Somewhat unique business, very uniqe management, page-28

Mars,

Apologies for reverting to your post only now but I rarely visit this stock’s threads (because they tend to be sparsely populated).

Responding to your post:

1. Growth Going Forward

Your points raised under “Growth Going Forward” make for great debate, because as we all know, it is the very growth outlook that informs the stock’s (apparently full) valuation multiples.

Your analysis of 7% to 8% organic potential growth under the scenario of a 70% dividend payout ratio and without accessing any debt capital is what I would classify as a worst case scenario and one that is probably not very realistic, in my view.

Certainly it is at stark odds with history (more on this below).

While a high payout ratio is likely to remain in place (because dividend income is largely the way the CEO pays his personal bills given his relatively modest stipend), I think what can – and should – be subjected to increased flex is the level of the company’s borrowings.


To support this line of argument, some historical context is invoked:

A little after the company’s IPO in 2005 and before the GFC - an aggressive phase of the company’s growth strategy - ONT’s board was happy to fully deploy the capital raised at IPO stage (net cash was $4.7m @ June 06) and then to also run up reasonable level of borrowings, with NIBD-EBITDA in excess of 1.0x by June 2008 (at which time NIBD amounted $7.4m).

Specifically, in FY2007 and FY2008, ONT spent about $3.0m on capex and about $8m on acquisitions. That amounted to a significant investment campaign in the context of a then sub-$35m market cap company.

And right through the GFC and following it, the company’s managers were happy to run the business funded with modest levels of debt capital, with NIBD-to-EBITDA averaging around 0.4x between FY2009 and FY2011.

Then in DH2012 the company undertook the biggest equity raising in its relatively short listed life – an $8.3m placement @ zero discount to market price – which was ostensibly done to avail management of the opportunities to acquire practices from vendors who were expected to become far more willing to deal following the fallout of the CDDS shock.

Net cash following this raising was $9.6m (@ end December 2012), and from this peak it has fallen to $5.0m, following some $10.6m in acquisitions since then.

So, while for some time now ONT’s balance sheet has had a net cash position, the point being demonstrated is that, in the past, the board has been willing to utilise borrowings as a source of funding. And I think they will be happy to do so again in the future (and so they should; it’s a highly cash generative, negative working capital business with granular customer base and no lumpy capital requirements…highly bankable stuff).

By my calculations, there is almost $25m of acquisition firepower sitting on the balance sheet at present which, if deployed towards acquisitions (and I recognise that’s easier said than done), could easily bring about 35% EPS accretion (assuming 5x EV/EBITDA acquisition multiple and 7.5% cost of debt).

And then there’s the option of yet further equity capital to fund growth.

Usually I don’t like companies seeking recourse to shareholders for funds (an investment, in my mind, is something that puts money into my pocket; not take it out), but ONT directors have been very judicious on the two occasions (FY2006 and FY2012) they saw fit to issue new stock.

And given the fragmented nature of the industry, as a long-term shareholder, I would be very happy for the board to tap equity markets for capital if it means accelerating growth (provided of course, that the acquisition discipline and due diligence standards are maintained).

So that’s why I make reference to 20% pa as the potential growth rate of the business. But of course, practice and theory often depart one another.

But the point I have been labouring is that the constraint on growth is certainly not capital availability; rather it is execution capability and the extent that management wishes to be aggressive on that front.

A final note worth making on the subject growth: in my experience, explicit forecasting can be a bit of a fool’s errand for a host of reasons.

So I far prefer looking at the past to help inform what the future might hold. And in ONT’s case the precedent is illuminating for prospective shareholders:

Over the decade it has been a publicly listed company, ONT has generated a total of $60m in Operating Cash Flows, and has tapped the market on two occasions for $10m of equity capital. The company’s debt capital has remained relatively unchanged over this period (in fact, net cash is today a few million dollars higher than when the company first listed).

From these capital sources, around $14m has been reinvested into the business in the form of capex and $24m has been applied to acquisitions. Impressively, shareholders have received $28m in dividends.

[As an aside, if you bought the stock in the IPO (80c issue price), it would have taken less than 7 years to recoup your investment outlay. By the time the company pays its FY2015 full-year dividend (which I’m guessing will be no less than 10cps), you would have received ~135c in dividend payments, a remarkable 170% of your entry price. And, needless to say, the share price has risen commensurately.)

[PS. For further context, in the 6 years before the CDDS impact, ONT was, in fact, growing EPS at a clip >20%pa (EPS for the 12m to Dec 2012 = 28.9cps vs EPS for 12m to Dec 2006 = 9.4cps). And since listing, the company has grown EPS by a compound annual rate of 13%pa which, while not quite 20%, is still quite noteworthy given that the company has encountered two major macroeconomic shocks during its relatively short history, viz. the GFC in 2009 and the adverse changes in CDDS legislation in 2013.]



