U.S. Markets open in 7 hrs 14 mins

Edited Transcript of SDC.OQ earnings conference call or presentation 12-Nov-19 9:30pm GMT

Q3 2019 SmileDirectClub Inc Earnings Call

Nov 23, 2019 (Thomson StreetEvents) -- Edited Transcript of SmileDirectClub Inc earnings conference call or presentation Tuesday, November 12, 2019 at 9:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Alison Sternberg

SmileDirectClub, Inc. - VP of IR

* David B. Katzman

SmileDirectClub, Inc. - CEO & Chairman

* Kyle I. Wailes

SmileDirectClub, Inc. - CFO

================================================================================

Conference Call Participants

================================================================================

* Brandon Couillard

Jefferies LLC, Research Division - Equity Analyst

* Glen Joseph Santangelo

Guggenheim Securities, LLC, Research Division - Analyst

* John Charles Kreger

William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst

* Jonathan David Block

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Kevin Caliendo

UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution

* Laura Allyson Champine

Loop Capital Markets LLC, Research Division - MD

* Michael Leonidovich Ryskin

BofA Merrill Lynch, Research Division - Associate

* Robert Justin Marcus

JP Morgan Chase & Co, Research Division - Analyst

* Stephanie July Demko

Citigroup Inc, Research Division - VP & Senior Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Greetings. Welcome to the SmileDirect Third Quarter 2019 Earnings Call. (Operator Instructions) Please note, this conference is being recorded. I will now turn the conference over to Alison Sternberg, Vice President, Investor Relations, SmileDirectClub.

Thank you. You may begin.

--------------------------------------------------------------------------------

Alison Sternberg, SmileDirectClub, Inc. - VP of IR [2]

--------------------------------------------------------------------------------

Good afternoon. Before we begin, let me remind you that this conference call includes forward-looking statements. For additional information on SmileDirectClub, please refer to the company's SEC filings, including the risk factors described therein.

You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements that we make on this call are based on assumptions and beliefs as of today. I refer you to Slide 2 of our presentation for a description of certain forward-looking statements. We undertake no obligation to update such information, except as required by applicable law. In this conference call, we will also have a discussion of certain non-GAAP financial measures, including adjusted EBITDA and free cash flow.

Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures is included in the presentation slides for this call, which can be obtained on our website.

We also refer you to Slide 20 of this presentation for a reconciliation of certain non-GAAP financial measures to the appropriate GAAP measures.

I am joined on the call today by Chairman and Chief Executive Officer, David Katzman; and Chief Financial Officer, Kyle Wailes. Let me now turn the call over to David.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [3]

--------------------------------------------------------------------------------

Thanks, Alison, and thanks to all of you for joining us on the call today. We are excited to report our first quarterly results as a public company. I want to extend special thanks to our new investors for their confidence in our team and our company. I'd also like to thank the SmileDirectClub team for their hard work during the IPO process and their endless commitment to our club members. I'll address a few highlights from this quarter, but will focus mostly on the trends in our overall business.

As this is our first earnings call, I also want to take some time to share the SmileDirectClub story and tell you about our operating philosophy.

After that, I will turn the call over to Kyle to discuss our financial results and guidance, and then we will take your questions.

Post-IPO, our team remains laser-focused on execution and our results for the quarter, all of which exceeded management's expectations, are a testament to the strength and momentum of the underlying business.

Kyle will provide greater detail later in the call, but here are some financial highlights. Revenue for the quarter grew 51% year-over-year to $180 million. We shipped 106,070 unique aligner orders, up 47% year-over-year at an ASP of $ 1,788 for the quarter. Gross margin for Q3 was 77%, up over 700 basis points year-over-year. This margin improvement is a result of manufacturing 100% of our aligners in-house compared to outsourcing a portion of our manufacturing in Q3 2018 as well as our continued discipline to improve manufacturing automation and supply chain efficiencies.

Finally, adjusted EBITDA came in ahead of management's expectations at negative $45 million, reflecting continued investments that we believe will position us favorably to capture the long-term market opportunity. Our unit economics remain very strong. In light of these results for fiscal year 2019, we expect the following: Revenue between $750 million to $755 million, representing growth of 78% year-over-year at the midpoint of the range; and adjusted EBITDA for the fiscal year is expected to be between negative $73 million to negative $80 million.

We are very pleased with our Q3 results. Our core business metrics are trending positively as we continue to execute against our massive untapped opportunity through delivering the best possible customer experience.

Since this is our first earnings call as a public company, I'd like to take a step back and discuss the SmileDirectClub story. We are very pleased with what we've been able to accomplish over the course of just 5 years since our founding, and we look forward to the next chapter of our company life.

We're on a mission to democratize access to a smile each every person loves by making it affordable and convenient for everyone. For too long, teeth straightening was limited to those who could afford to pay $5,000 to $8,000, but we are changing that with a safe, convenient and affordable solution. We are a team of 5,400 team members across the country and abroad who are united in support of this mission every day. We are passionate about our work and constantly thinking of new ways to make our club member experience even better. Every day, we receive messages from our members about the impact we have on their lives and how we have changed their lives for the better and given them confidence that they never had before.

We are changing smile hiders to grinners, and we could not be prouder of the life-changing impact we have had on our club members.

It is incredibly rewarding to have a positive impact on someone's confidence, and we thank them for instilling their trust in SmileDirectClub. We operate in a large and underserved market, where roughly 85% of people have some form of malocclusion, yet less than 1% are treated annually. We believe our aligner treatment can help over 90% of this population achieve a better smile. With our differentiated value proposition founded upon access, convenience and cost, we are uniquely positioned to address the long-standing unmet consumer needs in this category.

