1300 Smiles. Smiles all round

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1 ADD Current price: Target price: A$7.11 A$7.94 Previous target: A$ Up/downside: 11.7% Reuters: Bloomberg: Market cap: Average daily turnover: ONT.AX ONT AU US$122.0m A$168.4m US$0.03m A$0.05m Current shares o/s 23.70m Free float: 100.0% Price performance 1M 3M 12M Absolute (%) Relative (%) Scott POWER T (61) E scott.power@morgans.com.au Dr Derek JELLINEK T (61) E derek.jellinek@morgans.com.au 1300 Smiles Smiles all round ONT has a solid history of profit and dividend growth across its ten-year history as a listed company. While ONT has a strict approach to acquisitions, the highly fragmented nature of the dental industry provides opportunities to grow the number of practices. The dental industry has grown by 4.0% over the last ten years according to IBISWORLD and that growth is forecast to moderate to 2020, with the corporate dental models likely to benefit. We initiate coverage with an Add recommendation and A$7.94 price target. Dental industry continues to grow The Australian dental services industry generated revenue of A$8.8bn in CY14 and is forecast to grow at low-single digits to The industry is made up mainly of independent sole proprietors operating small-scale dental practices. The major players including 1300SMILES (ONT), Dental Corporation and Pacific Smiles have grown organically and through the acquisition of smaller practices. The majority of dental care expenses are funded directly by individuals, with the rest funded by private health insurance, and state and federal governments. Full service dental operator growing the footprint ONT owns and operates 26 full-service dental facilities across New South Wales, South Australia and Queensland. It has expanded through acquiring existing practices and establishing new ones. ONT currently has the capacity (based on its fixed cost corporate overhead structure) to operate up to 112 dental surgeries, with 118 dentists and over 230 support staff. The oversupply of dentists, driven from recently qualified dentists (almost 1,000), an under-employment of experienced dentists and deferral of retirement creates further growth opportunities for ONT. Sustained strong performance from affordable dentistry ONT has maintained an average EBITDA margin of 30% since The margin rose to 35% for FY15 due to a combination of improving business processes and the successful acquisition of BOH Dental. The recent final dividend issue of 10.2cps is the highest since its IPO. The driving theme of ONT to make dentistry more affordable should lead to an increasing customer base and steady revenue streams, in our view. Initiate coverage with Add recommendation We initiate coverage with an ADD recommendation and a price target and valuation of A$7.94, based on a blended (DCF/PE) methodology. The capital growth together with the dividend yield of 2.8% provides for a forecast total shareholder return of 14.6% from the current share price. ONT has a decade-long history of operational success. The main risk lies in its ability to continue to acquire dental practices at reasonable multiples to maintain the solid historical growth levels, countered by its ability to grow organically. Financial Summary Jun-14A Jun-15A Jun-16F Jun-17F Jun-18F Revenue (A$m) Operating EBITDA (A$m) Net Profit (A$m) Normalised EPS (A$) Normalised EPS Growth (20.6%) 30.3% 8.6% 11.8% 10.3% FD Normalised P/E (x) DPS (A$) Dividend Yield 2.11% 2.70% 2.81% 3.09% 3.38% EV/EBITDA (x) P/FCFE (x) NA Net Gearing (4.7%) (19.8%) (9.4%) (12.1%) (14.9%) P/BV (x) ROE 17.7% 21.6% 21.7% 22.4% 22.7% % Change In Normalised EPS Estimates Normalised EPS/consensus EPS (x) SOURCE: MORGANS, COMPANY REPORTS IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN ) AFSL A PARTICIPANT OF ASX GROUP