2. Returns on Capital


When the company started on its journey, it was generating ROE in the mid-30% level; today it is closer to 25% (although I expect some residual CDDS effect is still being felt in the form of sub-optimal capacity utilisation).

By any measure, that’s still a handsome rate of return which provides a wide safety margin against any potential errors of strategic judgment.

Still, your question is well-founded. Return fade is happening. But I think that the law of diminishing returns is one of the inevitabilities of enterprise growth, for that is what history shows.

But the criterion for continued shareholder value creation is that the return on incremental invested capital remains well above the company’s cost of capital which, given the nature of the business and its prudent management with more than ample aligned interest in the stock, I’m sure will be the case.

In terms of acquisition discipline, I feel that ONT does indeed offer dental practitioners something unique, something in the form of professional durability and sustainability, as opposed to just a one-off cash handout. This, I feel, should naturally cap what ONT needs to pay in order to get new dentists on board.

The few dentists I have spoken to about ONT, and who have come across the company, certainly expressed none of the sort of revulsion at the prospect of working within an ONT framework, that would require nothing less than an egregious some of money to be paid over for said dentist to be won over.

As a case in point, the May 2014 acquisition of BOH Dental in the Brisbane CBD was undertaken at an acquisition multiple of around 7.0x EV/EBITDA. This I understand was the highest ONT have ever paid for a mature practice; usually the going rate is 4x to 5x. (But BOH Dental was, and is, quite a strategically valuable asset, with significant scope for improved performance via wider pool of referrals).

And I guess that, in the event that the bidding landscape becomes too hot, ONT could always switch from Buy to Build, since the company has enough scale to build greenfield practices, and also has some form in that regard.


3. Margins

I am less concerned about margins, than I am about Return on Capital (recognising that the former informs the latter).

My understanding is that, as a critical input to the business, the supply of dentists actually presents a nice tailwind to the business currently, and this looks set to remain the case for some time.

Plenty of them – too many, in fact, according to some commentators – are graduating at present (but they need to be trained, mind, and there’s a cost to doing that, so it is not the preferred path) and experienced dentists are almost always amenable to the idea of focusing on plying their trade of fixing teeth, rather than administering a business (staff, rent, maintenance, inventory management and procurement, advertising etc.)


In closing, make no mistake about it: this is a professional roll-up story and normally I am wary of these “neck-up” businesses.

By way of expanding on this, I’ll take the brazen liberty to quote myself from an earlier post:

“In my observations, most professional roll-up stories come unstuck at some point or – at best – they simply stall.

There are many examples of this:

PRY (Medical GPs):
Big question marks exist today in investment circles about the accounting practices and the justification for the value of the goodwill that has been recognised.

GXL (Vets):
They eventually gave up rolling up vet practices and decided instead to get into pet car retailing. The jury is out on whether they have ended up overpaying for the retailers they have acquired in recent years; I suspect they have.

WHG aka Crowe Horwath (Accounting and financial advisory practices):
They always struggled to exercise control over the individual practices they acquired. Company nearly went to the wall, in my view. They were finally taken out for cents-in-the-dollar, compared to peak valuations.

VEI (Opthalmologists):
The eye specialists had all the negotiating power and all that ended up happening was a transfer of value from VEI shareholders to the form of the specialists in the form of higher and higher salaries and retention bonuses. (There was also a company of radiologists that was listed in the early 2000s which befell a similar fate as VEI: the radiologists employed by the company (Gribbles was its name) – at a time when qualified and experienced radiologists were in scarce supply – needed more and more money thrown at them to prevent them departing the business)

COF (Geotechnical engineers):
Made too many acquisitions at the top of the mining boom, and are now having to get rid of – at a cost, naturally - all those specialist “human assets” they paid too much for a few years ago.

LYL (Structural and mechanical design engineers):
Almost identical story to COF (see above)

ONT (Dentists and dental practices):
This seems to be one of the few professional service roll-up stories that seems to have been successful, but I strongly suspect that is due to the particular individuals involved in driving the company, more than it is due to dental industry somehow being a great business per se.


Ultimately the problem with roll-up strategies involving people businesses is that the acquisitions need to keep getting bigger and bigger for them to make any material difference.

And with larger-sized acquisitions comes increased risk and too often I have seen executives in these sorts of situation - under pressure to keep growing - pay less heed to risk and become less disciplined in prices they are willing to pay for acquisitions.”


In summary I don’t think ONT is a must-own-at-any cost company, but it certainly has ample growth runway ahead of it, with limited execution risk.

But, lust like all micro-cap companies, it’s operating and financial performance need to be watched and monitored for potential chinks in the armour.

It should never represent in the order of 20% of one’s investable capital.

5%, maybe. At a maximum.

For what it’s worth, I personally have 2.5% of my wealth invested in this business (a disproportionately small amount compared to the amount of time devoted to discussing the company.)