And despite being in the very early innings of this opportunity, we are already gaining significant traction with approximately 5 million monthly unique website visitors and over 750,000 members treated since inception.

We are confident in our long-term trajectory because of our key competitive strengths of moats. First and foremost, we have a mission-driven brand with a positive member experience. More than 95% of our members surveyed would recommend our SmileShop experience to friends, and approximately 20% of our members today come through referrals. We also enjoy a large and growing presence in social media with over 500,000 likes on Facebook and over 350,000 followers on Instagram.

Out of over 60,000 Google reviews, 97% reflect positive sentiment, placing us well ahead of other traditional DSO providers.

Lastly, out of approximately 125,000 reviews on our website, our average rating reflects 4.9 stars on a 5-star scale. As you can see, our members are extremely happy, and we are very proud of these results, this is a direct reflection of the incredible team members that we have at SmileDirectClub.

Secondly, we are pursuing our opportunity with an omnichannel approach, allowing our members to utilize our products through a doctor prescribed impression kit mailed to their home or a visit to one of our 360-plus SmileShops, including those in our partner locations in CVS, Walgreens and other retailers. Third, we have an exclusive affiliated doctor network comprised of dentists and orthodontists licensed within every state in which we operate, allowing us to operate our model at scale, while maintaining the highest standards of care.

Next, we offer SmilePay captive financing, which removes price as a limiting factor for our members. Finally, we bring all our strengths together in a completely vertically integrated MedTech platform empowered by our proprietary software, [Smile Check]. Our control of the end-to-end process throughout the members' experience from their initial visit to the website to aligner manufacturing fulfillment and ultimately throughout treatment, positions us to rapidly innovate against member pain points and feedback.

We are the only fully integrated company in our industry, which delivers a true end-to-end consumer experience.

In summary, individually, these competitive moats are significant and highly differentiating, but collectively, they are what allow us to preserve credible unit economics as we continue to grow and achieve scale.

Turning to growth drivers. While we are very pleased with our progress to date. We believe there is significant opportunity to grow beyond approximately 750,000 plus members who have gotten smiles they love using our platform. Given we have captured less than 1% of the total market opportunity, we will continue to focus on our omnichannel marketing approach to raise aided awareness, which is up to 50% today.

And through our CRM strategies, educational efforts, technology advancements and data-driven insights, we expect to continue to improve conversion and engagement at every touch point across our member acquisition funnel.

International expansion is also a key growth driver for us. With approximately 75% of the market opportunity outside of the U.S., we continue to focus on expanding our international footprint. We launched our first international market, Canada, in November 2018, our second international market, Australia, in the second quarter of 2019 and our third international market, the U.K., in the third quarter of 2019. And just last month, we launched into New Zealand and Ireland.

We have a robust international road map with plans to launch into additional regions throughout the end of this year and into next year. Our performance in all of these countries is off to a great start as access, convenience and costs are problems that are not unique to the U.S. and our mission-driven brand and business model resonates with consumers globally.

We also remain focused on product development. We have already launched a series of ancillary products, including retainers, lip balm, bright on premium whitening and an LED accelerator light. In late July, we launched our very innovative nighttime only clear aligner product, which enables our members to straighten their teeth only while they sleep. And there's more to come.

We continue to deploy resources towards our research and development efforts in support of lengthening our relationship with our members, while also enhancing our recurring stream of revenue. Our continued SmileShop rollout is also a key driver in expanding access to care and improving conversion, including our arrangements with retail partners, such as CVS and Walgreens in the U.S., Chemist Warehouse in Australia and Shoppers Drug Market Canada.

Looking at other corporate partnerships, we have recently entered into agreements with UnitedHealthcare and Aetna to include insurance coverage on an in-network basis. This means our members who participate in these plans will no longer need to retroactively submit for reimbursement.

I'd also like to add that in support of our growth, we have recently announced plans to establish a new dental manufacturing lab in Kyle, Texas. This exciting new expansion is expected to meaningfully increase our production capacity while also providing redundancy to our Tennessee facilities.

We expect the new location to come online towards the end of Q1 or early Q2 2020. Before I conclude, I do want to take a moment to address the regulatory climate within which we operate. I spent my career building and scaling disruptive businesses, and as a disruptor it is not uncommon to face reactions from an entrenched industry that has not previously been challenged. This is not new for us as a company, nor is it something that will disappear overnight. We have activated a national and international lobbying effort and have successfully beat attempts by several organizations who have resorted to various tactics to advance their anti-competitive agendas and preserve their pricing power, all in an effort to keep consumer prices high.

We believe we are in compliance with regulatory requirements in each of our markets, and we will continue to enact a proactive effort to defend our mission against anti-competitive behavior. You can expect us to continue this fight in order to protect the access to care that consumers want and deserve. That said, we welcome the opportunity to continue to partner with the dental community in support of providing access to convenient, low-cost patient care.

Last but not least, our success in getting to where we are today has come as a result of the hard work of a talented team of which we are incredibly proud to be a part of. Our team, while delivering growth at scale through an exceptional customer experience, has also demonstrated execution rigor that has resulted in expanding gross margins and improved operating efficiencies.

Thank you for your attention today. Now I will turn the call over to Kyle, who will provide a more detailed review of our Q3 results and walk you through our financial outlook.

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [4]

--------------------------------------------------------------------------------

Thank you, David. As David mentioned, we were very pleased with our performance in the third quarter. Our focused execution produced outperformance in August and September, which allowed us to come in ahead of our plan despite the headwinds we have previously cited.