2 Smiles all round Company overview 1300SMILES (ONT) owns and operates full-service dental facilities at its sites in New South Wales, South Australia and ten major population centres in Queensland. It expands through acquiring existing practices and establishing new operations. It currently has the capacity to operate up to 112 dental surgeries, with 118 dentists and over 230 support staff. The administrative and corporate services headquarters is located in Townsville. Investment view We initiate coverage with an ADD recommendation. We have valued ONT at A$7.94 using a combined DCF/PE compco methodology. Our price target has been set at the same level. Key strengths Growing market - Growing awareness for dental hygiene. Australia's ageing population and the affordability offered by ONT through its Dental Care Plan and Dental Members Australia (DMA) Vouchers program provide an expanding customer base. Business model - ONT s business model minimises managerial time for dentists and provides full administrative support to private dental specialists. This allows the dentists to focus on the delivery of dental services rather than on the administrative aspects of carrying on their businesses. It offers stable income streams from services fees paid under Dental Service Agreements between the company and the dentists. BOH acquisition - In May 2014, ONT acquired BOH Dental in the largest acquisition ever made by the company in terms of revenue, NPAT, and EPS increments. The successful acquisition of BOH Dental contributed to the rise in EBITDA margin in FY15. Management estimates that BOH will make an annual contribution at the EBIT level of A$1.25m. Economies of scale - Increasing the number of facilities and dentists under management would allow ONT to achieve greater economies of scale. This could lead to a reduction in operating costs (as a percentage revenue), improved training and support for dentist practitioners and increased flexibility for patients. Fiscal position - ONT has zero borrowings and maintains a strong cash position for practice acquisitions and dividend payments. QIP accreditation - In 2014, ONT achieved the highest level of accreditation for all of its dental practices under a scheme developed by the Quality Innovation Performance Group (QIP) under the Australian Dental Association's Accreditation program. This provides further incentive for dentistry practices to join ONT, as many individual practices struggle to satisfy the requirements of this accreditation. Key risks Oversupply of dentists - The annual increase in new graduates and dentists on working visas poses the threat of oversupply in the industry. The number of dental practitioners registered in Australia in 2011 was 18,803, of whom 14,179 were dentists. The annual growth rate in the supply of the Australian dental workforce is between 3.75% and 4.25%, which is well in excess of population growth. 2

3 Government policy - The history of Commonwealth funding of dental services is mixed, with different programs and funding approaches being favoured by governments of different political persuasions. Most dental care is currently funded directly by individuals rather than by governments or private health insurance. Competitor risks - As of 2011, 80% of dentists work in the private sector with the majority of businesses having less than three dentists. ONT's major competitors are Dental Corporation and Pacific Smiles. Dental Corporation is owned by Bupa and it had the largest market share of 4.4% in It has practices across all states in Australia and in New Zealand. It provides the infrastructure and support to simplify management of and to grow dental practices. Pacific Smiles has over 40 dental surgery locations in ACT, VIC, QLD and NSW. Pacific Smiles partners with independent practitioners and provides them with services and facilities. With the opening of the first branded Bupa Dental practice in Hobart and its expansion plan across Australia in 2015, ONT will be exposed to higher competitor risks. Growth outlook ONT can expand its current operation by: Increasing the size of its existing 26 practices and attracting more skilled dental specialists; Mentoring and training its existing dentists to increase turnover; Establishing new practices in existing and new regions; Acquiring profitable existing practices; and Managing dental facilities owned by others. Industry overview Industry size In Australia, the dental services industry generated annual revenue of A$8.8bn in CY14, according to Australian Institute of Health and Welfare and over the last 10 years has achieved an average annual growth rate of 4.0%. IBISWORLD has forecast growth of 2.5% from CY15 to CY20. It is mainly made up of independent sole proprietors operating small-scale dental practices. The three major players resulting from acquisition or organic growth are 1300SMILES (26 centres), Dental Corporation and Pacific Smiles (49 centres). 3

4 Figure 1: Total national expenditure on dental services (A$m) SOURCE: AUSTRALIAN INSTITUTE OF HEALTH AND WELFARE Dental care funding The majority of dental care is currently funded directly by individuals. Of the A$7.9bn spent on dental care in Australia in 2010/11, the out-of-pocket expenses of individuals and private health insurance were 58% and 14% respectively, with the remaining 30% paid by federal or state governments. In comparison to general medical services with 77% funding from the government, dental industry has a relatively low reliance on funding. Figure 2: Sources of dental care funding (A$m) Federal and State Governments Health Insurance Individual Other SOURCES: AUSTRALIAN INSTITUTE OF HEALTH AND WELFARE Age and gender In 2011, the average age of employed dentists was 43.5 years. There are significantly more men in the older age groups and slightly more women in the youngest age group (20-34). The proportion of female dentists in the workforce rose from 29.0% in 2006 to 35.6% in 2011, and is expected to reach 50% by Service offerings Core operation ONT owns and operates full-service dental facilities and partners with dentists by providing them with staff, equipment, facilities, consumable goods and management support to deliver services. The dentists pay fees under a Dental Service Agreement with the company. ONT refers patients to locally trusted dental specialists and provides flexibility to patients with its organised workforce. 4

