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SmileDirectClub (NASDAQ:SDC ) is an oral care company and the creator of the first MedTech platform for teeth straightening. The stock is down more than 70% from its 52-week high of $16 and trades, as of Thursday (2.12.2021) at $3 per share. SDC is one of the biggest positions in my portfolio and today I would like to share with you the main reasons why I am bullish about this stock.

I find SDC as a rare combination of hidden improving fundamentals, cheap valuation, and high growth potential. While the market may treat SDC as a bankruptcy contender (which it is not, as I'll show later), I think the new GP and international expansion through their new marketing strategy and great product offering will eventually lead to long-term sustainable growth.

First things first, let's talk about the business. SDC was founded in 2014 with the mission of revolutionizing the oral care industry. Their main product is clear aligners (CA) for teeth strengthening. In addition, they also offer a variety of ancillary oral care products, such as whitening kits, toothbrushes, and more, all with the vision to create and maintain a perfect smile.

Since inception, SDC has treated over 1,500,000 patients. According to the company, they can help over 90% of people with malocclusion, estimated at around 500mm people worldwide with roughly $25B for the US market, achieve a better smile. Now, though investors tend to get over-excited when facing a company with such a large TAM, let's just agree that the TAM is definitely there for SDC to compete on.

SDC is a DTC (direct to consumer) company. Assuming a patient wants to start a treatment with SDC he faces 3 options to start.

Each patient may decide on one of two treatments: A 4-6 months plan, 22 hours daily wear treatment; or 10 months nightly wear treatment. Using the information collected, SDC creates a draft custom treatment plan that demonstrates how the member's teeth will move during treatment. Next, via SmileCheck, SDC's 24/7 end-to-end platform that controls the entire procedure, a state-licensed doctor reviews the information collected from the member, determines if the member is appropriate for treatment and if so finalizes and approves the member's treatment plan.

The company offers two payment options.

Then they manufacture and ship the aligners to the member. The treating doctor monitors the member's progress, requests additional information, and communicates with the member over the course of treatment through SmileCheck. Upon completion of treatment, most members purchase $100 retainers every six months to prevent their teeth from relapsing. If they are compliant with treatment protocols, each member is entitled to a Lifetime Smile Guarantee. This ensures a full refund within the first 30 days, or additional aligners at no cost for further adjustment at any point later in the process. The company also accepts insurance and is in-network with the top providers in the US.

SDC offers their aligners for $1,950 which is highly competitive against the >$5000 for both the Invisalign treatment and traditional braces. All while maintaining a gross margin of above 70% and guiding for a long-term gross margin of 85%. To understand how SDC can charge 60% less than the alternatives, I would separate and tap into the three main options on the market today.

1. The traditional braces treatment. The most used and reliable method is still mostly preferred by most old-school orthodontists. With a manufacturing cost of $200-$300 and an end price of $5,000+ to the customer, it is highly profitable for orthodontist clinics. The downsides of this method were and will always be esthetics and affordability. Many people can't afford it and others, especially grown-ups, avoid it for appearance reasons.

2. The clear aligners method by Invisalign. The first company to introduce this method was Align Technology (ALGN) through the Invisalign brand. This method had improved substantially and is now accepted by many doctors for almost all cases. CA are much cheaper to produce, and their appearance is almost invisible to the patient. Invisalign's business model is to partner with clinics, sell them their scanning equipment, and reduce their overhead cost by lowering the number of appointments and the associated manpower. From a business perspective, ALGN sells a $1,200 kit to the clinic with less than $100 manufacturing costs leaving high operational margins. The clinic lowers the per-patient overheads costs, and by selling it for ~$5,500, achieves EBITDA margins of 25%-50%. Needless to say, it now opens a wider market share for the clinic due to the esthetic benefit of the invisible treatment.

3. SDC's clear aligners method. SDC's disruptive method took the CA one step forward enhancing it with a DTC business model. Removing the man-in-the-middle cost overhead by eliminating the interface between the patient and the doctor results in a 60% cost reduction to the end-customer with high gross margins. But nothing comes for free and SDC has to deal with gaining credibility. Not having the physical doctors managing the customer and relieving his concerns is a paradigm shift that many patients need to go through. That is why SDC also invested in offering their treatment through a Partner Network program that allows patients who want the physical touch, at least at the beginning, to have their first scanning appointment at a physical clinic for the same cost. The partnership benefits SDC by improving brand credibility and extending its reach to the clinic's own customers. As for the clinics, they get a fee from SDC for each patient that they convert, and for their chair time, while also gaining traffic and potential long-term patients out of SDC's patients who come for a scan.

