Tue 01/04/2022 07:00 AM
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Relevant Documents:
10-K (FY 2020)
IPO Prospectus
Convertible Notes Indenture

SmileDirectClub Inc., which has historically burned substantial amounts of free cash flow, in excess of $775 million cumulatively from fiscal year 2018 through 2020, and approximately $215 million for the Sept. 30 LTM period, could seek to raise structurally senior operating-company-level debt, according to an analysis by Reorg, to extend the company’s liquidity runway. With a liquidity balance of $307.6 million as of Sept. 30 (consisting entirely of cash on the balance sheet), the company’s current run rate of LTM free cash flow burn would imply less than two years of liquidity runway, which could require the company to raise new-money capital in the absence of a significant improvement in operations.

SmileDirectClub’s 0.0% senior unsecured convertible notes due 2026 traded lower by approximately 20 points to 50% of par value on Nov. 11 after the release of third-quarter 2021 earnings on Nov. 8, 2021. The convertible notes have since continued to trade lower by more than 10 points, quoted at 39.375% of par value as of Monday, Jan. 3, according to Solve Advisors (implying a market value of $294.3 million on $747.5 million of aggregate principal amount). The convertible notes were issued at par value in February 2021.

Additionally, since mid-November, the common stock has traded lower by more than 35% (near its all-time low) to $2.61 per share as of Jan. 3, implying a market capitalization of $1.014 billion, still well in excess of the implied market value of the convertible notes.

The following analysis aims to outline potential debt financing options for the company. As the convertible notes are the only funded debt instrument in the company’s capital structure, the lack of restrictive covenants in the convertible notes indenture allows for maximum flexibility with respect to new-money debt financing options, although structural and quantum considerations would likely be guided by the company’s organizational structure and the perceived value of the assets. The analysis concludes that a secured debt financing option at the operating subsidiary level, structurally senior to the holdco convertible notes with respect to the operating assets, would be the likely preferred path for any new-money credit investor. Furthermore, applying conservative enterprise value / revenue multiples from public comps implies that a new-money credit investor may be willing to lend up to approximately $1.25 billion, which could fund the business through multiple operating cycles at the current cash burn run rate.

Reorg has no current knowledge as to whether the company is planning to seek new-money financing (either equity or debt). The following analysis is meant for illustrative purposes only.

Financial Overview, Capital Structure, Organizational Structure

The company has generated EBITDA losses in each of the past three fiscal years, as marketing and selling expenses, in addition to its overhead G&A expenses, accounted for almost 100% of the company’s total revenue in fiscal year 2020.

The company’s capital structure is shown in the table below.

(Click HERE to enlarge.)

As noted in the company’s fiscal year 2020 10-K, SmileDirectClub Inc. is a holding company, and its sole material asset is its equity interest in subsidiary SDC Financial LLC. According to the company, all of the company’s operations are conducted by SDC Financial through its direct and indirect subsidiaries. Notably, however, SmileDirectClub has a minority economic interest in SDC Financial but has the sole voting power and controls the management of SDC Financial.

The company provided the following org chart in its IPO prospectus, outlining the economic interest splits of SDC Financial (27.4% to SmileDirectClub and 72.6% to the “Continuing LLC Members”). SmileDirectClub is the issuer of the convertible notes and Class A common shares, implying that convertible noteholders and Class A common shareholders have claim to only 27.4% economic interest of the operating assets held at SDC Financial and its subsidiaries.

Illustrative New-Money Debt Financing

With a market capitalization of over $1 billion as of Jan. 3, the company could seek to raise equity capital, although such an offering would likely be highly dilutive; the stock is currently trading near its all-time low at $2.61 per share as of Jan. 3; the company’s IPO in September 2019 of Class A common stock was priced at $23 per share.

As such, raising debt could be a more likely outcome for the company.

As previously noted, parent entity SmileDirectClub is the issuer of the senior unsecured convertible notes, which have no listed guarantors in the indenture. Furthermore, as is common in many unsecured convertible notes indentures, the indenture governing the company’s 0.0% senior unsecured convertible notes due 2026 has no restrictive covenants with respect to the incurrence of additional debt or liens.

The holding company convertible notes were trading at 39.375% of par value as of Jan. 3, implying a yield to maturity of over 24%, so it is reasonable to assume that any new-money debt investor would require a secured debt option, which as previously noted would not be restricted by the convertible notes indenture. Additionally, given that the holding company SmileDirectClub Inc. owns only a 27.4% minority economic interest in operating company SDC Financial, it would also be reasonable to assume that a new-money debt investor would require a secured debt option at SDC Financial. Because the convertible notes have no designated restricted subsidiaries and no subsidiary guarantors, debt incurred at SDC Financial would be permitted under the convertible notes indenture and would be structurally senior to the convertible notes with respect to the operating assets at SDC Financial.

With liquidity of $307.6 million as of Sept. 30 and a negative free cash flow run rate of over $200 million, the company would likely need a significant new-money debt investment to fund multiple operating cycles. The amount of debt that a new-money credit investor would be willing to lend would depend on the estimated valuation of the company’s assets.

Negative EBITDA and negative free cash flow preclude applying valuation metrics such as EBITDA multiples or discounted cash flow. As such, a revenue multiple method may be more applicable, although there is a wide range among the few public comparables, with Align Technology (owner of Invisalign) trading at an enterprise value / LTM revenue multiple of 13.2x, and Dentsply Sirona trading at an enterprise value / LTM revenue multiple of 3.3x. Dentsply Sirona acquired Byte, a maker of clear aligners, in December 2020 for $1.045 billion, which implied an approximate 5x multiple of then-estimated 2021 run-rate sales of “at least” $200 million.

As SmileDirectClub is a smaller competitor with negative EBITDA and free cash flow, Reorg applies more conservative revenue multiples to provide illustrative estimates of the enterprise value of SmileDirectClub across multiple scenarios. As shown in the table below, assuming a normalized revenue run rate of $700 million, Reorg provides an illustrative estimate of the value of the assets of $1.05 billion to $3.15 billion; applying an assumed LTV (loan-to-value) ratio of 40%, Reorg estimates that a debt investor may be willing to lend $420 million to $1.26 billion of secured debt at SDC Financial, which would help to provide the company with multiple years of liquidity at the current run rate of negative free cash flow.

On Dec. 7, 2021, the company announced the resignation of CFO Kyle Wailes to pursue a CEO opportunity at a healthcare company.
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