5 Treatment and care plans With the aim to make dentistry more affordable, ONT provides different care plans for patients including: $1 a day dental care plan, which provides patients with basic dental care and financial certainty by fixing the payments. It gives ONT a growing annuity revenue stream; 1300SMILES DMA Vouchers, which helps patients finance expensive dental treatments with a payment of $99 per week. These vouchers have experienced strong initial demand since their introduction in Financial summary FY15 results show continued strong growth Over the counter (OTC) revenue, which records the total amount paid by customers for services rendered, increased by 23% yoy to A$53.2m in FY15. Statutory revenue, which is OTC revenue less the amount retained by self-employed dentists, is up by 15% yoy to $36.6m. EBITDA margin, as the measure of the quality of ONT s core operation, increased by 35% yoy, which is above the historical average of 30% maintained since its lpo. Net profit, EPS and the full year dividend were are all up by 32%. The final dividend of 10.2cps is the largest single dividend ever paid and brings the full year dividend to 19.2cps. ONT has a dividend payout ratio of 69% and has maintained an uninterrupted stream of 22 fully-franked dividends since listing in The company does not have any borrowings. It maintains a strong cash position and uses its cash flow to fund new acquisitions and dividend payments. Figure 3: OTC and statutory revenues (A$m) OTC Revenue Statutory Revenue SOURCES: COMPANY REPORTS FY16 outlook For FY16, ONT expects to expand its core operation by acquiring existing practices and establishing greenfield sites. With the focus to achieve strong productivity and profitability per practice, ONT appears to have a sustainably profitable business model. The dental treatment and care plans should generate growing annuity income streams as their popularity increases among patients. Fragmentation of the dental industry and the large number of private practices provide ONT with further consolidation opportunities and economics of scale. 5

6 Board and shareholder base Figure 4: Board of Directors Name, Role Robert Jones (Chairman) Dr. Daryl Holmes (Managing Direcor) Description Mr Jones was a Director and Chairman of the Mater Health Services North Qld Ltd from 1993 until Mater Health Services North Qld Ltd owns and operates two fully accredited private hospitals in Townsville, the Mater Hospital (Pimlico) and Mater Hospital (Hyde Park). Mr Jones is a member of the Australian Institute of Company Directors. Dr. Holmes is the founder of 1300SMILES Limited and a qualified dentist having obtained his dental qualifications (BDSc (Hons)) at Queensland University in During the last two years of his five year degree he accepted a scholarship from the Royal Australian Air Force (RAAF). Upon completion of his degree he practised dentistry as a RAAF Dental Officer ( ). Thereafter, in 1991, he began private dental practice in Ayr and Home Hill, North Queensland later that year. Since that time he has operated dental surgeries in the Burdekin region, Townsville, Cairns and more recently throughout most of Queensland s major centres. Dr. Holmes has been a member of the Australian Dental Association (ADA) for 26 years. Dr. Holmes has extensive experience in operating dental practices and an intimate knowledge of the management, administrative and other support services required in a dental practice. He has been instrumental in establishing the support network and suite of services that 1300SMILES Limited currently provides to its dental clients. Dr. Holmes has been a Director, and currently Deputy Chairman, of the Cowboys Leagues Club for the past 11 years. He owns 62% of ONT. Glen Richards (Non-executive Director) Dr Richards was the founding Managing Director of Greencross (ASX: GXL) and was instrumental in building it into Australia s largest veterinary healthcare group from 32 practices at listing to over 120 veterinary practices and 200 pet specialty stores and led its merger with Petbarn in February During Dr Richards s tenure Greencross Ltd has been one of the most consistent performers on the ASX in recent years with five straight years of better than 25% revenue and profit growth year on year and total shareholder returns above 1000%. Dr Richards continues as a non-executive director of Greencross. Dr Richards is also a non-executive director of Regeneus Ltd (ASX: RGS) an ASX listed clinical-stage regenerative medicine company developing and commercialising a portfolio of cell therapies in the human and veterinary health markets with a focus on musculoskeletal disease, oncology conditions and dermatology. SOURCE: COMPANY REPORTS Valuation and recommendation Valuation We have valued ONT at A$7.94 using a combined DCF and PE compco valuation methodology. Figure 5: Weighted valuation Weighting Valuation DCF 50% 3.93 PE 50% 4.01 Weighted valuation 7.94 SOURCE: MORGANS To derive our DCF of A$7.86, we have assumed a weighted average cost of capital of 9.74%, and a long-term growth rate of 5%. Other assumptions are: ONT acquires one new practice each year, with OTC revenue per practice growing at 4% p.a.; Total expenses grow at 3% p.a.; and Variable costs including consumable, lab fees and other supplies, and employee benefits expenses expand in line with the number of practices on top of the 3% growth rate. 6

