Volatility In SmileDirectClub Likely To Continue So Waiting To Buy May Be Best

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Summary

SmileDirectClub, Inc. (SDC) is a young company that sells clear dental aligners direct to the public and a small amount of dental hygiene products. The company aims to disrupt the large and traditional orthodontics market view home or small office do-it-yourself dental impression kits and a series of these aligners correcting dental alignment issues with less cost and office visits. The company went public on September 12, 2019 as a "unicorn" and currently has a market value of $5.1B. Since then is has been a volatile stock, hitting a high of $21.19 a share a few days after going public and a low of $7.72 in early December of 2019. The stock has rebounded recently to the $13-14 range near the mid-point of its valuation as a publicly traded company. The stock closed at $12.96 today, falling back below $13 a share. Despite this rebound and discount from IPO price, I consider it still a very risky stock that, instead of making you smile beautifully like the company's product could, might leave you frowning.

Issue #1-Regulatory and Legal Issues

Orthodontia is a highly regulated industry under a fragmented set of state regulations in the United States and different regulations in countries throughout the world. State Dental Boards regulate dental and orthodontic care in the U.S. and local and in some cases regional regulations such as in the European Union regulate the treatment in other countries. SmileDirectClub has already faced challenges and continues to do so in the U.S. and the few countries the company has expanded to internationally. Numerous dental boards are questioning these and similar devices that are used outside orthodontists' care. This is done under the guise of patient protection, a likely benefit but also has a self-protection and anti-competition flavor to it. As the company grows domestically and expands into more countries, dealing with this pushback and increased regulatory complexity will be a challenge.

Additionally, the company already faces lawsuits relating to failed treatments, including some that worsened existing conditions and caused others such as migraines and chewing difficulties. Most of these lawsuits are in their early stages, and honestly may not be financially material to the company. The risk is more in perception and marketing however. As SmileDirectClub is a leading pioneer of non-traditional orthodontia without traditional braces, these negative outcomes and bad press from these lawsuits could influence both acceptance of the treatment and value of the company.

Issue #2-Corporate Structure

SmileDirectClub is one of many recent IPOs to have a dual stock-class structure. In this company's case, one family and their investment fund controls the Board membership and has overwhelming and insurmountable voting power. The IPO was for Class A shares, which realistically have no say in the governance of the company. Additionally, the founder, Jeffrey Katzman and his father, Chairman and CEO, David Katzman, through Camelot Venture Capital, own and control the company with no outside independent directors. Additionally, David Katzman is involved in running Camelot Venture Capital and other companies though the fund. This might not be an issue, however, SmileDirectClub is planning on aggressive expansion in the U.S. while also expanding internationally. The ability of the company's management and board to handle this rapid growth is highlighted as a risk in reporting, and the inability of outside investors to have a corrective vote if they falter is one risk if a minor one.

Issue #3-IPO Lock-Up Period Expiring Soon

Like all IPOs, SmileDirectClub has a lock-up period after the IPO. In this case, it is 180 days, meaning the lock-up expires in mid-March. Especially as a unicorn, there is a huge amount of value for the Katzman family and other initial investors locked up in the stock. One venture capital fund has seen its investment double since the 2014 funding round and will likely seek to cash out some of this profit. While basically a family-run company, both Katzmans and Camelot Venture Capital are largely invested in the company, with most their wealth tied to this stock. Even though the company is trading nearly 50% below the IPO price, it is likely many more shares will come to market post lock-up expiration. With highly volatile daily trading volume and also large short positions approaching 10% of existing float, insider selling would put downward pressure on the stock.

Issue #4-How To Value A Money-Losing Disruptive Fast-Growing Company

Like many other unicorns, SmileDirectClub grew quickly with venture capital as noted above and during an early funding round was valued over $3B. This valuation was doubled when the company went public in September of 2019 despite ongoing operational losses. With only one quarter of reporting-the initial quarterly report in November of 2019-and another report soon, many inferences and predictions have to be made.

The positives are easy to see if not financial at the present. SmileDirectClub has an amazing brand presence, a huge untapped market even in the companies where it already operates, and some ability already in place to scale. Additionally, one major impact on the November financials was $324M in stock-based compensation, a huge one time hit related to the IPO. Healthily, SDC has little debt and a large cash stockpile from the recent IPO.

There are negatives lurking in the financials as well, and these could result in frowning faces even if the teeth are perfect. Even backing out the $324M in stock-based compensation and another one-time $6m in IPO related costs, SGA expenses totaled $60M, 100% more than the year ago period. Yes this is a fast-growing, expanding company, but this spike of 100% is much greater than the growth in both revenues and gross margin. As other authors have pointed out, customer acquisition costs also continue to rise. In some cases and for some periods, every $1 in new revenue is costing more than $1 to earn, which is not sustainable. Just today I noticed on the SmileDirectClub website a $150 off discount code and $25 for completing a scan-this totals about an 8.5% discount.

I'm staying away from the stock until there is more reporting and a stabilization in general and administrative costs. While waiting too long could cost some capital gains, with both the second quarterly report due soon and IPO lock-up period expiring, I believe there will be clearer opportunities to smile after initiating a position after these pass.

Best wishes for investment and life success!

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