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Outlook Still Bright For Pacific Smiles

Small Caps | Jun 01 2017

Dental chain Pacific Smiles has signalled softer trading conditions occurred in April and May. Regardless, brokers remain positive about the longer term outlook.

-Some impact because of fee reductions to align with nib's "first choice" network
-FY18 outlook suggests margin expansion is not on the cards for 12 months
-Funding capacity for expansion unaffected by downgrade

By Eva Brocklehurst

Dental chain Pacific Smiles ((PSQ)) has signalled softer trading conditions were suffered in April and May. While downgrading near-term estimates, brokers remain positive about the longer term outlook.

The company has lowered FY17 underlying operating earnings (EBITDA) guidance to $20.4-21.0m from $21.7-23.2m previously, while same-centre patient fee growth guidance is reduced to "at least" 3% from previously being set at 5%.

Pacific Smiles has stated that no particular centre or geographic region stands out as the main contributor to the shortfall but notes there was some forward activity in the March quarter, with a subsequent reduction in the June quarter, because of changed arrangements with nib ((NHF)).

This is primarily volume-related with some pricing impact because of slight fee reductions to align fees with nib's "first choice network".

Nib Network

The company opened six new centres in the second half and plans two more by the end of June, including an nib-branded centre. Pacific Smiles dentists that practice at the nib-branded centres, along with Pacific Smiles-branded centres, are part of the new network arrangements.

Bell Potter understands that nib will now be offering "no gap" benefits exclusively to its policy holders and only at the nib-branded centres.

Yet the broker expects Pacific Smiles to benefit from greater exposure through nib's marketing and through an increase in patient volumes at the seven nib-branded centres it runs.

Admittedly, some of the increased volumes maybe redirected from existing Pacific Smiles branded centres, as patients take advantage of the “no gap”, and this may offset any immediate increase in patient volumes.

Nevertheless, marketing support should allow Pacific Smiles to benefit by directing customers from competing dental centres in the long run, Bell Potter contends.

The company has been able to take advantage of its scale and advertise widely, while the increased retail orientation of new centres has allowed it to adopt more retail-type marketing such as pop-up booths in malls.

Downgrades

The broker continues to expect the company will fund organic growth through operating cash flow and maintain its dividend pay-out ratio of 80-90% of net profit.

Bell Potter downgrades forecasts for operating earnings by -6% and net profit by -8-10% for FY17-19 to account for the company's softer guidance. A Buy rating is retained with the target lowered to $2.22. The broker assesses the company's business model to be superior to its nearest listed peers.

The headwinds in the short term, such as the pace of the centre roll-out and muted same-centre patient fee growth from older centres, do not detract from the medium to long-term growth outlook and Bell Potter continues to expect double-digit growth year-on-year from FY18 onwards.

Wilsons downgrades to Hold and lowers its target to $2.00, although acknowledges the company's network performance appears better than that of the broader dental industry.

The setback is disappointing in regard to short-term earnings and FY18 margins but Wilsons emphasises, strategically, nothing has changed. High growth is reported by new centres and above-market growth from mature practices.

Moreover, the business is scalable and consumer-directed and the broker notes the company seeks to roll out practices in a demographically sensible way and there are high returns on invested capital. Funding capacity for expansion is also unaffected by the earnings downgrade.

Adjusting same-store fee growth assumptions, Wilsons cuts net revenue estimates by -4%. The broker believes increased corporate expenses in FY18 should keep margins flat and delay any leverage opportunity until FY19.

Nothing in the update changes the broker's positive attitude towards the company's aspirations in the Australian dental market. However, the FY18 outlook suggests that margin expansion is not on the cards for at least 12 months, in which case the stock's premium valuation multiples appear less resilient.

Morgan Stanley observes margins in the early stages of the rolling out of a business are highly sensitive to a shift in the speed of the roll-out, or investment, and will come into focus.

On the broker's calculations guidance implies a step down of 125 basis points in margins in FY17 and a further 27 basis points slide in FY18. Management has confirmed it expects an improvement in FY19. Morgan Stanley downgrades FY17 forecasts for earnings per share by -12% and FY18-19 by -20-22%.

The company has indicated it will roll out at least 10 new centres in FY18. The broker expects more, although even if this turns out to be incorrect the outlook of 10-15% fee growth implies continued softness in comparables into FY18.

Morgan Stanley retains a Overweight rating with a reduced target of $2.25 (from $2.60) as the organic performance and opportunity remain intact, despite the fact that the business is relatively less resilient than previously thought and the margin improvement will be pushed out.
 

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