While Invisalign became an attractive solution for the upper class, SDC became an attractive solution for the middle class and specifically the $50K-$70K annual income households - the people who wanted their teeth straight but could afford neither Invisalign nor traditional braces.

SDC has faced some severe accusations throughout the years, and specifically in 2019-2020. Perhaps, the most damaging bad press happened in March 2020 when CBC News' Marketplace released a report where they found the company had made misleading claims and gave unreliable treatment plans. Marketplace sent four potential customers wearing hidden cameras to SmileDirectClub locations in Toronto. While SDC approved all patients, orthodontists that reviewed the treatment plan said none should have been approved.

In response, SmileDirectClub stated that "all four were acceptable and would result in the improved appearance of smiles." It also released a list of changes that they implemented immediately throughout the organization:

Those changes include increasing SmileShop training, adjusting the consent and history form so customers understand the need to visit a dentist six months prior to starting treatment, and will now be supplying customers with the name and contact information of their treating doctor as soon as they are approved for treatment.

When facing a healthcare-related decision, treatment credibility is one of the most important metrics. After hearing those accusations, many wouldn't consider SDC's treatment no matter its price. Therefore, during 2019-2020, SDC couldn't effectively compete with Invisalign on the upper-market demographic. But, since early 2020, the company has improved immensely on its product and procedure. They can now treat much more cases and their brand image had improved. It appears that topics of complaints from 2018-20the 19 reviews of SDC's product and service have now been replaced with highly positive feedback and are even pointed towards the strengths of SDC's offering in the 2020-2021 reviews. This is another good sign for a company that listens to its customers, thus contributing to the tremendous progression in the reported brand image in the last several quarters.

According to research that was funded by SDC and conducted by a 3rd party team, SDC's customer experience is neck to neck with Invisalign's. And maybe the most crucial metric for the brand's credibility is GP awareness. SDC is focused on expanding its Partner Network and it seems to work quite well for them. In the latest quarter, it has expanded into 735 locations worldwide with 1,600 locations in the pipeline, up from 1,000 locations QoQ.

Another extremally positive point from the latest quarter is the decision of the AACA to deviate from actively campaigning against SDC and instead asking it to become a member of the organization. After years of scrutiny and criticism from national oral care organizations, many are now reconsidering SDC's approach and contribution to this market as valid.

I knew it was plausible for SDC to miss expectations, but to be honest, I didn't anticipate this bad of a result. Revenue declined 18.3% YoY to $138mm and earnings came at a loss of $89mm (down 105% YoY), while adjusted EBITDA came at a loss of $54mm (down $57mm YoY). Both last and previous quarters came below expectations, though the latest quarter was much worse.

Now, the company is giving two main explanations for the results. The first is macroeconomic related. The company noted that its most important household demographic, the $50K-$70K, suffered a lot from the recent inflationary environment. Lately, those households are in a state of uncertainty, and when combining inflation, underemployment, uncertainty, and an overall recent preference of goods over services, they had less spare income.

The second is related to the iOS 14.5 AppTrackingTransparency (ATT) upgrades. Those changes impacted social media platforms from properly tracking their ads. The two issues with the upgrade were: 1) Tracking efficiency has declined, therefore it is more expensive to achieve prior results. 2) Measuring performance has declined as a result of underreporting iOS web conversions.

SDC has heavily relied on marketing through social media with a mid-funnel strategy, which means that the company targets potential customers that are already interested or have a high potential of interest in the company's products. It's like fishing for fish that kind of want to be caught. The "problem" with mid-funnel marketing is that it has little to no impact on aided and unaided awareness. Or in other words, you can't fish the fish that don't know about you. Therefore, because of the ATT changes and the improved credibility of SDC's brand, the executive team has decided to rethink their marketing strategy towards a top-of-the-funnel approach. By switching its strategy the company aims to improve its brand awareness and compete with Invisalign for the upper market. But in the meantime by directing the same $95mm of marketing towards different strategy the company has turned less potential customers toward real patients. Or with less interested fish because of macroeconomic issues and fewer fishing rods the company caught less fish.

