Top-line has increased significantly (mainly from acquisition) but so far small effect on bottom line. One reason is that a loss making US operations was added into 2017 figures. Maybe it will be famous last words, but my investment thesis here is that we are experiencing the worst right now. On the flip side there is a lot of potential for margin improvements, if management delivers in terms of synergies and operations of scale in general and for the U.S in particular. Another factor for margin improvements, will be few years down the line, when the move to the new factories in Dongguan are completed.

P/E contraction

Given the declining share price and flat Net Income, the P/E has just kept contracting, reaching as I see it, attractive levels.

Acquisitions Overview

Given the large number of acquisitions this becomes an important component to poke a bit deeper into. The below tables summarizes the acquisitions over the past 5 years.

Larger Acquisitions

 

Smaller acquisitions (dental labs)

In total since 2013 MDG has done acquisitions to the tune of 1.2bn HKD, the current market cap of MDG is 1.29bn HKD, adding on net debt of about 450m HKD, the Enterprise Value of MDG is 1.75bn HKD. For MDG to currently be fairly valued they must have grossly overpaid for the companies the bought. Or the market has miss-priced the company and its significantly undervalued.

Has MDG in general overpaid?

The short answer is, probably yes. The slightly longer answer is, the earlier acquisitions seems to be OK-ish. Its hard to judge exactly how improvements and synergies are moving along per region and contributing to the bottom line. The jury is still out on the execution of their strategy of lab purchase RTFP (MicroDental) being the main one. Just looking at the purchase prices of the larger acquisitions, the market price seems to be around 1x Revenue of the companies, which without any deeper insight, sounds fairly cheap. The problem child in my view is RTFP, which is bleeding pretty badly.

One case where the company was somewhat unlucky was the SCDL acquisition in Australia/New Zealand. Australia’s government changed the contributions to dental healthcare, which has reduced the business significantly overall in Australia. The market is slowly recovering from this.

A look at RTFP Dental (MicroDental)

This acquisition in 2016 is quite different from the larger ones done in the past. First, this is the only large scale dental lab acquisition done. Second, this is the first significantly loss making operation bought. As you can see in the second table above, MDG has also started to selectively buy Dental Labs in other places of the world, but that has been small scale compared to this huge acquisition of 21 labs in one go. MDG acknowledged that RTFP was losing a lot of money, US$-9.3m which translates to -73m HKD (that is a lot for MDG which has a historical Net Income of about twice that).

These were their main rational why this still made sense to acquire:

Brand Name – MicroDental is a renowed brand in USA.

Customer network – Platform for MDG to further penetrate the USA market, mainly through the 21 labs around USA.

Laboratory EBITDA – at US$5.9m EBITDA on lab level shows there is actual value in the company. RTFP is burdened with high admin costs, an expensive facility in Dublin etc. MDG believed it could improve results through offshore product lines, elimination of unnecessary corporate expenses, reductions in rent and operating expenses for the facility in Dublin and streamlining measures.

Location of dental labs of RTFP Dental

Tax benefits – MDG can enjoy tax deductions through amortization of goodwill, to the tune of US$7-9m.

Finance cost – 2016 US$2.4m of the losses were due to Finance costs and MDG would be able to fund this more cheaply.

The Latest comment released last month on MicroDental business outlook:

“The North American market has experienced a slight drop in sales (of less than 2%) and a drop in sales Volume (less than 3%) due to (i) the management’s focus and attention on the ongoing restructuring and integration of MicroDental during the period as a result of the temporary distortions arose from closure of inefficient locations and relocation of production facilities during the period; and (ii) the management’s planned decision to focus on higher priced and margin products and gradually phase out the lower priced and margin products in MicroDental Group.”

In the latest semi-annual report they disclose how the reshaping of the MicroDental business is progressing, in total it contributed -9m HKD in loss for the first half of the year. Still terrible, but much better than the 73m HKD loss before. This progress will be key to MDG’s long term success and potential share price recovery. I think it will be hard to come out of this and create shareholder value, meaning turning this business highly profitable. So far the market agrees with me and I think this the main reasons why the stock is down -60% since the acquisition was announced. This of course give us that invest now, a good discount. So the damage done by this acquisition is in my view already reflected in the share price, now there is upside if they actually manage to turn it around properly. There are some early signs that they are making good progress.

