-- U.S. dental practice management services provider Smile Brands Group
Inc. had negative free operating cash flow after elevated capital spending for
the past four quarters, resulting in depleted liquidity.
-- Early in 2013, we expect Smile Brands to bring capital expenditures,
mainly for new dental offices, into line with internally generated cash flow.
-- We are lowering our corporate credit rating on Smile Brands to 'B-'
from 'B' and revising our rating outlook to negative. At the same time, we are
lowering our rating on the company's senior secured debt to 'B-' from 'B'.
-- The negative rating outlook reflects the possibility that Smile Brands
will exhaust the $13.5 million of funds available from its revolving credit
facility as of Sept. 30, 2012, or breach a loan agreement covenant.
On Nov. 21, 2012, Standard & Poor's Ratings Services lowered its corporate
credit rating on Irvine, Calif.-based Smile Brands Group Inc. to 'B-'
from 'B'. At the same time, we revised the outlook on the rating to negative.
In addition, we lowered our rating on Smile Brands' senior secured debt to
'B-', in conjunction with the downgrade, from 'B'. Our recovery rating on this
debt remains unchanged at '3', indicating our expectation for meaningful (50%
to 70%) recovery of principal in the event of payment default.
The rating on dental practice management (DPM) services provider Smile Brands
Group Inc. continues to reflect its "vulnerable" business risk profile
(according to Standard & Poor's Ratings Services' criteria), characterized by
its narrow scope of operations in intensely competitive markets with low
barriers to entry. Smile Brands had negative free operating cash flow (FOCF)
after elevated capital spending for the past four quarters and we expect this
to continue in the fourth quarter of 2012. Our downgrade is based on the
expectation that early in 2013, Smile Brands will stem the trend of negative
FOCF by reducing spending for new dental offices or taking other actions, such
as paying interest on its holding company debt in kind, rather than in cash.
We also expect adjusted debt to EBITDA will rise to about 8x by the end of
2012, significantly higher than our prior expectations, but still consistent
with a "highly leveraged" financial risk profile. As of Sept. 30, 2012, debt
to EBITDA was 7.7x, adjusted to capitalize operating leases and including
holding company debt. We have lowered our expectations for Smile Brands'
revenue growth, EBITDA generation, and cash flow over the next one to two
We expect revenues will grow at a mid-single-digit annual rate, somewhat
faster than the total U.S. dental services industry over the next few years,
primarily fueled by Smile Brands' geographic expansion and a slowly
strengthening economic climate. Our prior growth expectations were mid- to
high-single-digit annual growth. Although Smile Brands' revenue growth slowed
in the second and third quarter of 2012, revenues increased 4.2% for the 12
months ended Sept. 30, 2012. We believe an unsuccessful marketing strategy,
which was subsequently abandoned, contributed to the growth slowdown. Still,
we believe underlying industry fundamentals remain sound and relatively
resistant to downturns. During the 2008 to 2010 recession, when revenue for
the total U.S. industry was nearly flat (according to data from the Centers
for Medicare and Medicaid Services), Smile Brands grew modestly, supporting
our expectation for continued, albeit modest, growth.
As newer offices mature, we expect the lease-adjusted EBITDA margin (11.7% in
the third quarter of 2012, compared with 12.8% in the third quarter of 2011)
to gradually recover to the 12% to 14% range, with some quarter-to-quarter
variation. Smile Brands' profitability is supported by its infrastructure,
economies of scale, and supplier discounts. More rapid office expansion in
recent quarters contributed to lower profitability. Smile Brands' EBITDA
margin (adjusted for leases, stock compensation and nonrecurring items) began
to dip in the fourth quarter of 2011, after rising substantially and steadily
from 8.9% in 2005 to 14.8% for the 12 months ended Sept. 30, 2011. Our lowered
expectations for 2012 and 2013 EBITDA also affect cash flow generation.
Smile Brands' affiliated dental practices operate a network of approximately
350 dental offices that offer general and specialty dental services. The $110
billion U.S. dental practice industry is extremely fragmented and highly
competitive, contributing to our vulnerable business risk assessment.
