Dentistry is an attractive industry for investors to consider due to its defensive qualities and positive long-term growth prospects driven by favourable demographic trends.
Two quality businesses
Furthermore, there are two high quality dental chains listed on the ASX: Queensland-based 1300 Smiles Limited (ASX: ONT) and its larger peer Pacific Smiles Group Ltd (ASX: PSQ). Their quality is evidenced by the high returns on invested capital that both companies generate.
I estimate that 1300 Smiles will create about $8 million of free cash flow this year and Pacific Smiles will deliver around $11 million. Both figures are adjusted for capital expenditure on growth initiatives such as store rollouts and acquisitions.
At 31 December, 1300 Smiles had equity of $35.3 million, cash of $8.6 million and no debt. Pacific Smiles had $43.1 million of equity, $5.3 million in cash and negligible debt.
Therefore, 1300 Smiles has a return-on-capital-employed (ROCE) of 30% versus a slightly lower 29% for Pacific Smiles. These are impressively high figures compared to other listed companies and so it is fair to say that both are either very good capital allocators, enjoy favourable business environments or a combination of both.
A few differences
However, the two businesses have markedly different growth profiles and profit margins. When 1300 Smiles listed in early 2005, it had seven surgeries and has grown to 23 locations today as per the company's website. Pacific Smiles had six centres in 2005 and has 62 today, roughly three times the growth rate of 1300 Smiles.
Both companies grow through a mixture of acquisitions and setting up new practices with 1300 Smiles seemingly placing an emphasis on the former and Pacific Smiles engaging in more of the latter.
Whilst Pacific Smiles is growing faster, it has inferior profit margins compared to 1300 Smiles. Pacific Smiles' earnings before interest and tax margin (EBIT%) was 17.2% in the first half of 2017 compared to 29.5% for 1300 Smiles.
One reason for this is because of Pacific Smiles' aggressive roll-out strategy. New surgeries take time to become established which softens group profit margins, particularly given the speed at which Pacific Smiles is growing.
Another reason for 1300 Smiles' superior margins is the extremely modest pay of its leadership team. Total pay for directors and key management was just $0.2 million in 2016 compared to $2.2 million for Pacific Smiles.
Verdict
I suspect that Pacific Smiles is a superior business to 1300 Smiles. It generates similar ROCE despite growing much faster so if it stopped growing for a couple of years I expect its ROCE would surpass that of 1300 Smiles as new locations would have a chance to mature, thus boosting profit margins and revenue.
Also, its locations are well spread across the east coast whereas 1300 Smiles is still heavily focused in Queensland. Therefore, Pacific Smiles is less susceptible to region-specific economic slumps such as the impact of the mining slowdown on Queensland that has hurt 1300 Smiles during recent times. However, 1300 Smiles is addressing this weakness and has started expanding into other states, recently announcing two acquisitions in Sydney.
On the other hand, Pacific Smiles has a much shorter history as a listed company as its IPO was at the start of 2015 whereas 1300 Smiles has been listed since 2005. 1300 Smiles has built up an exemplary track record over this time in terms of the way it treats shareholders. Its executive pay structure is one example of this and so is its clear and open market communication. It is unlikely that Pacific Smiles will be able to match its smaller rival on this score.
Finally, Pacific Smiles is trading at a significant premium to 1300 Smiles. Based on my estimated free cash flow figures, I reckon Pacific Smiles has an enterprise value-to-free cash flow ratio (EV/FCF) of 26.6 versus 20.4 for 1300 Smiles. Arguably, this is justified due to Pacific Smiles' stronger growth profile and so overall there is very little to split these two high quality investments.
If I had to pick one, it would be 1300 Smiles due to management's track record of treating external shareholders as equals. I am yet to find another ASX listed company that matches 1300 Smiles in this regard.