In particular, September was the highest revenue month in the history of SmileDirectClub. As a reminder, in addition to the normal seasonality of our business, which produces some sequential softness in Q3, we had 2 specific issues earlier in the quarter that put some downward pressure on conversion. First, we experienced a technical issue that ultimately delayed the delivery of treatment plans to our members; and second, given our rise in aided awareness and referral rates, we experimented with a messaging change in social media, specifically a new call to action within one of our larger digital marketing channels. While this messaging change produced a nice lift in bookings, we did not see the accompany conversion to aligner sales.

We're able to very rapidly identify and address both issues and see them both as very much behind us. This is reinforced by the fact that as mentioned a moment ago, September was the highest producing revenue month in our history. This is also a great example of how our completely vertically integrated MedTech platform allows us to quickly pivot in order to manage and optimize our performance.

Now let's turn to the income statement. Revenue for the quarter was $180 million, which represents an increase of 51% over the third quarter of 2018. This increase was driven primarily by a 47% year-over-year increase in aligner shipments, which came out at 106,070 and a modest increase in ASP, which came in at $1,788. Gross margin for the quarter was 77%, an over 700 basis point improvement versus the prior year.

This was driven by manufacturing 100% of our aligners in-house, as well as our continued discipline to improve manufacturing automation and supply chain efficiencies.

We remain very focused on improving our strong gross margin profile through continued advancements in our technology and further automation of our core manufacturing processes.

Marketing and selling expenses were $131 million or 73% of net revenue in the quarter compared to 48% of net revenue in Q3 of 2018.

During the quarter, we continued to make significant strategic investments in both expanding our footprint and our digital and media advertising strategy as we continue to build on our already strong brand recognition. In order to ensure we are best positioned to fulfill the growing demand in our marketplace, we have been focused on investing heavily in the rollout of SmileShops both domestically and with particular emphasis on our overseas efforts. That said, we currently cover the top 100 DMAs within the U.S., and we expect to begin to leverage this footprint in 2020 and beyond.

General and administrative expenses were $390 million in Q3 compared to $30 million in the prior year period. G&A expenses in the current year period include a onetime charge of $324 million related to equity-based compensation and $6 million of other onetime IPO-specific costs during the third quarter. As we mentioned in our S-1, we expected to have a onetime charge in the third quarter as a result of compensation expense related to the IPO.

We also experienced a significant increase in legal expenses within the quarter, resulting from the regulatory climate within which we operate. Our legal expenses doubled in the third quarter of 2019 compared to the second quarter. You can expect to see this continue into the fourth quarter as we maintain our proactive stance to defend our mission in support of consumer access to care. Additionally, we continue to invest in human capital across the company in preparation for our long-term growth. This investment is focused on technology, marketing, data analytics, data science, finance and other corporate functions.

Q3 net loss was $388 million compared to a $15 million net loss in Q3 2018. As I just mentioned, costs related to our IPO increased our Q3 net loss by approximately $330 million. Q3 adjusted EBITDA loss came in ahead of target at negative $45 million, a decrease of $49 million compared to Q3 2018. Our adjusted EBITDA margin was negative 25%.

Moving to the balance sheet, we ended the third quarter with $548 million in cash and cash equivalents. This includes approximately $100 million set aside for IPO expenses and future payments or distributions as referenced in our S-1. Cash from operations for the third quarter was negative $94 million. Cash from investing for the third quarter was negative $28 million, mainly associated with the launch of 56 SmileShops and continued investment in our manufacturing infrastructure.

Free cash flow for the third quarter, defined as cash from operations less cash from investing, was negative $122 million. I would like to point out that current cash on the balance sheet is expected to take us to cash flow profitability.

Quickly turning to SmilePay. In Q3 2019, 66% of our members elected to purchase using SmilePay, which is down from 68% in Q3 2018. With SmilePay, the $250 down payment is required upfront, which more than covers the cost of manufacturing the aligners. The remaining cost is financed with a credit card on file over 24 months at an average cost of $85 per month. Over the tenure of our program, we have seen positive trends in metrics such as time to care delinquencies and loss rates. Further, SmilePay continues to be a profitable program for our business, with the average APR more than offsetting any implicit price concessions associated with the program.

Implicit price concessions as a percentage of total revenue has also trended down since inception, with an associated delinquency rate of 9% in Q3 2019, which is down from 10% of revenue in Q3 2018. As David noted, SmilePay's the unique barrier to the success that we have built, and we continue to evaluate next steps for our long-term securitization strategy.

As we begin life as a public company, we want to ensure that we provide clarity and transparency to our shareholders as to how we operate the business while balancing our long-term focus. Our ability to move quickly to capitalize on growth opportunities will maximize long-term value for our customers, our team members and our shareholders. Balancing these priorities, we are taking a thoughtful and deliberate approach to quarterly and annual guidance on revenue and adjusted EBITDA. We are committed to being transparent about both our performance as well as our investments in the quarters and years to come, so shareholders are informed and understand our operating decisions.

As David mentioned earlier, we are in the very early innings of a massive untapped opportunity. Our vertically integrated MedTech platform allows us to deliver a superior consumer experience with strong, attainable unit economics, and we believe we are uniquely positioned to continue to gain meaningful share in the U.S. and abroad.

With that in mind, I'd like to turn to our outlook regarding the upcoming quarter and the remainder of the year. For fiscal year 2019, we expect the following: revenue between $750 million to $755 million, representing growth of 78% year-over-year at the midpoint of the range; adjusted EBITDA for year is expected to be between negative $73 million to negative $80 million. We plan to discuss our 2020 guidance on our fourth quarter earnings call in the first quarter of 2020.

