Why SmileDirectClub's Spending Should Leave Investors Frowning

view original post

Without a doubt, SmileDirectClub (NASDAQ:SDC) is in the doghouse on Wall Street. As the share price continues to reach new 52-week lows, contrarian investors may be tempted to engage in some bottom fishing. They might observe that SDC stock trades for less than $5, while SmileDirectClub’s closest rival, Invisalign maker Align Technology (NASDAQ:ALGN), has a stock that’s approaching $700. But remember the old Benjamin Graham/Warren Buffett saying: Price is what you pay, but value is what you get. And when it comes to SmileDirectClub, the value of cost containment seems to have been lost on the management lately.

Image source: Getty Images.

Misaligned numbers

During 2021’s second quarter, SmileDirectClub undoubtedly vexed some of its cost-conscious stakeholders with an adjusted operating loss of $52.7 million and negative free cash flow of $51 million.

What ought to have been the greatest cause for consternation, though, was the company’s penchant for spending money it doesn’t actually have. At the end of that same quarter, SmileDirectClub carried an eye-watering $719 million in long-term debt, yet the company’s quarterly marketing and selling expenses increased 177.9%.

Any hopes of fiscal discipline were promptly dashed in Q3 as SmileDirectClub posted gross profit of $98.2 million, against a “marketing and selling” expense of $96.1 million.

Playing the blame game

Also during Q3, SmileDirectClub posted a trifecta of wide misses, with worse-than-expected showings on revenue, earnings, and forward revenue guidance. If ever there were a time for some mea culpa, this would have been it.

Instead, CEO David Katzman blamed SmileDirectClub’s poor quarterly performance on “macroeconomic headwinds that are influencing the spending of our core demographic.” This doesn’t necessarily comport with the common-sense test, though. The economy was recovering by Q3 2021, and besides, SmileDirectClub’s aligners are cheaper than an aligner made by a dentist.

SmileDirectClub’s problem isn’t an inability to generate revenues. Rather, it’s the company’s penchant for overspending — as a side-by-side comparison with a similar aligner designer demonstrates.

Where’s the money going, exactly?

It’s hard to pinpoint the most frustrating thing about SmileDirectClub right now. Maybe it’s that the company might have prevented its poor Q3 performance with some belt-tightening in the marketing and selling department. Perhaps it’s just the difficulty of making sense of the “marketing and selling” category of expenses.

One thing that’s crystal-clear, at least, is that SmileDirectClub’s marketing and selling expenses, as a share of the company’s revenue, have ballooned year over year : $96.2 million or 69.9% of revenue in Q3 2021, compared to $66.7 million or 39.6% of revenue in Q3 2020.

When we broaden the snapshots to nine-month periods, however, the gap’s not as pronounced: Marketing and selling expenses as a percentage of revenues increased to 56.6% in Q3 2021 from 51.6% in Q3 2020. Still, these are all high percentages for just one category of spending, and the latest quarterly figure of nearly 70% is disconcerting. This seems to suggest that SmileDirectClub’s been ramping up its marketing and selling spend, as a portion of the company’s revenue, as time goes on.

There’s no meaningful breakdown from SmileDirectClub as to what’s it’s spending on “marketing” (social media, television advertising, local events, etc.) as opposed to “selling” (bricks-and-mortar location rent, travel, supplies, labor, etc.). This lack of transparency makes it difficult to know where the company might be overspending, and how it might achieve fiscal stability.

Besides, rival Align Technology proves that a business in this niche doesn’t have to be run this way. Align was firmly in the green in Q3 2021 with over $1 billion in revenue (up 38.4% year over year), net income of $181 million (up 29.8% year over year), and total assets ($5.6 billion) that exceed the company’s liabilities ($2.1 billion). Moreover, Align Technology’s operating expenses consist of $428.4 million for selling, general, and administrative costs (42.2% of net revenues), as well as $65.6 million for research and development (6.5% of net revenues). None of that comes close to what SmileDirectClub spent in just one of several expenditure categories.

Nothing here to smile about

Clearly, SmileDirectClub’s management could learn a thing or two about cost containment from its chief competitor. Unless SmileDirectClub starts making strides in reducing its expenses — and accepting responsibility for its disappointing performance — it’s going to be difficult to recommend SDC stock.

Even if SmileDirectClub finally does start to turn that ship around, Align Technology should still inspire more investor confidence. The latter company hasn’t demonstrated a habit of spending money it doesn’t have, or allocating too much of that money into one category. As for SmileDirectClub’s investors who are sustaining deep losses, for the time being, they’ll just have to grin and bear it. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.