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The dental industry is well known for pain-inducing tooth extractions and fillings. Less understood are its pleasurable qualities for investors: a large, growing market, fragmented competition and high-quality performers such as 1300 Smiles.

The Townsville-based firm has a five-year average annualised total shareholder return of 23 per cent (including dividend reinvestment) to June 8, 2014. 1300 Smiles is arguably among the market’s best run small-cap companies.

Return on equity (ROE) has averaged a whopping 33 per cent for the past nine financial years, strong cash flow growth has enabled a funding surplus, and there is no debt. In some ways, 1300 Smiles has been run more like a lean private company; founder and major shareholder Daryl Holmes owns 62 per cent.

That’s the good news. The bad news is that savvy investors are well aware of 1300 Smiles’ strengths and have valued it according. At the current $6.20 share price, 1300 Smiles is fully valued, for now.

Another issue is 1300 Smiles’ falling ROE, albeit off a high base. After peaking at 41 per cent in FY09, according to Morningstar, ROE has had four years of decline. It was 23 per cent in FY13, still higher than many companies but down on 1300 Smiles’ previous standards.

The biggest attraction of 1300 Smiles, its ability to buy dentistry firms in a fragmented industry, might also be a weakness in some respects. A recurring problem with so-called industry consolidators is the risk of waning performance, measured by ROE, as the business rapidly expands.

This is not true of all consolidators. The listed veterinary services provider, Greencross, has soared from a 52-week low of $5.03 to as high as $9.95, and is now $9.35.

In fairness, 1300 Smiles is not a typical industry consolidator. With practices at 24 dentistry locations, nearly all in Queensland, 1300 Smiles has a steady acquisition strategy. It buys a few practices each year and focuses on building profits, rather than chasing outlet numbers or meaningless revenue growth.

That is a welcome relief from industry consolidators that acquire businesses at light speed, raise huge slabs of equity that dilutes existing shareholders, damage the ROE, pay for acquisitions mostly by scrip, and come unstuck when revenue growth slows and/or does not translate into higher profits.

1300 Smiles has always been conservative, possibly too conservative for the market’s liking. Small-cap fund managers might have preferred to see Holmes sell a bigger chunk of his shareholding to bring more shareholders onto its register and improve stock liquidity, or for 1300 to raise more equity capital to quicken its acquisition strategy.

Investors in 1300 Smiles’ float in 2005 will be glad it has taken a steady, rather than spectacular, approach. Its valuation has increased from $15 million at listing to $126 million, and was briefly much higher when shares hit a 52-week high of $7.25 late last year.

Managing director Holmes still practices dentistry one morning a week, has sold only a small amount of  his shares over the past few years, and continues to strive towards 1300 Smiles’ mantra at listing: to build Australia’s first national chain of dental practices.

The dental industry has solid medium-term prospects. Business forecaster IBISWorld predicts the industry revenue ($9.4 billion in FY13) will grow at 3.8 per cent annually between FY14 and FY19. Although down on 4.7 per cent annual growth in the preceding five years, the dental industry is still growing faster than the Australian economy.

The industry has some tailwinds: demand for dental services is rising; patients are consuming more expensive dental procedures, such as teeth straightening and whitening; and there has been a real increase in the average price of dental services. Higher Medicare funding of dental services has also promoted industry growth.

Long-term, the dental industry should benefit from the declining rate of tooth loss, and more people keeping more of their natural teeth. There has been a recent increase in the rate of caries (tooth decay or cavities) among children because of higher intake of sugary food and drink, but the long-term rate of caries is falling, thanks to better toothpastes, fluoride supplements, water fluoridation, and more regular dental visits.

Dentists are therefore expected to do fewer restorative procedures, such as fillings, and more work on preventative services, periodontics and other cosmetic procedures. Providing mouthguard-like dental stgices to treat sleep-related illness, such as sleep apenoa, is another growing revenue stream for some practices.

In theory, this subtle, slow shift between restorative and preventative work means dentists will spend greater time on higher-margin work, such as designing a brilliant white smile for a patient through cosmetic procedures, and less lower-margin work.

The industry’s other attraction is fragmentation. There were 11,339 dental-related business in Australia in FY13, according to IBISWorld. 1300 Smiles estimate there was just over 15,000 registered dentists in Australia in 2013, which shows how many suburban one-dentist practices still exits. Some private companies have tried to capitalise on this opportunity, but for all their efforts, Australia still does not have a national dentistry brand.

Practice consolidation makes sense. Bigger, clinic-type dental practices attracts more patients, provide higher economies of scale, and allow for greater investment in technology and the use of less-qualified or fewer assistants.

At the same time, Australia’s ageing population means there will be thousands of baby-boomer dentists looking to retire, or reduce their working hours in the next five to 10 years. Selling their practice to 1300 Smiles or other consolidators, and working in the same practice, free from the administrative hassle of a running a small business, is attractive.

1300 Smiles has a simple business model. It identifies successful dental practices, buys them, and takes over the lease and plant and equipment. It then provides the receptionists, dental assistants, stock and administration, and the dentists pay a turnover rent based on their annual revenue. Freeing dentists from administration means they can spend more time doing what they like – dental work – and bring in more business for 1300 Smiles and themselves.

So far, the model has worked well, given 1300 Smiles’ consistent growth in revenue, earnings and dividends. The only blemish was in the first half of FY14, when revenue fell almost 30 per cent over the same half last year and after-tax net profit dropped 36 per cent.

Care is needed in comparing the FY14 half to others. There was an anomaly in the FY13 result after the former Federal Government rocked the dental industry with the sudden termination of the Chronic Disease Dental Scheme in August 2012. Dentists and patients had three months to complete treatments under the scheme, which ended in November 2012. That meant 1300 Smiles had a furious period of activity and record monthly revenues, then a big slowdown when the scheme ended.

Even so, the market did not like 1300 Smiles’ FY14 interim result, driving it shares from $6.90 to $6 around the news. With Government budgets under immense pressure, regulatory risk for the dental industry, which relies heavily on Medicare funding, remains a significant threat.

Moreover, as income growth slows and people battle a higher cost of living, dentistry is a service that those under financial pressure can defer or avoid. Higher-margin preventative and cosmetic procedures are a lot more discretionary than lower-margin restorative procedures.

Nevertheless, in a soft economy, 1300 Smiles still has plenty of scope of growth, organically or by acquisition. Its clever dollar-a-day dental plan had had reasonable traction, with more than 5,000 members since its launch in October 2012. It could provide 1300 Smiles with an attractive annuity stream in time.

1300 Smiles says it has had more enquiries from dentists who want to sell their practice, and that there are better opportunities to buy good practices at lower prices. It clearly has the balance sheet and surplus cash flow to snap up undervalued practices as they become available.

1300 Smiles, established in 1995, has a good reputation and does plenty of pro bono work for disadvantaged communities in Australia and Papua New Guinea. The fact that its founder and managing director still owns 62 per cent is another good sign: it is common for founders to take more chips off the table through a full or partial exit when the share price rises.

On balance, 1300 Smiles is the type of high-quality small-cap stock that suits portfolios. It has a good position in a good industry, but is fully valued for now. Long-term value investors need to watch and wait in anticipation of better value.  It looks like a stock to buy during any sustained share-price weakness, or during a sharemarket pullback or correction.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at July 8, 2014.

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