Let me conclude by saying that we are pleased with our Q3 results, and we believe that we are in the early stages of our growth. We are very excited about our future and look forward to reporting on our progress in the quarters to come.

With that, I'll turn the call back over to David for closing remarks.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [5]

--------------------------------------------------------------------------------

Thanks, Kyle, and thank you to everyone for joining our call today. Q3 was a good quarter. We were able to demonstrate our ability to execute even when 100% of things didn't go our way. We have an incredible team, the best I've ever worked with. Overall, our business is better positioned than ever to capitalize on a massive market opportunity in front of us, and we look forward to demonstrating that in the quarters to come.

As I stated at the start of the call, we are laser-focused on our mission. We do this to bring smiles to people all over the world, and nothing makes us more excited than to show up and execute our business every day. With that, I will turn it back over to the operator for questions.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question is from Robbie Marcus with JPMorgan.

--------------------------------------------------------------------------------

Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [2]

--------------------------------------------------------------------------------

Congrats on the nice quarter. Maybe, Kyle, I was hoping you could start -- you talked about September being one of the strongest quarters in the company's history. Can you give us a little more clarity, maybe how third quarter progressed? I know there were some issues you disclosed pre-IPO in July. But just give us a little more flavor for how it progressed July, August, September?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [3]

--------------------------------------------------------------------------------

Sure. Yes. So as we entered into July, as we've talked about before, Q3 for us, seasonality is always a down quarter from a demand perspective, right? So seasonality in Q1 is always the strongest with the new year, new you effect. Our Q2 was relatively flat to that. And Q3 is typically down from a demand perspective, with a small pop back up in Q4. And we saw that again this year, in particular, in July, we had 2 other issues that we've discussed about in the past, they were quickly addressed and resolved in the month of July. So we saw August come back very nicely. And as I mentioned, September was the best month for revenue that we've had in the history of the company.

--------------------------------------------------------------------------------

Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [4]

--------------------------------------------------------------------------------

Great. One more here. You've just started to launch internationally. You've now added 2 countries over the past months. How would you say the launches are going? If you could talk to Canada, U.K., Australia, which are more recent and any countries that you plan to add in the near to mid-term that we can look forward to?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [5]

--------------------------------------------------------------------------------

Yes, the launches are going very well, right? So the same problems that exist here in the U.S. around access, convenience and cost exists globally. And so as we enter into these new markets, use Canada as a great example, we entered into Canada with 0 aided awareness within that country. Aided awareness today in Canada is up to 27% in just a quick year. And we're seeing similar traction in Australia and the U.K. and other markets that we've entered into as well.

As you look at Q4, we've got more countries that we plan for the remainder of this year and additional countries planned for next year as well in our international event.

--------------------------------------------------------------------------------

Robert Justin Marcus, JP Morgan Chase & Co, Research Division - Analyst [6]

--------------------------------------------------------------------------------

Okay. And then last for me, I'll jump back into queue. You signed agreements with United and Aetna recently. I know it's early, but any data points or trends or signs you can point us to? And how this is having an impact? I know it's typically cash pay, but what are you seeing with these early wins on insurance coverage?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [7]

--------------------------------------------------------------------------------

Yes. To your point, still very early with both of those. I think both were great wins for us to move in-network with insurance companies. That's a much longer-term strategy that we continue to do. We're also actively on the road in partnership with them in front of self-insured employers as well with the overall long-term goal of expanding access to care and having self-insured employers ultimately adopt adult ortho covers.

And so we're working closely with them on that mission.

--------------------------------------------------------------------------------

Operator [8]

--------------------------------------------------------------------------------

Our next question is from Glen Santangelo with Guggenheim Securities.

--------------------------------------------------------------------------------

Glen Joseph Santangelo, Guggenheim Securities, LLC, Research Division - Analyst [9]

--------------------------------------------------------------------------------

Kyle, just to follow up on that September comment suggesting that the revenues are the best in the company's history. We're getting some questions about the implied Q4 revenue guidance, maybe being a little bit lower than expected. And I was kind of curious, with just about half the quarter over, can you comment at all at maybe how things are trending quarter-to-date? And maybe the level of visibility and conviction you maybe have in the implied Q4 revenue guidance at this point?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [10]

--------------------------------------------------------------------------------

Yes, absolutely. So as you think about Q4, I really think you've got to think about it in the context of the full year, right, which is coming in ahead of our expectations. Revenue, as we mentioned, that $750 million to $755 million. That represents growth in the fourth quarter of 55% year-over-year, represents 10% growth sequentially quarter-over-quarter, which was exactly what we saw in 2018 as well.

So I feel very good about those numbers. But as we think about Q4, we're really looking at it in the big picture of the full year, beating our expectations $750 million, $755 million.

--------------------------------------------------------------------------------

Glen Joseph Santangelo, Guggenheim Securities, LLC, Research Division - Analyst [11]

--------------------------------------------------------------------------------

Okay. David, maybe one for you. You touched somewhat on the regulatory environment. Obviously, a lot of talk around bill AB 1519 in California and whether or not that would require a change to your business model. In your release, again, you reiterated that you don't think there'll be any changes that are necessary. Could you maybe talk in a little bit more detail about your California operations? What gives you the confidence that your current model satisfies the language in that bill?

