SmileDirectClub lost its smile in Chapter 11
SmileDirectClub (SDC) is not a club of smiling faces anymore. It filed for Chapter 11 on September 29, 2023, in Texas, and is looking for a buyer until November, otherwise, it will face liquidation. Centerview Partners is the investment bank and Kirkland is the law firm representing SDC during these proceedings. The company tried everything to protect itself from bankruptcy, including hopping on the AI trend. The bankruptcy was triggered by the deadline to pay Align’s lawsuit on September 29.
To give a quick background, SDC was founded in 2014 by Jordan Katzman and Alexander Fenkell. Initially, the company focused on buying and reselling aligners and retainers via its website, which helped the company grow its revenue but at high costs. So, it shifted its focus on manufacturing aligners itself, and opened its first 3D printing manufacturing plant in 2016, including an investment by Align Technologies (maker of Invisalign) with an exclusive supply agreement. This relationship soured quickly as both sides ended up in arbitration. SDC accused Align of replicating its business model, and arbitrators forced Align to divest from SDC and close its retail operations. In August 2020, after the end of the supply agreement, Align filed suit claiming that SDC violated its supply agreement, and the arbitrators found SDC liable for $63 million, which was confirmed by the California Trial Court in August 2023.
SDC’s business model was simple: manufacture aligners and sell them online or in retail. It was growing in high double digits, with peak revenue hitting $750m in FY19, only to decline to $470m by FY22 and performance worsening in the first half of FY23. In the CFO’s declaration, the company points out pandemic closures, high-interest rates, inflation, and Align lawsuit as the main culprit for the demise of its business. While it is true that the pandemic turned the business upside-down, its major problem stemmed from the fact that low-cost aligner isn’t profitable due to their high selling cost. The company on average spent ~59% on marketing and selling in the past 5 years, and its best year for EBIT margin (-10%!) was in FY18. Moreover, the company pursued an aggressive sales plan, which led to customers getting aligners they didn’t need or without proper consultation. This led to negative reviews piling up, damaging its brand image. Hindenburg Research outlined the negative development surrounding the company back in 2019, including a customer who couldn’t breathe after using SDC’s aligners.
I believe this story provides an important lesson, if a company is hoping to reach scale by offering low-cost solutions to customers, then the customer’s economic struggle becomes the company’s struggle. The average income of their customer was ~$70,000, and this group felt the most pain during current inflationary and high-interest periods, which forced them to reduce discretionary spending. Moreover, dental care is not as important compared to other healthcare-related spending, as its usually not life-saving.
When SDC filed for bankruptcy, it had a total of $891m in debt, with the majority of it related to the 0% convertible notes. None of the non-US entities are debtors in Chapter 11. HPS credit facility holds certain current assets held in an SPV as collateral, mostly related to SmilePay, the installment program initiated to offer low-payment options for its customers. SDC, the parent, guarantees 10% obligations of SPV related to the HPS credit facility agreement.
SDC’s financial profile took a turn for the worse after FY19, with revenue declining YoY 26% in FY22. The company reported adjusted EBITDA by adding back stock compensation, which I decided to exclude as an add-back. Although SBC is not a cash expense, it is a continuing expense that comes at the cost of shareholders. After adding back SBC, the EBITDA margin has been constantly negative, highlighting the poor business model that could not support the leveraged balance sheet.
The poor financials might be the reason why Centerview did not find any lender willing to provide DIP financing, as it reached out to 61 parties and only received 1 proposal that was deemed insufficient. The company was close to finalizing an exchange transaction with convertible note holders, resulting in a $85m capital injection, but the transaction required approval from HPS, and ultimately the convertible note holders declined to move forward. The founders stepped in to provide a total of $80m in DIP, with the first $20m available at filing, and the rest of the money available on meeting future milestones. The DIP also includes the roll-up of the $5m note to super-priority. It charges a 17.5% PIK interest and 10% PIK fees on the total amount received.
While the company is looking for an active buyer for the company, it looks like an ambitious plan. It already faced significant challenges raising DIP, and its brand image isn’t as popular anymore. Moreover, the financial performance doesn’t entice any benefit for potential buyers. The only benefit a buyer could receive will be the 3D manufacturing plant.
If SDC doesn’t find a buyer, it will begin liquidating itself as there won’t be any other alternative available. Assuming SDC uses $80m of its DIP, in liquidation, DIP will receive a recovery of 100 (total payback ~$90m including interest & fees). Next in the capital structure is the $138.1m HPS facility, which is backed by SPV collateral, and would recover 100%. Other current liabilities totalled $112m in Q2–23, assuming the amount is close to June end. Restructuring-related fees are hard to determine, but according to the DIP budget document, $15m in fees is expected to be paid in the next 3 months. The Align judgement will pull another $63m away from SDC. With total assets of $485m, $418m is used to pay secured creditors, fees, lawsuits and current liabilities. The remaining creditor is $747.5m convertible senior notes, which only has a claim to the left-over $67m in book-value assets. The remaining recovery for convertible notes will be lower than $67m, as after paying back the senior claims, the asset that would likely remain is PPE, which is valued at $175m at book. When looking closer to it, 60% of pre-depreciated PPE is derived from computer software and equipment, which has a lower market value compared to book as computer software becomes less relevant if the company doesn’t exist and used computer equipment does not fetch good used-market values.
Although the convertible notes might seem to get some recovery, ~1c on the dollar, the market has already priced that in. This notion questions the recovery for senior claims because if we assume inventories and prepaid assets only have 50% recovery, then certain senior claims will also rely on PPE value. If less value is derived from other asset accounts, then I won’t be surprised if other groups are impaired as PPE book value isn’t reliable. Based on the recovery estimate, Align’s lawsuit might be impaired as well, which might boost recovery in convertible notes as impaired groups would likely share the remaining pot only if they’re treated as one class.
The company’s plan to find a buyer for the company might provide some lifeline to creditors, especially the convertible noteholders, as there is a potential for convertible recovery to be above 1 if someone offers a premium. However, SDC doesn’t offer much value. At most, the buyers might tap into the existing relationships with customers and dentists, but SDC managed to lose millions during its time, pushing away interest in buyers looking for benefits. The founder did agree to put $30m of their own capital to assist in the sale, but the amount doesn’t seem significant enough to attract buyers. A potential buyer might be Align itself since they already have a judgment against the company, and they might use it to acquire SDC’s business. In such a case, the recoveries for the secured lenders would still be 100, but I doubt convertible noteholders will get any significant upside from it unless Align offers some recovery in the form of stock or cash to gain their approval. The convertible group will have the power to vote in the proceedings, as they would be the largest impaired group, so winning their approval would be helpful for Align.
As of writing this article, the current market cap for SDC is ~$65m, and the value is likely derived from its treatment as a call option by the market. Given that convertible notes would be impaired with a very low recovery rate, I doubt the common stock will get any recovery.
Overall, SDC’s bankruptcy doesn’t seem like a shock, as mounting losses combined with flawed business practices caught up to reality. However, the question does remain, why would lenders provide unsecured capital to a money-losing company? It’s not impossible for money-raising firms to raise debt, but the amount of debt raised here leaves an impression that lenders were assuming the business to grow and expand margins after the pandemic eases. It also seems like the lenders were focused on the upside and neglected the downside scenario in this case, as the convertible option probably made the deal attractive, especially when stock prices were trending upwards. While I’m not directly involved in the lending or investing world, I believe providing significant debt to a money-losing company is a bigger gamble than providing equity capital, as raising debt requires interest and principal payment. Also, providing online access to a dental service, or any medical-related service is not as easy as it seems.
