Key takeaways
- Arrail Group has passed a listing hear in Hong Kong after becoming profitable at the operating level in its latest fiscal year
- Company hopes to take advantage of a fragmented Chinese dental market that could be worth 300 billion annually yuan by 2025
By Molly Wen
The healthcare investment field is filled with colorful terms like “golden eyes,” “silver teeth” and “copper bones.” Such metallic expressions speak to how lucrative and promising private medical practice can be in areas like ophthalmology, dentistry and orthopedics.
Quite a few Chinese ophthalmological companies have gone public, showing there really is gold in eyecare. By comparison, dentistry has yet to attract the same kind of nods from investors. Arrail Group Ltd., one of the country’s top three private oral health care providers, is eager to change that, even as a costly Valuation Adjustment Mechanism (VAM) agreement hangs over its balance sheet.
Following a failed listing attempt last year, the company filed for an IPO a second time in Hong Kong early this year and passed the listing 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, orthodontic and dental implant services. Its namesake Arrail chain caters to deep-pocketed wealthy patients, while its Rytime brand is targeted at the middle-end of the market. During the six-months ended September 2021, the two brands contributed 430 million yuan ($68 million) and 410 million yuan in revenue to the company, respectively.
Dental diseases are common in China, even though few had the money to spend on proper dental care before the 21st century. Such care has become increasingly available and affordable in the last 20 years, but the penetration rate in China in 2020 was only 24%, much lower than the 70% in the U.S. That shows demand is not only growing, but there is also big potential not only for basic services like treatment of dental diseases, but also for elective services like teeth whitening.
According to the market data in Arrail’s prospectus, China’s dental health market stands to grow at a steady clip in the next few years from 119.9 billion yuan in 2020 to roughly 300 billion yuan in 2025.
As one of China’s few dental health companies with a national footprint, Arrail has become a private equity favorite. Big names like Goldman Sachs, Qiming Venture and Hillhouse Capital have all hopped on board since 2010. The company’s latest funding round in April last year was led by Singaporean sovereign wealth fund Temasek, raising close to $200 million and valuing the company at $980 million – just shy of the $1 billion mark for “unicorn” status.
Weak gross margins
Arrail may focus on high-spending customers, but it has yet to translate that to fat profits. In fact, the company vastly underperforms compared with its peers in gross margin terms. A report from Sealand Securities last year showed industry gross margins averaged around 40% to 50%. But Arrail’s were far behind that, coming in at just 15.2%, 10.1% and 24.1% in its fiscal years for 2019-2021, respectively.
The lackluster performance has everything to do with the company’s staggeringly high personnel costs. Over the same three years, its spending on employee-related costs totaled 460 million yuan, 500 million yuan and 580 million yuan, representing an average compound growth rate of 12.3%. Such spending has consistently accounted for more than half of the company’s total costs.
Curbing personnel costs doesn’t come easy for private companies like Arrail due to the short supply of dentists in China. In 2020, the nation had just 175 dentists for every 1 million Chinese, compared to 810 in Europe and 608 in the U.S. Arrail also admitted in its prospectus that it would have to compete with public and private dental health providers by offering better packages to attract the best talent.
Its financial performance also looks less-than-dazzling. Its revenues rose from 1.08 billion yuan to 1.1 billion yuan and 1.52 billion yuan in its three most recent fiscal years from 2019 to 2021, respectively. It logged operating losses of 84.04 million yuan and 133 million yuan in 2019 and 2020, before moving into the black with an operating profit of 124 million yuan in its most recent fiscal year.
The company has attributed the losses to business expansion and the suspension of operations during the pandemic, when many medical facilities were closed and people especially avoided dental clinics over 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 comes slowly to dental operators like Arrail, one thing working in its favor is the market’s high degree of fragmentation. China’s top five private dental operators only accounted for 8.5% of the market in 2020. Another factor in its favor is relatively low equipment costs. Unlike ophthalmological services that are highly dependent on expensive equipment, material costs for dental operations are low and clinics easily set up after securing necessary licenses.
Sealand Securities pointed out that most dental treatment services are generally considered safe and don’t require assistance from other medical departments. It added that using a franchise model in the sector also doesn’t bring much advantage in terms of capital needs, cost controls and standardized management.
Pressed by IPO deadline?
Arrail may also be looking to list now under pressure from its investors. According to the prospectus, the company’s debt was greater than its assets at one point during the reporting period covered in the IPO document. It registered net liquid liabilities of up to 4.26 billion yuan in 2021, which the company ascribed to earlier VAM deals it entered into with investors.
Under those terms, if the company failed to go public before the end of 2020, investors had the right to request redemption of their shares. That meant liabilities for its fiscal year 2021 included 3.2 billion yuan of preferred shares. The redemption date for those shares was ultimately extended to Dec. 31, 2023. When Arrail is successfully listed, those preferred shares will be converted into ordinary shares.
The effects of that agreement caused Arrail’s loss attributable to shareholders to reach 600 million yuan in its fiscal year 2021. We can calculate its valuation using a price-to-sales (P/S) ratio, referencing two listed dental groups with business close to Arrail. That pair, Angelalign (6699.HK) and Shanghai-listed TC Medical (600763.SH), both have P/S ratios of 24 times. Using that as a reference, Arrail’s valuation could reach as high as HK$44.8 billion, or about $5.74 billion, based on its revenue of 1.52 billion yuan in its most recent fiscal year.
However, TC Medical is a hot stock in China’s A-share market, with its market value exceeded 100 billion yuan in the past. Its gross profit margin in the first half of 2021 was also as high as 46.75%, twice that of Arrail. If Arrail wants to replicate TC Medical’s success in the capital market, it will need to operate more officially to pump some gleam into its valuation.