The strange land story

Going through the IPO documents a very strange story emerges. The very short version is something like this: The factories MDG are running in China are rented by some type of local community in the suburbs of Shenzhen. This was all well for many years, until Shenzhen grew so much that the land became more valuable. The city has after that re-evaluated the claims different people or groups have to that land. It happens so that Shenzhen government has realized that this local community does not have the legal rights to this land and therefore MDG ends up in a very strange position. Basically MDG could at any point be evicted from the land (with a grace period for moving out). Since this local community of course strongly opposed the Shenzhen governments view on the matter, this has ended up in some type of legal conflict. Consequently MDG decided, it’s time to start to look for a new factory in neighboring Dongguan. This also makes sense from a labor cost perspective, since Shenzhen starts to become a bit too developed and rich. Back in the IPO days, 2016, there was still a long runway until a new factory would be up and running. I can’t understand how investors would be willing to bare this big risk of being thrown out of their factory, before the new one is finished. Now this issue is diminishing, the first phase of the constructions of the new factory is scheduled to finish end of this year. Even if MDG was told to start to prepare to move out by tomorrow, the impact would not be terrible. I would not have been comfortable to invest in MDG earlier than now, just by this fact. These kind of issues is not something I contemplated for my other investments, you always learn something new and the number of traps in emerging markets are so much greater.

Valuation

Being the only listed company in it’s segment of course makes valuation from a peer perspective more challenging. What MDG themselves paid for the acquisitions is one guideline of the value of the business. Currently the Enterprise Value of MDG is about 1.75bn HKD with revenue of 2.28bn HKD for rolling last 12 months. On the very simple metric of paying 1x revenue, the stock is undervalued by some 30%. I don’t suggest this to be a very good method though, I prefer to look at cash flows.

As we have seen in Part 1/2, the dental business is not very cyclical and has a nice growth trajectory in many parts of the world. These are important reasons, since it gives stability to revenues and income. The big question for the valuation is, what will be happen with the margins? The company has gone from stable 14% Net Income margins in 2012, down to around 6% in the past years. Will that improve, become even worse, or stay stable going forward? This all depends on how well the company manages all the acquisitions done over the past 5 years, since they brought down the margins.

Assumptions:

For revenues I do not assume further large acquisitions, just some minor labs being bought. Majority of revenue growth is assumed to be organic growth. China as we have seen is growing very quickly and that will also feed through in the companies revenue growth. The growth rates are 2%, 4% and 6% per year.

My base case assumptions is that some type of efficiencies of scale will start to take effect. Also that the bleeding stops in the U.S. dental labs turn into a profit, there is a few percentage points of margin improvement just from that. Making the base case in my view, fairly conservative.

WACC = 12%, given the stable nature of the business with revenue from developed markets I think a lower WACC is warranted. 12% maybe is not even low enough. I would go even lower, if it wasn’t for that I wanted to keep some risk premium for the uncertainty around management execution.

This gives me my three valuations:

Base = 1.42 HKD per share (I give this a 60% weight)

Bull = 2.19 HKD per share (I give this a 30% weight, since I see it as more likely that margins will improve)

Bear = 0.53 HKD per share (I give this a 10% weight, I see it as unlikely that margins would further significantly deteriorate)

Which in turn gives me a weighted target price of 1.56 HKD per share and about 20% upside to the current share price.

Summary

I have been somewhat torn if this is a good enough case to invest in or not. I do love a good turn-around (maybe I like them a bit too much). It’s not easy to catch the bottom and this stock is currently a slow falling knife. 20% upside at a WACC of 12% is not extremely good, but a DCF is also tricky. I’m not a slave to the DCF and there is a lot about this company not captured in my simple DCF. Just changing the assumptions a little bit moves the valuation up and down by quite a bit. For example a WACC of 10% instead of 12% gives a Base case valuation of 1.86 HKD per share.

I like that the family is so heavily invested in this company, they must have a great understanding of the dental industry. They are executing on a strategy they believe will be fruitful in the long run and there are some early signs that the losses in USA are coming to an end.

I think what made me finally decide is the defensive nature of this business. There is a reason this company initially traded at a P/E of 30 and most healthcare and dental related companies are trading at very high multiples. So buying this below a P/E of 10, is pretty darn good for a defensive business.

I initiate this at a 4% position as a Long Term Holding in my portfolio, I will not increase my position before I see proof of margin improvements. I’m willing to give the company about 1-1.5 year to prove that they can improve margins from here.

 

 

 

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Portfolio Update & Changes (Amer Sports, Swedish Match)

After a very tough October, my portfolio has recovered somewhat and is in total down -1.6% on the year. That compares to MSCI World which is down -4.4% on the year. Both have achieved these returns, with the exact same volatility, 15.1% for the year (calculated on weekly returns). My correlation is 79.5% to MSCI World, which is rather high, but also somewhat expected. When markets fall correlation tends to increase between all equities (the correlation during 2017 was 64%). After being down to 0% cash, when I introduced my new three bucket investment approach, I’m now back above 10% cash after divestments in my funeral related companies and Amer Sports, which I will comment further on below.

