Unboxing Earnings: SmileDirectClub 3Q20 Earnings Analysis & Impact On Valuation (NASDAQ:SDC)


SmileDirectClub’s (SDC) third quarter was a complete reversal from Q2. Revenue increased from $107MM to $169MM, gross profit margin increased from 54% to 70.5%, and adjusted EBITDA increased $3MM from $(20.3MM). While this was a great rebound, there is some trouble as 3Q20 performance was below 3Q19.

Source: 3Q20 Earnings Presentation

It is nice to see gross margins improve, but are still lagging from the results in the second half of 2019. Management still contends that the decline is transitory in nature and is due to the product mix. Based on the increase in volumes, GPM is expected to reach normal levels in the low- to mid- 70s. Investors should find comfort in this and SDC continues to find ways to improve their manufacturing efficiency. They are ramping up their automated manufacturing to streamline their process. Increased volumes along with improved manufacturing are two important components to reach their long-term GPM target of 85%. This is critical for SDC and investor confidence. Improving GPM by 150bps will flow down nicely to cash flow. Management has to be careful with target dates because investors will hold them accountable if it does not materialize. Right now, SDC is in the reprieve zone and they probably have another quarter to get GPM to historical levels.

As discussed in recent conference calls, management needed to improve their operating leverage to hit their long-term EBITDA target. Man-o-man did they improve their operating leverage. Their largest expense, marketing & selling, decreased from $142MM (72% of revenue) in 1Q30 to $67MM (40% of revenue) in the latest quarter. In the earnings deck, it is mentioned that ~70% of Q3 purchases were need leads. This is amazing! The cost of acquiring customers is more expensive than keeping current customers and to generate that type of operating leverage is great to see for investors. There is a nice bullet point in the earnings deck:

This reflects the sustainability of lower sales and marketing spend as a percent of revenue to support our revenue growth going forward.

I am a little skeptical on the long-term viability in the near-term. Marketing and sales costs were much higher last year and to cut costs this much and still get a good return has me wondering if this is just a favorable timing issue. Perhaps customers were on the fence and feel more confident about their financial situation and made the plunge. Another reason could be that management over shoot their spending and became bloated and now they are right-sizing the operation.

David Katzman, CEO stated in the 3Q20 conference call:

One important fact is that G&A labor and other costs remain down 22% since Q4 2019. We plan vigilant on this front throughout the remainder of this year and beyond, as we continue to drive towards our long-term target of 15% of revenue in G&A spending.

As we have stated before, we believe streamlining our cost profile through operational efficiencies will not only improve our margin profile, but more importantly, we’ll provide a consistently superior customer experience that meets our expectations and it pulls our brand promise.

With the higher sales, revenue and operating leverage, both adjusted EBITDA and net income improved. The positive adjusted EBITDA landed the Company to their positive EBITDA goal one quarter ahead of schedule.

Guidance is somewhat of a mixed bag, just like this quarter. Revenue guidance for Q4 is $180MM, which is below where SDC was last year, but is an improvement from Q3. Guided total FY20 revenue is $615MM compared to $707MM in FY19. The good part is operating expenses are expected to remain at similar levels to the most recent quarter leading to a profitable Q4.

Q3 has been a pretty good quarter and is a rebound quarter. It has not fully returned to pre-covid levels, but it is making its way back. There optimistic reasons, in my view, appear to be strong than the pessimistic reasons. SDC’s stock price and price to sales ratios have improved after the earnings release. I think it has been modest, but this was a tough week with the infection rates creeping up and no further stimulus on the horizon. I do not think the one-year high of 8x is completely off the table, a 7x multiple may be reasonable as it incorporates the expected revenue bump, improved operating leverage and the continued ramp of their manufacturing process. Based on my FY21 revenue estimate of $707MM (15% growth yoy) with the 7x multiple, the projected stock price is $13 per share.

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When I read through the earnings package, I felt the whole range of human emotions. It was a mixed bag quarter, but a stark improvement from the previous quarter. Financial performance is still underperforming from last year due to the impacts of Covid. Management believes they are on track to continue the uptrend and if the pandemic moderates, SDC could reap the benefits of increased discretionary spending. And here lies the risk. SDC is somewhat a discretionary purchase and we witnessed the impact in Q2 when discretionary spending goes down the tubes. This is a huge risk and why the stock is down from its previous highs. All-in-all, I think a 7x price to sales multiple incorporates all the current risks and realistic outlook for next year resulting in a target price of $13 per share.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SDC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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