Modern Dental: A Turnaround Story with Tremendous Upside

Investment Thesis in Modern Dental

1. We believe that Modern Dental Group (3600 HK) has been a beneficiary of Covid as it has gained market share in the last 3 quarters globally in the dental prosthetics market. Q1 2021 showed 15-20% YoY revenue growth. Management guides revenue growth of not less than 10% for FY21 (vs. normalized high single-digit revenue growth from FY17-19) which we believe is conservative.
2. The company has emerged leaner from Covid 19 as they completed a massive restructuring in 2020, resulting in EBITDA margin expansion to 25% (from the 15-16% levels historically) in Q4 2020. We believe the company will maintain a 53% gross profit margin and 25% EBITDA margin, and 16.5% Net profit margin through 2021, resulting in 410 mn HKD net profit for FY21. Based on this estimate, the stock trades on 9.2x PE FY21 despite the stellar run in share price in Q1 2021.
3. With improving cash flows due to low Capex requirements (~90 mn HKD in FY21e and FY22e), we see Modern Dental Group (3600 HK) generate a free cash flow of 330 mn HKD in FY21e and 400+mn HKD in FY22e. At the very minimum, if the company adheres to its stated 30% dividend payout ratio, it will be net cash 52 mn HKD in FY21 and 338 mn HKD in FY22 ( almost 9% of the current market capitalization) from a net debt position of 158 mn HKD in FY20.
4. The company will use the excess cash on its balance sheet to raise the dividend payout ratio beyond 30%. We also think management will continue to buy back stock subject to management stake not increasing by more than 5% every year. The company has actively repurchased stock in 2020 and 2021.

Trading at an undemanding valuation of 9.2x/8.7x PE FY21/22, we think there is an opportunity for at least 50% upside as peers in the similar industry of dental supply trade in the 20-25x range. With a 30% payout ratio, there is also a decent dividend yield of 3.5% on the stock.