I agree with the decision for pivoting the marketing strategy. There is a tremendous potential for market share gain when combining the improved brand credibility with a push for higher brand awareness as displayed below.

The recent valuation of less than $1.5B is the market saying that there is a high probability of bankruptcy. I don't see it materializing. Let me explain why:

Further, free cash flow in the latest quarter was a negative $63mm. But it was an outlier because of the poor results. The typical negative free cash flow is $40mm-$50mm per quarter. From the above figures, I calculate that SDC has enough liquidity for at least a year. On top of that, the company has proven two important points.

1) They know how to raise money as they showed in their latest bond sale, which had much better conditions than companies in SDC's position tend to get.

2) During the highs of Covid in 2020, the company managed to reduce their cash burn to roughly $0.

I am convinced that SDC would achieve the 80%+ gross margin guided in their forecasts. The material cost of the aligners is cheap, and the efficiency of their 2nd Gen machines would make it cheaper. Combining manufacturing at a scale with low material cost and fewer headwinds from shipment will lead to the guided gross margins.

EBITDA margins are due to improve as well. The company's growth initiatives and specifically international expansion would have a negative impact for some time but eventually at scale, with G&A and marketing expenses stagnating, SDC has a highly profitable business model.

SDC's success is determined by its ability to generate brand awareness and preserve its product credibility. Because those are the main pillars for long-term sustainable growth in a healthcare innovator with a DTC model. The company is overinvesting in international expansion, and so far international margins lag those in the US. Moreover, in new markets like Spain and Germany, the company underdelivered relative to management's expectations.

The complete pivot in marketing strategy is a gamble that might not pay off. There is no guarantee that the upper-class demographic would replace Invisalign's great product for SDC's only for the price point (the main selling argument of SDC). Furthermore, all the recent initiatives and specifically the recent Partner Network expansion might come to an end in any case of bad publicity around the company. Lastly, one of SDC's many less known CA DTC competitors might gain momentum and replace SDC as a disruptor in the market.

SDC has huge growth potential for years into the future. Their product and market approach is most suitable for most people who search for teeth alignment treatment as it provides a compelling price, reliable treatment, and convenience with minimum hassle by the consumer. Revenue growth is not the only metric to look for in a growth company, and the recent developments in brand image, the Partner Network, and internationally (which I hadn't elaborated on) tell a great story that many do not notice. I expect the company to return to double-digit revenue growth in Q2-Q3 2022 (because of difficult comps in Q1), and for results to beat expectations in at least one of the next couple of quarters. SDC's stock has been so beaten down that next quarters' positive signs would stretch back the P/S ratio from less than 2 to more of a normal level.

Invisalign trades at a huge premium compared to SDC, and fairly so. The company is firing on all cylinders and growing tremendously. But it doesn't mean that SDC is not a bargain. SDC has the potential to gain market share in the higher income class demographic (which felt Covid the least). I believe that more and better CA options to the end-consumer would result in a quicker shift to the CA method from both traditional braces and from people who previously chose not to get treated.

I expect SDC to return to a double-digit growth rate at the latest in the second half of 2022 and from there on, with much easier comps, to grow revenues 20%+. As I previously discussed, SDC's business model has tremendous economic potential, its margins will expand, and revenue growth will come back stronger and more sustainable. When accounting for the above and for the S&P 500's P/S ratio of 3.2 (with SDC's long-term higher margins and faster growth), Invisalign's 13, SDC's 6+ prior to Q2 earnings, and assuming for a more cautious market because of the last couple of quarters, a P/S ratio of 4-5 is highly doable. Do note that SDC is not only a turnaround play, the potential for stock price appreciation is there for many years into the future.

At the end of the day, the clear aligners market is big and growing. In the market, there are two main players with two different approaches, from price point to treatment assembly. It won't be natural for only one player, and the more expensive one, to end up conquering the entire market - especially when both players have good brand credibility and product reviews. The business dynamics in the oral straightening industry are set for disruption at scale, and in today's environment when people are so mindful about their spending, SmileDirectClub has a great approach that combines affordability and convenience. The company is improving consistently, and when considering the international (75% of the market is overseas) and Partner Network expansions, it is just a matter of time before high revenue growth and margin expansion would come back, despite what one might infer from the latest quarterly results. All for a P/S ratio of less than 2.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of SDC either through stock ownership, options, or other derivatives. 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.