Somewhat unique business, very uniqe management, page-26

What a great little thread! I've enjoyed reading it and had a few chuckles too. Madamswer, I've particularly enjoyed your insightful and articulate commentary.

There is much that I too like about 1300smiles. I have been reviewing it, on and off, for a number of years now. I was close to buying a number of years ago, but regretfully decided not to. My concern stemmed from the fact that, at the time, I felt that 1300smiles was not yet proven in larger cities. It was well and truly proven in regional cities, especially in Queensland, but it was clear to me that the price multiples could only be justified if it could achieve substantial growth in capital cities.

I guess it is now starting to demonstrate that it’s value proposition is not restricted to regional Queensland.

Just a couple of things I was hoping you may want to comment further on.

1. Growth going Forward

You refer to 1300smiles being able to achieve 20% growth for the foreseeable future.
I note that the business has in recent times achieved a return on shareholder funds in the range 20% to 35% (roughly). Prior to the impact of the cessation of CDDS it was probably achieving upward of 30%. This was achieved on the back of substantial leverage. My numbers indicate that the business, without leverage, would have achieved somewhere in the range 25% to 30%.

As fantastic as these numbers are, with the company sporting a dividend payout ratio of nearly 70%, growth of the sort you refer to will only be achieved via very substantial leverage going forward. For example, if the company can achieve incremental returns on its capital in the future (in a post CDDS world) of 25%, then without leverage, and shackled with a 70% payout, the company will only be able to achieve about 7% to 8% growth.

On the other hand, it’s worth considering what growth the business could achieve if it took on substantial debt (it is currently debt free, as you no doubt know). If it borrowed to the tune of 50% of its equity, and it could invest the funds immediately at the 25% returns previously mentioned, then even if we ignore the interest bill, it will still only achieve growth over the next five years in the order of 17% per annum (assuming it makes no further borrowings in the next 5 years).

Sure 1300smiles is no doubt able to sustain this sort of borrowing, going forward, and if it borrowed closer to 100% of its equity (to achieve a debt to equity ratio of 100%) it would probably be able to achieve growth close to 20% per annum.

I personally like a conservative balance sheet and would much prefer 1300smiles to keep its capital (reduce the dividend) where it can be of most value to shareholders.


2. Returns on Capital going Forward

The fat returns on capital, described above, have to a very large degree been driven by the purchase of established practices at low multiples to their earnings.
I have no issues with regards to the morality of this (as some people seem to have). 1300smiles is buying a practice with minimal goodwill beyond the value of the existing dentists, and is adding enduring value through its ability to attract and retain dentists going forward.

However, my question is one of economics. Capitalism, being what it is, rarely allows very high returns on capital to exist for ever. It seems that 1300smiles is recovering strongly from the cessation of the CDDS. However, will the profitability of the current dental chains attract more entrants and will the competition for practices erode returns on capital, going forward? Its quite possible that 1300smiles is better able to buy practices where the practitioners are driven by a desire to practice within a culture that they like, rather then just dreaming about the Bahamas. But if the payouts get fat enough, the temptation will be too much, for many. Just a question.


3. Margins going Forward

The fat returns on capital, described above, have also been to a large degree enable by the very fat operating margin enjoyed by 1300smiles (and dental practices generally). I believe 1300smiles has typically demonstrated margins in the order of 22% (ratio of EBIT to dental fees).

I guess there’s a question about how sustainable these margins are, over the next 5, 10 or 20 years. I note that that there has been a large increase in the number of students in dental schools. I am unsure wether this will reduce margins going forward. On the other hand, reduced profitability for dentists may play to 1300smiles strengths, as it will make it less appealing for dentists to own their own practices. I’m unsure.

The other point to consider, I think, is that 1300smiles prides itself on being able to provide affordable dentistry. This may be at odds with a very fat margin, going forward.



I don’t want too sound too negative. As I say, there is much to like about the business. For instance, as 1300smiles grows, it may be able to increasingly extract scale benefits, particularly with regards to advertising.

Looking forward to your feedback.

Thanks
Mars