And then maybe any updates on any other state board complaints that have received attention, like Georgia or Alabama? Or are you aware of any other pending legislation that's kind of worth mentioning on the call?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [12]

--------------------------------------------------------------------------------

Sure, Glen. So first of all, there's no impact on the business, as we stated presently or anticipated. We're in compliance with all regulatory laws across California as well as the United States. It's important to note that our objection to the legislation because it's been brought up, why do you object to it if you're in compliance with it. It was really based on the principle that we do not think clinical patient-specific decisions should be made by the legislature. Medical and clinical decisions should be made and left up to the treating doctor.

So today, how we operate if our doctors and our network after reviewing the patient's health history, their complete photo set and intraoral scan, if they determine that an X-ray is needed, we do that today by requiring a clearance from that patient to review their most recent X-rays or get new X-rays. So it's really up to the treating doctor, not the state legislature. That was our opposition to the bill.

As far as being in compliance, we're in full compliance as it stands today. Remember, overexposure to X-ray is not a good thing. It's not a good health practice. The governor, when he signed the bill, Governor Newsom said that there will be debate over this. And by the way, in California, a citizen or resident of California has the right to deny X-rays. If they think that it's not necessary, could cause a health risk.

As far as your second question, other than us being the plaintiff in the Georgia and Alabama cases, there's nothing outstanding. Listen, as we stated, this is not my first disruptive business that I've been involved in, even in the contact lens business, they're still fighting the fight. We will continue to fight for our customers, for access to care, and we've had over 30 state dental board inquiries. We've -- every single one of those, we've been cleared, there's been no adverse actions. And so we will -- I think as investors out there, you have to understand that, that's the nature of this disruptive business, which is also what keeps competitors out, which -- it's really a barrier in a lot of respects.

--------------------------------------------------------------------------------

Operator [13]

--------------------------------------------------------------------------------

Our next question is from Jon Block with Stifel.

--------------------------------------------------------------------------------

Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [14]

--------------------------------------------------------------------------------

Maybe the first one, just talk about the current and future pipeline. Any more details on the nighttime aligners, and what percent of cases in the quarter, even an approximation were nighttime, how do you see that in Q4? And then when you talk about the future pipeline, where are you guys focused? In other words, is it on the current aligner side of things and rounding out the portfolio? Or is it more earmarked for some of those ancillary opportunities? And then I just got a quick follow-up.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [15]

--------------------------------------------------------------------------------

Yes, I can take that. So in nighttime, we're very pleased with the adoption so far. What it's done is brought in new customers into the funnel that might otherwise never have looked at teeth straightening due to their specific occupation. They may be a chef, they may speak a lot, the inconvenience of wearing clear aligners all day.

We did a lot of research around this. Pretty much what the research showed is what's happening here, it's bringing in that new customer to the top of the funnel, which we're very excited about. As far as R&D, we have a full team now. We have -- actually as we speak this week, we're down in Costa Rica, where we're doing our treatment planning. And they're down there looking at new opportunities, new products for aligner therapy wear, as far as advancements in technology in all dental products.

So we're a health care company. We're a company that's going to commit to R&D and innovation, and you'll see other products and technologies coming out in 2020.

--------------------------------------------------------------------------------

Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [16]

--------------------------------------------------------------------------------

Okay, very helpful. And then I hate to push on regulatory, but I do think it's obviously a focal point for investors. And just to be clear, is this just a question of interpretation, David? In other words, there's other parties out there in the dental world that seem to think specifically that 1519 speaks to the need to have an X-ray performed before proceeding with clear aligner therapy?

And I guess, just to be clear, SDC's take is different and you don't think any changes or tweaks would need to be made to the current business model.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [17]

--------------------------------------------------------------------------------

Yes. So as we read it, and there'll be a lot of debate over it, but as we read it, the legislation does not require consumers to have a new X-ray performed in order to get clear aligner therapy, what AB 1519 says, it's very clear that the treating doctor must review a recent X-ray or other bone imaging suitable for orthodontia.

We do that today. We require our customers to have a recent visit to their dentists within the last 6 months, to have a recent set of X-rays. So all that information is there. So we don't feel that this does anything to our model.

And -- but we are going to debate it with the governor and other legislatures, other bodies of legislature. It's just -- it's not right as far as access to care, which is what our company is founded on, teledentistry. But as far as being in compliance, we feel we are fully in compliance.

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [18]

--------------------------------------------------------------------------------

Yes. And I'll just add to that quickly, John. So in terms of that, even if you say go to sort of what's a possible worst-case scenario in that event, right? Even if we had to put an X-ray in the shop, right? It doesn't impact the unit economics that we've always talked about. We're still at incredibly powerful unit economics within the business. And there's nothing about AB 1519 or any other legislation that would impact that.

--------------------------------------------------------------------------------

Operator [19]

--------------------------------------------------------------------------------

Our next question is from Stephanie Demko with Citigroup.

--------------------------------------------------------------------------------

Stephanie July Demko, Citigroup Inc, Research Division - VP & Senior Analyst [20]

--------------------------------------------------------------------------------

Congrats on the quarter. But I just wanted to dig a little deeper into the fourth quarter. I know we've touched on it already. Just given some of the puts and takes, there's some extra spend for combating regulation. There's also September being the strongest quarter -- strongest month you've seen so far. How are you getting to the bill for fourth quarter? And how much conservatism is built in?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [21]

--------------------------------------------------------------------------------

Yes. Look, as we talked about on the call, as we think about our conservatism, we look at what we're doing today, right? So we're not factoring in changes in conversion into the model. We're not building new countries into our assumptions. We're looking at the execution that we have today in the business, and that's what's going into our assumptions. Again, I think you've really got to look at it on a full year basis. If you look at that in terms of Q4, like I said before, we're up 55% year-over-year, 10% sequentially quarter-over-quarter, which is exactly what we did in 2018.