 

Amer Sports – The Chinese are buying

When I launched my big portfolio change: GlobalStockPicking 2.0 – Major Portfolio Changes, it just happened that information came out about a non-binding interest from HK listed Anta to make a bid for Finish listed Amer Sports at 40 EUR per share. Having looked into Anta when I invested in XTEP, the other sport shoe producer I thought this really made sense. Mainly because Winter Olympics in China is coming up. So I used my new Opportunistic investment bucket to take a 4% position in Amer Sports at 34.1 EUR per share.

I wrote at the time: “My own expectation is that this should be priced at 85%*40 + 15%*29 = 38.35 EUR”. I think the market has caught up with my analysis now, given that the stock closed at 38.37 on Friday. I still think this will go through, but there are some small tail risks, that for example USA will block the deal. Usually these things also take quite a long time, needing Chinese approvals. So I’m happy to leave the last 1.5 euro on the table and close my position here. This netted my a 10% gain in USD (some currency headwinds) in a market which was down -9% for the period, very happy with that. As always when an investment goes well, you just wished your bet was a bit larger.

This is the second time I got a more short term bet right, where there was Chinese related corporate action around a Nordic company. The first time was the Rezidor/Radisson case (Adding Rezidor Hotel Group – HNA related idea) which also ended with a buyout from another Chinese company.

 

Swedish Match – Adding 30% to my holding

The producer of Snus and moist snuff which through countless of studies have proven to be much less destructive to your health than smoking. The stock has been on a wild ride lately, first the markets have been very positive on the possibilities for growth of Zyn in USA. Lately the focus seems to be elsewhere, for example that Swedish Match will not be allowed to sell it’s products in the rest of Europe. I think they have a terrific product as good as all the e-cigarette alternatives. The company is very well run and highly cash-generative. This is one of those companies I plan to hold forever, now was a good opportunity to add to my holding. I add about 30% to my holding as of close Friday, bringing this holding to 6.1% of my portfolio.

 

Defensive feels good in these times

For the frequent reader, you know that I have been skeptical of markets for quite some time. I have expressed this in many ways, but the main theme has been finding defensive long term holdings. Early on in the sell-off my defensive approach did not really work out, because the only thing that held up MSCI World, was the U.S. market and tech stocks in particular. Being underweight both was therefore short term not good for relative returns. Lately it started to work better though when tech “finally” stopped defying gravity. Defensive feels very good right now, but that doesn’t mean I want to miss out on the stocks with higher return potential, or very undervalued cases. I will hold true to my defensive style as long as the valuation difference to growth/value doesn’t become too large. Now I’m actually more excited about stock picking than I have been for quite some time. Today I find much more interesting investment cases than I did a year ago, one example of that being Tonly Electronics – Another Hong Kong value investing case. There are many more I have on my Watchlist and even some not yet mentioned there. The point of my dental series has been an attempt to find 1-2 companies to invest in, which are defensive health care companies I can understand. To summarize my defensive holdings:

What I see as defensive holdings:

Dairy Farm (7.9%) – Asia – Dairy Farm – Asian food giant

Swedish Match – Sweden/Nordic/USA – (6.1%) – Mentioned above.

Nagacorp – Asia- (6.1%) – Nagacorp – Casino in CambodiaNagacorp follow-up conclusions

Olvi (5.7%) – Finland/Baltic – Produces beer and other alcoholic and soft-drinks, selling mainly in Finland and the Baltic countries.

Gilead Science (5.2%) – Global – Biotech company with market leading products against HIV and hepatitis.

Essity (5.2%) – Global-  New Holding Essity – Wood base hygiene products, like tissue paper, diapers, feminine care etc.

Diageo (4.1%) – Global – One of the worlds largest distillers with brands like: Johnnie Walker, Smirnoff, Gordon’s Gin, Captain Morgan and numerous others. Also Guinness is a large portion of revenue as well as its 34% stake in Moet Hennessy drinks division of LVMH.

Inditex (2.8%) – Global – The world famous clothing retailer Zara, so far keeps defying the e-commerce slaughter by producing outstanding clothes at a fantastically low price point.

Cash (10.7%)

Total = 53.8% of my portfolio is held in defensive companies or cash.

