Key points to remember
- Arrail Group has passed a listing hearing in Hong Kong after becoming operationally profitable in its last financial year
- The company hopes to tap into a fragmented Chinese dental market that could be worth 300 billion yuan a year by 2025
By Molly Wen
The field of healthcare investing is full of colorful terms such as “eyes of gold”, “teeth of silver” and “bones of copper”. Such metallic expressions show how lucrative and promising private medical practice can be in fields like ophthalmology, dentistry and orthopedics.
A number of Chinese eye companies have gone public, showing that there really is gold in eye care. By comparison, dentistry has yet to attract the same kind of nods from investors. Arrail Group Ltd.one of the country’s three largest private oral healthcare providers, is eager to change that, even as a costly value adjustment mechanism (VAM) deal weighs on its balance sheet.
Following a failed listing attempt last year, the company filed for an IPO a second time in Hong Kong earlier this year and passed the registration hearings on Monday.
Arrail provides oral health services from 111 hospitals and clinics in 15 of China’s largest cities. Its repertoire includes regular dental services, orthodontics and dental implants. Its namesake chain Arrail caters to affluent patients with deep pockets, while its Rytime brand targets the mid-range of the market. In the six months ending September 2021, the two brands contributed 430 million yuan ($68 million) and 410 million yuan in revenue to the company, respectively.
Dental disease is common in China, although few people had the money to spend on proper dental care before the 21st century. This care has become increasingly available and affordable over the past 20 years, but the penetration rate in China in 2020 was only 24%, well below the 70% in the United States. This shows that the demand is not only growing, but that there is also great potential. not only for basic services like treatment of dental diseases, but also for optional services like teeth whitening.
According to market data in Arrail’s prospectus, China’s dental health market is expected to grow at a steady pace over the next few years, from 119.9 billion yuan in 2020 to around 300 billion yuan in 2025.
As one of the few Chinese dental health companies with a national footprint, Arrail has become a favorite in private equity. Big names like Goldman Sachs, Qiming Venture and Hillhouse Capital have all jumped on board since 2010. The company’s last funding round in April last year was led by Singaporean sovereign wealth fund Temasek, raising nearly 200 million and valuing the company at $980 million – just short of the $1 billion mark for “unicorn” status.
Low gross margins
Arrail may focus on high-spending customers, but it has yet to translate that into big profits. In fact, the company is grossly underperforming its peers in terms of gross margin. A Sealand Securities report last year showed that industry gross margins averaged around 40-50%. But Arrail was far behind that, with just 15.2%, 10.1% and 24.1% in its 2019-21 financial years, respectively.
The lackluster performance has everything to do with the company’s incredibly high personnel costs. In the same three years, its expenditure on personnel costs totaled 460 million yuan, 500 million yuan and 580 million yuan, an average compound growth rate of 12.3%. These expenses have always represented more than half of the company’s total costs.
Reducing personnel costs is not easy for private companies like Arrail due to the shortage of dentists in China. In 2020, the country had just 175 dentists for every 1 million Chinese, compared to 810 in Europe and 608 in the United States. Arrail also admitted in its prospectus that it would have to compete with public and private dental providers by offering better packages to attract top talent.
Its financial performance also looks less than dazzling. Its revenue rose from 1.08 billion yuan to 1.1 billion yuan and 1.52 billion yuan in its last three fiscal years, from 2019 to 2021, respectively. It posted operating losses of 84.04 million yuan and 133 million yuan in 2019 and 2020, before going black with an operating profit of 124 million yuan in its last fiscal year.
The company attributed the losses to business expansion and suspension of operations during the pandemic, when many medical facilities were closed and people mostly avoided dental clinics for fear of infection. In 2019 and 2020, the company opened 16 and 10 dental clinics and hospitals respectively. But it only opened two in 2021 in a bid to control costs.
While return on investment is slow for dental operators like Arrail, one thing that works in its favor is the high degree of market fragmentation. China’s top five private dental operators accounted for only 8.5% of the market in 2020. Another factor in its favor is the relatively low cost of equipment. Unlike ophthalmology departments which rely heavily on expensive equipment, the material costs of dental operations are low and the clinics are easily set up after obtaining the necessary licenses.
Sealand Securities pointed out that most dental services are generally considered safe and do not require the assistance of other medical services. He added that using a franchise model in the industry also does not bring much benefit in terms of capital requirements, cost control and standardized management.
Hurried by IPO deadline?
Arrail may also seek to list now under pressure from its investors. According to the prospectus, the company’s debt exceeded its assets at some point during the period covered by the IPO document. It recorded net liquid liabilities of up to 4.26 billion yuan in 2021, which the company attributed to previous VAM agreements it entered into with investors.
Under these terms, if the company failed to go public by the end of 2020, investors had the right to request redemption of their shares. That meant liabilities for its 2021 financial year included 3.2 billion yuan of preferred shares. The redemption date for these shares has finally been pushed back to December 31, 2023. When Arrail is successfully listed, these preferred shares will be converted into ordinary shares.
The effects of this deal caused Arrail’s loss attributable to shareholders to reach 600 million yuan in its 2021 financial year. We can calculate its valuation using a price-to-sales (P/S) ratio , referring to two listed dental groups whose activities are close to Arrail. This pair, angelalign (6699.HK) and listed in Shanghai Medical CT (600763.SH), both have P/S ratios of 24 times. Using that as a benchmark, Arrail’s valuation could be as high as HK$44.8 billion, or about $5.74 billion, based on its 1.52 billion yuan revenue during the of his last exercise.
However, TC Medical is a safe bet in the Chinese A-share market, with its market value having exceeded 100 billion yuan in the past. Its gross profit margin in the first half of 2021 also reached 46.75%, double that of Arrail. If Arrail wants to replicate TC Medical’s success in the capital market, it will need to operate more formally to give its valuation a bit of a shine.