And then on the profitability side, I think if you look at Q3 for a second, right, so Q3, obviously, profitability came in ahead of our expectations. Profitability for us, it's really a managed outcome, right? So with an 80% gross margin, it provides us a lot of flexibility on how we think about growth versus profitability overall. On the marketing side, we're continuing to invest in and drive aided awareness. Aided awareness for us is up to 50% today. That's up from 24% in just over a year.

On the SmileShop side, we already cover the top 100 DMAs today, and we've invested over the past several years and quarters into that footprint that we have. We expect to start to leverage that footprint in the near future and beyond. We've invested significantly in international sales and marketing as well. Where, when we launch into these new markets, we do overinvest for the first 6 months to drive aided awareness, as I talked about in Canada before, which is up to 27% today.

On the G&A side, we're investing for future growth, right? So that's our international team. It's IT, it's marketing, data analytics, R&D, as David mentioned a minute ago, with our manufacturing R&D, but also product R&D with a nighttime product and other new products that we're focused on. Q3 had the legal expenses as well, which were double from Q3 compared to Q2, and we're expecting that in our forecast to occur in Q4 again.

So in summary, we're thinking about it as ahead of our profitability expectations for the quarter. We're investing for growth, and we still feel very good about the long-term targets that we put out there, being 25% to 30% EBITDA margins.

--------------------------------------------------------------------------------

Stephanie July Demko, Citigroup Inc, Research Division - VP & Senior Analyst [22]

--------------------------------------------------------------------------------

Understood. And when you think about the long-term target is going kind of, looking a year ahead. What isn't baked in to give you extra shots on goal for upside in the coming year?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [23]

--------------------------------------------------------------------------------

Yes, we have a lot that we're working on today. There's a lot of new countries that we're focused on expanding into. There's lots of ancillary products that we're working on and a variety of other initiatives.

--------------------------------------------------------------------------------

Stephanie July Demko, Citigroup Inc, Research Division - VP & Senior Analyst [24]

--------------------------------------------------------------------------------

Well said. Last one for me, for AB 1519, do you think about the possibility of having to add in something like an X-ray that you mentioned to the shop? When would you have to -- would it be after all the dust has settled, you're done with your defense on this? Or is it going to be something more near term to think about?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [25]

--------------------------------------------------------------------------------

Well, right, today, the way AB 1519 is written, we're in compliance. We do not have to put a doctor in the shop, we don't have to do an X-ray in the shop. So we're good with it.

And so as far as, what Kyle mentioned, I think he was talking about worst-case scenario. Once again, being in a disruptive business, I know people are very focused on it. They want to understand it. If you look at all the different regulatory -- it's a regulatory environment and what some of these states are trying to enact, dental boards, Georgia, Alabama, California, the fact that we have this 300-plus footprint of SmileShops, we have those brick-and-mortar shops, all we have to do is put a dentist in them.

So I think if everyone just takes a breath and says, "Oh, if you put a dentist in there, what is this?" It's like Aspen Dental or Heartland Dental or any other." There's -- but we don't feel we have to do that. And that's why we're fighting the fight in Alabama and Georgia, and that's why we'll continue to fight in California for access to care for California residents.

But if you read it, it doesn't say -- and by the way, that bill, they tried to originally put in there that there must be a new X-ray taken and that was changed because there was lots of opposition. That's a health risk to a consumer. Taking that unnecessary X-ray is not a good idea. So our dentists and orthodontists in our network do a thorough review exam of all the photo sets, of all the health history, the intraoral scan, which is very revealing. And they make a determination if an X-ray is needed, no different than a dental office today. If you walk into your local dental office and want to buy Invisalign, they'll make a determination whether an X-ray is warranted or not. And if he looks at your gums and teeth, your scan, your intra-oral scan, and determines it's not necessary, well that's good because you really don't want to get an X-ray unless you have to. And that's why the way the language is written, I think it's a much better outcome than it originally started out.

--------------------------------------------------------------------------------

Operator [26]

--------------------------------------------------------------------------------

Our next question is from Brandon Couillard with Jefferies.

--------------------------------------------------------------------------------

Brandon Couillard, Jefferies LLC, Research Division - Equity Analyst [27]

--------------------------------------------------------------------------------

David, I'd like to start with SmileShops, and now it's been about 6 months since you've previously started the CVS relationship. Are you happy with how those stores have progressed and ramped over the last 6 months? And can you give us some color in terms of where the locations are, the -- perhaps some of the newer stores were in the back or in the front of the house and convenience stand on sort of exterior signage on both sides?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [28]

--------------------------------------------------------------------------------

It was a little hard to hear you, maybe it was just me, I don't know if anyone else in the call. But I think what you're asking is are the CVS relationship, how it's progressing. So yes, no great partners, both CVS and Walgreens. We're a little further ahead with CVS, great relationship within the store with their team members and our team members. We're doing -- we're going to start rolling out some home marketing that we have not done yet. In terms of both e-mail, direct mail, other pieces of marketing collateral. And so we will continue into 2020 with our expansion with CVS.

We're going through a really interesting study right now about where these shops should be. So we're very excited about that. We should have that information actually next week. So being a little more thoughtful about these locations, and we'll share that with you probably on our Q4 call.