7 Comparative analysis The most direct comparative company is Pacific Smiles (PSQ, not rated) which trades on a forward PE of 28x, with ONT trading on a PE of 22x for FY16. We believe the 6 point discount is unwarranted and think a 5% discount is more appropriate reflecting lower liquidity. PSQ has guided the market to expect 8 to 10 new centres in FY16 which will potentially result in a higher growth rate. PSQ has noted CAGR of 23% since FY08 which is comparable to ONT which has recorded CAGR of 22% over the last 10 years. Figure 6: PE valuation 2015A 2016F Peer multiple to apply (x) (Disc)/prem to peers -5% -5% PE to apply to 1300smiles (x) smiles FY13 EPS (c) smiles PE valuation (A$ps) SOURCE: FACTSET AND MORGANS To complete the analysis we have included other domestic health care players being Primary Health Care (PRY, Hold, Price Target A$4.69, last close A$3.93), Sonic Healthcare (SHL, Add, Price Target A$22.33, last close A$18.68), which are the major players in the pathology services industry and Capitol Health (CAJ, Add, Price Target A$0.94, last close A$0.55), a smaller diagnostic imaging player. ONT trades on higher PE and EV/EBITDA multiples based on its higher growth profile and lower liquidity levels. Figure 7: Comparative analysis Earnings Price to Price to Price to Enterprise Enterprise Enterprise Total debt/ Company Fiscal Enterprise per share earnings earnings earnings FY1 value/ value/ value/ Total Debt/ enterprise name period value FY1 Actual FY1 NTM Date sales EBIT EBITDA EBITDA value 1300 Smiles 06/30/ x 21.42x 20.40x 06/ x 17.93x 13.80x 0.00x 0.00% Average 3, x 19.79x 18.86x 2.93x 19.61x 14.30x 2.47x 20.91% Median 1, x 16.49x 15.86x 2.65x 19.81x 14.88x 3.17x 22.95% Pacific Smiles Group 06/30/ x 30.81x 28.88x 06/ x 25.67x 19.33x 0.02x 0.12% Primary Health Care 06/30/2015 3, x 15.38x 14.86x 06/ x 13.14x 8.08x 3.04x 37.63% Sonic Healthcare 06/30/2015 9, x 16.57x 16.14x 06/ x 19.65x 14.43x 3.30x 22.84% Capitol Health 06/30/ x 16.40x 15.57x 06/ x 19.97x 15.33x 3.54x 23.07% SOURCE: FACTSET AS AT 26th OCTOBER 2015 Forecasts and sensitivities Our model is sensitive to a number of factors. If the growth rate of OTC revenue per practice increases/ decreases by 1%, it impacts our valuation by A$0.39 and (A$0.39) respectively. A 1% increase/decrease in the long run growth estimate impacts our DCF valuation by A$1.79/(A$1.79) respectively. Additionally, the number of additional practices acquired each year is subject to access to appropriately priced practices and management decisions. If the expansion slows due to increasing market saturation, the valuation would decrease as a result. Recommendation We initiate coverage with an ADD recommendation and a price target and valuation of A$7.94, which together with the dividend yield of 2.8% provides 14.6% upside to the current share price. ONT has a decade-long history of operational success. The main risk lies in its ability to continue to acquire dental practices at reasonable multiples to maintain the solid historical growth levels. 7

