Editor's Note: This article has been updated to reflect that there will not be a delay in the implementation of the California dental board bill to allow for public statement and argument. The bill will go into effect January 1, 2020.
New public company SmileDirectClub (NASDAQ:SDC) has been the poster child for a frothy pre-IPO market, in which high-growth yet money-losing businesses come to market at high valuations from the private market, only to be sold off significantly once the shares become publicly traded. Recent examples include Uber, Lyft, and Slack, but none have been sold off quite as much as SmileDirect. Since its initial public offering in September at $23 per share, SmileDirect's stock plummeted over 60% since, to just $8.96 as of this writing.
Why the large drop in shares? High expectations surrounding the company's disruptive service ran into concerns over regulations that could upend the company's cost structure -- or worse, its entire business model. Two short-seller reports in October raised concerns over the safety of SmileDirect's business, which bypasses the traditional model that requires visits to an orthodontist, and revealed previously undisclosed raids on its California SmileShops by regulators that were not disclosed in its IPO documents.
But after such a large drop, is SmileDirect's stock an opportunity, or is it still a no-go?
SmileDirect's exciting business
No doubt, on the surface, SmileDirect has exciting prospects. The company has developed a direct-to-consumer approach to tooth realignment. Customers can either stop into one of over 300 SmileShops to get a 3D scan, or use an at-home impression kit and mail it into SmileDirect.
After the customer mails in the results, a licensed orthodontist in SmileDirect's doctor network approves a plan, then sends clear aligners directly to the customer's home. The whole offering, which takes place without the need for X-rays or regular visits to an orthodontist, costs about $1,895, compared to traditional solutions that go for $5,000 to $8,000.
The cost-saving service has achieved high growth since its founding in 2014. This year, management guided for revenue in the range of $750 million to $755 million, representing 78% growth over 2018 at the midpoint. The company has helped more than 700,000 people improve their smiles to date, and recently expanded to the U.K., Ireland, Canada, Australia, and New Zealand.
Even more enticing, SmileDirect has a huge addressable market. The U.S. orthodontics market is $234 billion and the worldwide market is a whopping $945 billion. That overall market is also set to grow, as about 85% of the world's population has malocclusion, or imperfect teeth positioning when the jaws are closed, but only 1% seek treatment.
Trouble in smile paradise
Of course, there's a reason the stock has fallen so far so quickly. While many investors were initially lured in by the company's eye-popping growth and market opportunity, some big risks are now coming to the fore.
Before SmileDirect's IPO, Alabama and Georgia already passed dental board rules that require a licensed dentist to be present whenever 3D images were taken. Putting a licensed dentist and X-ray machine in all 300-plus SmileShops would definitely increase the company's costs, so SmileDirect is suing both states' dental boards.
After the IPO, California passed Assembly Bill 1519, reauthorizing the Dental Board of California; language was put into the bill requiring an X-ray for orthodontic care. SmileDirect claims it can still operate as normal in California for now, but should the bill go into effect as worded on January 1, it could add even more costs to the company's business model.
In the recent quarter, SmileDirect's legal costs surged, doubling over the prior quarter, as the company paid up for more proactive lobbying to take on various states' regulatory hurdles. While it's a positive that the company is taking a more proactive approach, these added costs are eating into its cash hoard, which last quarter totaled $547.5 million, while it had $225.8 million in debt.
Adding costs to the business model could be harmful to SmileDirect: Despite its torrid revenue growth, the company is still losing money. Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) -- itself a dubious metric that may overstate true profitability -- is still projected to be negative in 2019, between negative $73 million and negative $80 million. Adding costs at this point would make SmileDirect even less profitable. And if the company raises prices, it could limit growth.
Problems called out by short-sellers
The concerns of these state dental boards may have real merit. A recent short report by Hindenburg Research said the Better Business Bureau received 1,200 complaints against SmileDirectClub, and the report presented several individual cases of patients being harmed by the company's aligners, including one particularly troubling story about a customer who had to use wire-cutters to break his aligners after they got stuck, making it difficult to breathe. Even more troubling, Hindenburg discovered that in exchange for reimbursement, harmed and dissatisfied customers were forced to sign an agreement not to post negative reviews about SmileDirect online.
While short-seller reports sometimes exaggerate their findings to promote their position, the potential for consumers to accidentally hurt themselves in performing do-it-yourself orthodontics is plausible.
Corporate governance concerns, too
Hindenburg is also, rightly, focused on corporate governance. SmileDirect is largely run by chairman and CEO David Katzman. His brother Steve is the chief operating officer, and his son Jordan is a director and co-founder of the company. These three and another co-founder, Alexander Fenkell, own some 90% of the company's Class B voting stock, giving them nearly that much voting power and thus total control over the company.
With such a small team controlling so much of the company, Hindenburg points to a couple of instances that could be interpreted as insiders benefiting at the expense of public shareholders. For instance, most of the $1.3 billion in IPO proceeds didn't actually go back to the company: About $700 million was used to pay off insiders and other pre-IPO investors, almost $400 million of which went to the three Katzmans.
The company also purchased the CEO's private plane for about $3.4 million, after "renting" said plane from Katzman to the tune of about $1 million per year, according to its registration statement.
These instances shouldn't necessarily eliminate SmileDirect from your consideration, as everything was disclosed in the registration statement, and insiders do still own a lot of stock -- far more than they sold. Still, it's not a great sign to see founders cashing out this much of their stakes just when they're asking the public to buy in.
Too early to say
Management has, predictably, been steadfast that its treatment is safe, and points to the fact that it adheres to all U.S. Food and Drug Administration regulations. However, even a few incidents of customers getting hurt -- perhaps inevitable in this business model -- could tie up the company in legal disputes. While it's still unprofitable, the company is in a tough spot: It needs to spend not only on marketing to keep up growth expectations but also on legal expenses for defense and lobbying to keep restrictive legislation at bay.
There are definitely a lot of risks with SmileDirect, so I'd steer clear of the stock for now. If the company can overcome its legal issues and get an "all clear" from both federal and state governments, while also keeping its cost structure intact, SmileDirect could eventually be a winner. But if that happens, it's still a ways off.