--------------------------------------------------------------------------------

Brandon Couillard, Jefferies LLC, Research Division - Equity Analyst [29]

--------------------------------------------------------------------------------

Okay. And then one follow-up for Kyle. Kyle, you can share with us in terms of the step-up in the gross ASP in the third quarter and kind of what you're assuming for that metric and [a bit of a] percent that steps back down to the kind of the first half?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [30]

--------------------------------------------------------------------------------

Yes, it's a little hard to hear. Again, I think you're asking about ASP and the step-up in the third quarter. So if you look at ASP trending to $1,788 in the third quarter, the step down that you saw in Q1 and Q2 2019, that was associated with the international business, right? So we launched Canada towards the end of Q4 last year.

As we launch in these international countries, we enter with a slightly lower ASP to take price out of the equation. And then in 3, 6 months later, we tend to raise that price. So you've seen that in Canada. It's the same plan in other countries that we're launching into as well.

So ASP, I would expect similar trends to what we've had within Q3. But as the international business becomes a bigger portion of that, and we're launching into those countries, there will be small dips down for each of those countries as we enter into them.

--------------------------------------------------------------------------------

Operator [31]

--------------------------------------------------------------------------------

Our next question is from Kevin Caliendo at UBS.

--------------------------------------------------------------------------------

Kevin Caliendo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution [32]

--------------------------------------------------------------------------------

I noticed that financing revenues actually grew slower than overall revenues. And certainly, in the third quarter grew slower than they had over the first couple of quarters. Is that a reflection of a change in mix? Or can you talk to that trend in the third quarter?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [33]

--------------------------------------------------------------------------------

So as you think about financing revenue overall, we did have a price change earlier in the year, right, where it jumped from $80 to $85 per month, and that's associated within there as well. If you look at SmilePay, it has to come down a little bit, right? So I mentioned last year, it was 68% of total customers out there versus 66% today, and we've seen that trend down quarter-over-quarter. So that's having an impact on that as well.

--------------------------------------------------------------------------------

Kevin Caliendo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution [34]

--------------------------------------------------------------------------------

All right. And just happy to hear the bad debt number came down to closer to 9% in the quarter. What about -- can you talk a little bit about refunds at all. And the trend that you saw in the third quarter with that part of your revenue?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [35]

--------------------------------------------------------------------------------

Yes. So refunds has been flat as a percentage of revenue to what we've seen historically. We keep approximately a 5% reserve for any type of refunds.

--------------------------------------------------------------------------------

Operator [36]

--------------------------------------------------------------------------------

Our next question is from John Kreger with William Blair.

--------------------------------------------------------------------------------

John Charles Kreger, William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst [37]

--------------------------------------------------------------------------------

I'm curious with your newer payer relationships ramping up. Do you think that changes the seasonality of volume at all? Just curious if there -- if we should expect any sort of a step-up after kind of the typical January enrollment. And a related question, how do you feel about adding additional payers beyond United and Aetna in the coming months?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [38]

--------------------------------------------------------------------------------

Thanks. Yes. So on the first one, I think it's too small right now to really see an impact, right? I think as we continue to grow that business. It might change the seasonality a little bit. The seasonality is really focused more on the new year, new you effect more than anything else. And as we think about other payers, absolutely. We're currently in negotiations with a variety of other payers as well and see that being an important component to our growth in future years.

It's really a build. And as we talked, we were on the roadshow, the in network, it's phenomenal. It took a while to get there. Our services have always been covered, but it's been after treatment and the customers lay out the cash and they get reimbursed. This will be a real bonus to the customer, where they only have to come out-of-pocket $500, $600 and insurance will pay for the rest.

But it's really a build of selling these into these companies, and we are on the road with -- hand-in-hand with United and Aetna, soon to be others, so that it will become effective in 2021. I think that's when we'll start to see the real pop. But it's exciting, but it's not baked into any of our numbers today.

--------------------------------------------------------------------------------

John Charles Kreger, William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst [39]

--------------------------------------------------------------------------------

And one more. Kyle, so as we think longer term about margins, can you just go through sort of key puts and takes? It sounds like as you roll into international markets, maybe there's some downward pressure. I don't know if that's true in margin, I know you said for ASP. Also curious how rolling in the new plant in Texas might have an impact.

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [40]

--------------------------------------------------------------------------------

Yes, absolutely. So in terms of our long-term margins, so 85% gross margin, there's no change in that assumption as we sit here today. I think what's going to walk us up from where we are today is that 85% is really the continued focus on treatment plan automation, on manufacturing automation and the additional purchasing power that we expect to get as we grow the business.

On the sales and marketing side, no change to the 40% to 45% that we put out there. To your point, as we grow internationally, we do over invest for a period of about 6 months in each country that we go into. So as international is growing quickly, that will have an impact on the short-term sales and marketing as a percentage of revenue, but no change to the long-term assumption that we see there being 40% to 45%.

And then same thing on the G&A side, no change to our 15% assumption, all of that driving to the 25% to 30% EBITDA margin that we put out there.

--------------------------------------------------------------------------------

Operator [41]

--------------------------------------------------------------------------------

Our next question is from Laura Champine with Loop Capital.

--------------------------------------------------------------------------------

Laura Allyson Champine, Loop Capital Markets LLC, Research Division - MD [42]

--------------------------------------------------------------------------------

It's about capacity utilization in your Tennessee facilities. Where do you expect to be roughly at the end of this year? And what level of utilization do you expect to have by the time you get Texas up and running middle of next year?

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [43]

--------------------------------------------------------------------------------

Yes. So capacity, as we sit here today, we can produce about 3.5 million aligners per month in the plants that we have. If you do the math on that, that's approximately $150 million in monthly revenue. So significant capacity that we have today to support the business.