8 Figure 8: Financial summary Profit and loss Jun-15A Jun-16F Jun-17F Jun-18F Valuation details Revenue Share Price $7.12 Market Cap A$168.5m Gross Profit Price Target $7.94 Total Operating Costs Total shareholder return 14.3% WACC 9.7% EBITDA Depreciation Amortisation & impairments EBIT Net Interest Income Pre-tax Profit Tax Reported Profit Exceptional items Normalised Profit Gross dividends Cash flow statement Jun-15A Jun-16F Jun-17F Jun-18F Key metrics/ multiples Jun-15A Jun-16F Jun-17F Jun-18F EBITDA P/E Net interest Yield 2.7% 2.8% 3.1% 3.4% Tax PEG Changes in working capital EV/EBITDA Operating cash flow Price/ Book Value Capex Price/ Net Tangible Assets Free Cash Flow Acquisitions and divestments Operating cash flow yield 5.2% 3.7% 6.5% 7.0% Other Investing cash flow Free cash flow yield 4.8% 2.3% 5.1% 5.6% Investing cash flows Increase / decrease in Equity Per share data Jun-15A Jun-16F Jun-17F Jun-18F Increase / decrease in Debt Diluted shares on issue Dividends paid Reported EPS (A$) Other financing cash flows Normalised EPS (A$) Financing cash flows Dividends per share (A$) Payout ratio 69.2% 66.3% 65.3% 64.6% Balance Sheet Jun-15A Jun-16F Jun-17F Jun-18F Assets Result quality Jun-15A Jun-16F Jun-17F Jun-18F Cash And Deposits Cash flow conversion 95.0% 71.3% 100.7% 100.7% Debtors FCF vs. NPAT 122.3% 55.1% 106.9% 106.5% Inventory Gross dividends vs FCF 0.0% 0.0% 0.0% 0.0% Other current assets Total Current Assets Gearing Jun-15A Jun-16F Jun-17F Jun-18F Fixed Assets Net Debt Investments Net Debt / Equity -19.8% -9.4% -12.1% -14.9% Goodwill Net Debt / EBITDA (x) Intangibles EBIT interest cover (x) Other non-current assets Invested Capital Total Non-Current Assets Enterprise Value TOTAL ASSETS Growth ratios Jun-15A Jun-16F Jun-17F Jun-18F Liabilities Revenue 15.6% 8.8% 8.0% 7.9% Short Term Debt Operating costs Creditors EBITDA -26.4% -9.8% -8.0% 7.9% Other current liabilities EBIT -28.6% -11.2% 10.4% 9.8% Total Current Liabilities NPAT -30.3% -8.6% -11.8% 10.3% Long Term Debt EPS growth -30.3% -8.6% -11.8% 10.3% Other Debt (inc hybrids) DPS growth 28.0% 4.2% 10.0% 9.1% Other Non curren liabilities Operating cash flow -6.7% 28.8% -76.6% 7.6% Total Non -Current liabilities TOTAL LIABILITIES Margin analysis Jun-15A Jun-16F Jun-17F Jun-18F EBITDA Margin 33.1% 33.4% 33.4% 33.4% Equity EBIT margin 25.6% 26.2% 26.8% 27.3% Issued capital NPAT margin 18.0% 18.0% 18.6% 19.1% Retained earnings ROE 20.7% 20.9% 21.5% 21.7% Other reserves and FX ROIC 37.5% 38.3% 35.0% 36.4% TOTAL EQUITY ROE less WACC 11.1% 11.3% 11.9% 12.1% ROIC less WACC 27.9% 28.7% 25.4% 26.8% SOURCE: MORGANS RESEARCH, COMPANY 8

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