Treatment volume, especially for more discretionary services such as
orthodontics, and patient financial capacity exhibit some sensitivity to
economic conditions. The availability of financing for patients influences
demand. We also see vulnerabilities in the nature of the DPM structure. While
we believe potential changes in state or federal laws, regulations, or
accounting rules could hurt the DPM industry, we do not currently incorporate
any adverse developments in our base-case scenario.
The DPM business model has many retail industry attributes, and so carries
risks associated with advertising and promotion, branding, and real estate
selection, among others. Smile Brands markets its brands, selects high-traffic
office locations, and offers customers convenient hours, comprehensive
treatment, financing, and prices typically 15% to 25% below those of
traditional dentists. It targets middle-income patients in growing
metropolitan areas. Affiliated offices operate in 18 states, but there are
material concentrations in Texas and California.
The company provides administrative, financial, and operating services to
affiliated professional corporations (PCs). Although the company does not own
the affiliated PCs, its financial statements consolidate them. Smile Brands
generally owns the dental office assets, but dentists and hygienists generally
are not employees of the company, in accordance with state laws. We analyze
the consolidated financial statements on the basis presented (adjusted for the
capitalization of operating leases and other standard adjustments) because we
believe they best reflect the economic substance of the company's business
We revised our assessment of Smile Brands' liquidity to "less than adequate"
(according to our criteria), reflecting its diminished liquid resources. As of
Sept. 30, 2012, Smile Brands reported a negative cash balance of $0.5 million,
and $13.5 million was available from its $35 million revolving credit
facility. We believe Smile Brands may borrow an additional $1 million to $5
million in the fourth quarter of 2012.
We estimate Smile Brands will generate about $20 million of funds from
operations (FFO) in 2012 and $25 million in 2013. We expect small, if any,
annual increases in working capital. We project about $32 million of capital
expenditures in 2012 (actual spending for the first nine months was $27.5
million), including the recently completed roll out of digital x-rays. In
2013, we expect Smile Brands to bring capital expenditures, mainly for new
dental offices, into line with internally generated cash flow. We believe
annual maintenance capital spending is less than $10 million.
Our assessment of Smile Brands' liquidity profile incorporates the following
assumptions and expectations:
-- Over the next 12 months, we expect sources of liquidity, including
potential borrowing under the revolver, to exceed uses by 1.2x. Even if EBITDA
is 15% below our projections, we estimate liquidity sources would cover cash
needs, although in that scenario the revolver could be fully drawn.
-- Debt amortization is only $2.4 million annually through 2014.
-- Our analysis of Smile Brands includes unrated holding company notes
with a face value of $100 million ($87 million after the original issue
discount). Smile Brands has been paying the 10% coupon in cash. To conserve
cash, we believe it may begin to pay interest in kind at 13%.
-- We expect Smile Brands to remain in compliance with its loan agreement
covenants, notwithstanding requirement tightening. As of Sept. 30, 2012, there
was a 17% cushion under the tightest covenant.
-- We assume Smile Brands will not make any acquisitions over the next
For our complete recovery analysis, see our recovery report on Smile Brands,
to be published following this report on RatingsDirect.
Our negative rating outlook on Smile Brands reflects the possibility that it
will exhaust the $13.5 million of funds available from its revolving credit
facility as of Sept. 30, 2012, or breach a loan agreement covenant. We would
consider lowering the rating if negative FOCF persists in the first quarter of
2013 or we expect the covenant cushion to approach 5%.
We would consider revising the outlook to stable if Smile Brands generates
discretionary cash flow (through a combination of improved EBITDA and lower
capital spending), restores availability of its revolver, and we expect the
covenant cushion to stay above 15%.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global
Corporate Issuers, Sept. 28, 2011
-- Standard & Poor's Revises Its Approach To Rating Speculative-Grade
Credits, May 13, 2008
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008
Downgraded; Outlook Revision
Smile Brands Group Inc.
Corporate Credit Rating B-/Negative/-- B/Stable/--
Senior Secured B- B
Recovery Rating 3 3