Kyle, Texas, as we launch that facility, it's really going to be focused on providing redundancy. So if something were to happen in our facility here in Antioch, would have redundancy in Kyle, TX as well. And we're building a full redundancy across those 2 plants.

--------------------------------------------------------------------------------

Operator [44]

--------------------------------------------------------------------------------

(Operator Instructions) Our next question is from Michael Ryskin with Bank of America.

--------------------------------------------------------------------------------

Michael Leonidovich Ryskin, BofA Merrill Lynch, Research Division - Associate [45]

--------------------------------------------------------------------------------

I have a quick follow-up for Kyle and a sort of a bigger picture one for David. Kyle, you just talked about some of the long-term margin bridge and kind of how you get there on -- between gross profit line and sales and marketing.

If you think of the sales and marketing expense sort of in terms of customer acquisition costs. I realize there's a lot of moving pieces there. And you talked about some of the international growth, but you're still trending gradually higher versus lower in terms of sales and marketing as a percent of revenue or in terms of year-over-year growth. If you exclude some of that international spend, are you moving in the right direction towards that $40 million to $45 million if you look at just the U.S.? And what gives you confidence in being able to achieve that target over time?

There's a really sizable inflection in the next couple of years. Does that have to do with your referral rates or sort of aided awareness, kind of just talk about the visibility there?

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [46]

--------------------------------------------------------------------------------

Yes, absolutely, right. So we're not going to obviously split out the marketing number versus the sales number. But what I'll say is it's a purposeful investment that we're making, right? So we're investing in marketing today. That's really going to drive that aided awareness, we're up from 25% a year ago to 50% today. That's really going to drive and support the long-term growth that we have in the business. And the same thing on the selling side. If you look at the investments that we've made in shops and the utilization that we have within our SmileShops today, we're going to start to get leverage out of both of those in 2020 and beyond. And so we feel very confident about that 40% to 45% sales and marketing margin as our long-term target because it's a purposeful investment that we're making today. And as I said before, on profitability, it really is a managed outcome for us because we're starting with an 80%, approximately 80% gross margin, which gives us a lot of flexibility for how we think about our growth versus our profitability.

--------------------------------------------------------------------------------

Michael Leonidovich Ryskin, BofA Merrill Lynch, Research Division - Associate [47]

--------------------------------------------------------------------------------

Great. And David, thinking about some of the legal and regulatory risks, just big picture. We've seen Alabama, Georgia, now California in the headlines continue to come up one at a time. You talked about taking a more offensive action on some of the legal issues. How do you see that playing out, this change in strategy over the next couple of years? And what do you think needs to happen on the legal and regulatory side to remove some of the overhang? Because these states and these challenges can keep coming up one at a time and can -- continue to sort of persist for some time now.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [48]

--------------------------------------------------------------------------------

No, that's a really good point. When we first started and up until recently, we were very reaction-oriented to these new state inquiries. As of late, we've -- and part of the reason for the increase in our legal expenses -- we've got a really good lobby team, both in the U.S. as well as abroad. Senator Bill Frist, who's on our Board, is also the Chairman of the Board of Teladoc, and he's really helped us out with a playbook for that. And they went through the same fight early on, and then they finally got proactive, and we're doing that now. So we're in a handful of states enacting teledentistry legislation, getting ahead of the curve here. So we're not waiting for the next state to come after us.

We feel very good about it. Telehealth really paved the way for us. Because today, in the country, and this wasn't the case, what, 5, 6 years ago. Thanks to Teladoc, that it is very favorable. It's seen as -- it's real, and you don't hear about states going after the telehealth industry. So we're taking a playbook there, you'll see more proactive legislation that will start to come out.

But as far as these -- when you mentioned, I'll say it again, Alabama, Georgia, we're the plaintiff there. They were talking about interpreting old laws on imaging devices that might also include the iTero scanner, which is just not true. It's not an imaging device like an X-ray. It takes a series of photographs. So we got out ahead of that one. That is getting out ahead of it. And we became a plaintiff there.

So listen, nothing has changed. We first came out, you guys really weren't around, when we first started out 5 years ago we had 30 state inquiries. We have to go in front of the dental boards of 30 different states, some in person, some just over the phone. And as they request information we provided it, and all of them started to understand our model and what we are doing here, and it's all totally within compliance. So there's no huge concern.

And like I said -- and we actually don't think this is going to happen. But if we had to put a dentist in every single building that we have, we would take that network of what we call ELPs, our affiliated network of dentists and orthodontists that are licensed in every state, and we would transfer them and put them into the shops. So the unit economics are really not affected. It's not a huge cost increase to us, but it's just not how our consumers want to transact. It's not how we built the model. So we'll continue to fight for what we believe is right.

--------------------------------------------------------------------------------

Operator [49]

--------------------------------------------------------------------------------

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing comments.

--------------------------------------------------------------------------------

David B. Katzman, SmileDirectClub, Inc. - CEO & Chairman [50]

--------------------------------------------------------------------------------

I think we're good. I want to thank everyone for coming. It's our first earnings call, we had 150 people or so, which I heard is a big number. So I'm glad there's a lot of interest. We'll be following up with you throughout the rest of the week. I know we've got a lot of inbound calls and inquiries, we were happy to discuss our business. And we look forward to talking to you guys again in about 90 days. Thank you.

--------------------------------------------------------------------------------

Kyle I. Wailes, SmileDirectClub, Inc. - CFO [51]

--------------------------------------------------------------------------------

Thank you.

--------------------------------------------------------------------------------

Operator [52]

--------------------------------------------------------------------------------

Thank you. This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.