The above companies are a mix of daily needs, like food, clothes and hygiene and vices, like alcohol and gambling. All of the above holdings I’m confident to hold long-term, especially in a bear market. That doesn’t mean though that none of them will ever leave the portfolio. I try to think long term and get to know my companies well, something I didn’t appreciate enough in the past. Part of being long term is to not rush into the new investments, I will take my time and get to know new companies properly before investing. But if I find a new investment that feels much stronger than what I currently hold, the old will go out.

 

Currently thinking about

Lately I spent a lot of time trying the understand the Chinese tech scene better. There are a couple excellent podcasters out there who educate anyone willing to listen, on everything related to China tech. One thing that is very clear, is how extremely hot this sector is and how fierce the competition is. It seems to be on a totally other level than outside China. On top of that we have the Chinese government interfering in a lot of different niches. The competition and the intervention has again made me more negative in general. So the three of my holdings I’m currently thinking most about all have strong China and tech ties:

NetEase – Great company, with quality games and co-ops with western gaming companies. Given how much U.S. listed Chinese companies have been punished lately I think investors still really like this company, trading at a trailing P/E of 37 and estimated P/E of 24, is not dirt cheap. Obviously partly this is due to the halt in new game launches in China and everyone is expecting this to be temporary. Still, the government is showing who is boss and they won’t allow especially young people to be gaming addicts. Just as the funeral case, this hampers the upside for NetEase. Although I would argue that it probably very long term is healthy for the company to have more balanced customers and not school drop-out gaming addicts. The other aspect is the competition, which seems to be brutal. In Sweden a number of listed gaming companies have plummeted lately, it’s not that easy to keep delivering one of the few hit games everyone is playing. I have a hard time deciding of this a long term keeper or not, maybe the competition will eat up NetEase future? My Original Post on NetEase: NetEase – Chinese Gaming

JD.com – Here we have a company that is again fighting in fierce competition in the e-commerce space. The moat though and reasons for investing in this company is the fantastic delivery/logistics network they have built up. This is the hidden value in the company and the reason I invested. Some nasty details has been coming out about what the CEO has done in rape allegation case. It doesn’t feel very good to be shareholder alongside someone accused for something like this, but the company as such, I think is valued very low currently. If we disregard from personal feeling around the allegations (which is hard to do), this is in my mind a value investment at these levels.

Coslight – I haven’t written much about this company for a long time, it has been a big disappoint lately. This was an early investment for me on the theme of EVs and back-up power stations. The company has developed poorly due to needs for large investments which has been impossible with the already high debt levels (a misjudgment on my side). The solution became to sell of parts of the factory producing batteries for laptops. I think that was the best they could do out of a bad situation, but I’m not sure if they will be able to succeed to play with the big boys like Panasonic, LG, Samsung and CATL. Already back in 2016 it was clear to me I needed to wait until 2020, before EVs would start to sell in larger scale, now we are almost there. This should perhaps move into the Speculative bucket, but I held it for a long time and I will let this Electric Vehicle hype actually play out before I decide further on Coslight. The same reasoning goes for LG Chem, but there I don’t have doubt about their success, they are and will continue to be one of the market leaders. My original post of Coslight: Coslight Outstanding results

 

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Dental Industry – Part 2 – Labs and Distributors

In this second post we will start to understand more of the dental supply chain and it’s players. The below picture borrowed from a Modern Dental Group presentation, gives a nice overview of the different market players. This pictures also reveals the major investable industry players:

Source: 2016 Modern Dental Group Presentation.

Dental laboratories and distributors

The focus in Part 1 was on total industry level, revenue and all the different services provided by a dentist. There are a handful of listed dental clinic companies globally and some of them are listed in the picture above. Singapore listed Q&M has an interesting spin-off that I might come back to, but for now I find the other segments more interesting. The next layer in the supply chain are the laboratories and distributors. There is only one listed company in this layer of the supply chain, Modern Dental Group. It has been listed about 2 years now on the Hong Kong stock exchange.

How are dental prosthetics made

There are many different services at a dentist, the more simple ones being just a filling. But when you need a prosthetic of some kind, you enter into a more complex product supply chain, with companies supporting the dentist. This is what we will learn more about now.

Before we dig into more detail we non-dental experts need some more background info first. It’s a pretty complex production flow to replace or repair teeth, I found videos like the ones I linked below very helpful to understand the process and turn-around time to produce any type of dental prosthetics. This is what makes it so fun to be an investor. On the journey to find new investments, you get to learn so many new things. I really had no idea about these processes a few months ago!

Press Read More for videos and further details:

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