SmileDirectClub, Inc.
Q2 2020 Earnings Call Transcript

Published: 13 Aug 2020

[Operator:]

Greetings, and welcome to SmileDirectClub Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation [Operator instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Alison Sternberg, Vice President, Investor Relations. Thank you. You may begin.

[Alison Sternberg:]

Thank you, operator. 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 will make on this call are based on assumptions and beliefs as of today. I refer you to our Q2 2020 earnings 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 Web site. We also refer you to 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 Katzman:]

Thanks, Allison. Good afternoon, and thank you for joining us today. During a very complex time, I'm pleased to report that Q2 results exceeded expectations and demonstrate continued progress across the business. Our performance in Q2 and more importantly since the quarter reflects the strength of our teledentistry platform, along with the flexibility and agility of our business model, both in the context of our COVID-19 recovery efforts and our traction towards our long term growth and margin target. As stated in our prior earnings call, we have always first and foremost been a telehealth business and we are excited to see the growing level of understanding and acceptance of telehealth, especially for dentistry. We're seeing increased consumer and clinical adoption of the telehealth model and we've continued to invest in our proprietary platform to innovate against unmet consumer needs. As Kyle will discuss in further detail, we were especially pleased to see such robust demand from new leads during a period of significantly reduced market expense. This is an important reinforcement of the brand equity we have built, not only with our existing customers but also with all consumers thinking about straightening their teeth. This is due to our unwavering commitment to continue to optimize and improve the customer experience, which is the cornerstone of our business and our north star. For today, I'd like to first call out some of the notable highlights from the quarter, followed by a summary of how we are tracking against our growth and cost initiatives. I’ll then touch on the regulatory environment before turning over to Kyle to walk through our financial results and current trends in more detail. Now turning to the results within the quarter. In Q2, we shipped roughly 57,000 unique aligner orders at an ASP of $1,817; achieved $107 million in total revenue; saw continued strong performance in our SmilePay program with delinquency rates and first pass credit card authorization rates remaining consistent with past history; generated negative $20 million of adjusted EBITDA for the quarter, a sequential improvement of 70%. I'd also like to highlight that marketing and selling expenses came in at $35 million or 32% of net revenue in the quarter compared to 72% net revenue in Q1 of 2020 and 72% of net revenue in Q4 of 2019. As we noted on our Q1 call, this trend reflects the several years we've spent investing in the customer experience and brand building, alongside our continued focus on highly efficient acquisition channel. This also reinforces the strength and importance of our omni channel approach, which provides the ability to drive more demand through a fixed infrastructure over time. Lastly, this demonstrates what we have stated previously, our small shops do not drive demand but rather act as fulfillment centers. Demand is driven through our Web site and enabled by our teledentistry platform. It is important to point out that even with this reduced spend, roughly 60% of club members who purchased aligners in Q2 were first time leads, which is close to where we have been historically. Now turning the progress against our growth drivers. In addition to our core business, we saw great momentum in the quarter across the three growth drivers we have previously discussed. As a reminder, they are expanding our customer acquisition channels, expanding our presence and the team demographic, and continuing our international expansion. On the first initiative, expansion of our acquisition channels, club members, historically were driven to our Web site through aided awareness, referrals and marketing but they would either book an appointment at a SmileShop or request the doctor prescribed impression kit. As we think about expanding our acquisition channels, we are focusing on accommodating new customer on ramps to our clear aligner therapy through the professional channel, corporate partnerships and retail and we have made great progress across all three since the first quarter. I will spend a bit more time on the professional channel, but first let me briefly touch on corporate partnerships and retail. On corporate partnerships, we recently partnered with Allianz, one of the most trusted and reputable leading insurance providers in the world. The insurance program launches this month in Germany and allows German customers to instantly obtain insurance coverage for SDC aligner therapy right at the point of purchasing their aligners. This solution will replace SDC SmilePay option in countries where the program is available. All customers are accepted into the program with a monthly payment option similar to our current monthly SmilePay program tied to Allianz’s dental insurance plan. This new association with Allianz is great for bringing credibility to our brand and increasing our cash flow. On another note Q2, we expanded our insurance network in the U.S. with Anthem Blue Cross Blue Shield and Empire Blue Cross Blue Shield insurance programs, joining United, Aetna and others that cover our customers with in network orthodontia coverage. On the retail side, our oral care products, which debuted at Walmart in January of 2020, led category growth in several areas at Walmart. These products not only provide consumer accessed premium oral care products in an affordable price point but also raise brand awareness of our platform and increase the life time value of our existing club members. In addition to Walmart, these products are now available in over 3,000 CVS locations nationwide, and we expect more retail partners in the near future, both domestically and internationally. Now turning to the professional channel. In January of this year, we announced our intent to enter the professional channel, enabling consumers to start the journey in a dental office. Our new partnership with Smile Brands with 450 dental offices across 18 states, represents a key step in our continued efforts to partner with GP and ortho practices, and gives consumers another option to start their SDC journey. This acquisition channel is complementary to our current offering as dentists across the country want the ability to offer SDC clear aligner therapy to the patients, and the segment of consumers who want to start their journey in-person at a dentist office. Given this, we are testing into several go to market strategies with Smile Brands that we will also make available to more DSOs and dental offices over time. First, we're opening Smile shops inside dental offices, taking over several operatories and each practice with our own Smile guys and shop managers. This is similar to our Smile shop inside CVS or Walgreen. Everything will be heavily branded SDC. This will enable us to accommodate leads to schedule appointments through our Web site for those that might want to see a dentist in person, and drive additional new patient opportunities to our DSO partners while also giving us access to the dental practice’s existing patients. Second, for existing patients of a dental practice seeking clear aligner therapy, the initial scan or impression will be conducted by the dental office. The practice will then upload the data through our portal and the rest of the member journey will occur as it does today with one of our hundreds of affiliated dentists orthodontists in our teledentistry platform, reviewing that information and being fully responsible for all aspects of that member’s care throughout treatment. This will allow us to capture existing dental practice leads as another acquisition channel, while not taking up valuable share time for the dentist and provide club members with the ability to let their own dentists start their journey. Third, we're enabling SDC leads either need or prefer an in-person doctor visit rather than doing an impression at home to go through the initial assessment at a partner dental office. Similar to the second approach, the practice will then upload the data to our portal and the rest of the member journey will occur as it does today. This provides another option for consumers to start their journey inside of a dental office, while providing additional new patient opportunities to our DSO partners. And lastly, in DMAs where we did not have a Smile shop, we will be hosting pop up events similar to our SmileBus events at the dental practices. This enables us to increase conversion in kit only DMAs and provides the dental practice the opportunity to convert new potential patients to their dental home. We can drive hundreds of new potential patients to our partner dental practices each week. In a COVID and post-COVID environment, this is a very compelling new revenue source for our general partner. All of these go to market strategies provide meaningful value to the dental practices by increasing practice revenue with minimal chair time, and providing the opportunity for a new dental home for SDC club members. Our partnership with Smile Brands is only the beginning of our professional channel expansion. We look forward to continuing to partner with other DSOs and dental and orthodontic offices, both domestically and abroad in the weeks and months to come. Our second growth driver is expanding our value proposition across all age demographics with a new focus on teens who represent approximately 10% of our business today, yet 75% of total industry case start. We recently launched SmileDirectClub Teen designed just for teens. This new product offers a more affordable and accessible alternative to metal braces, giving teens and parents the convenience of our telehealth platform with 24/7 access to dental professionals, while still priced up to 60% less than traditional orthodontic products. The third growth driver, international expansion, continues to progress well. As we've alluded to before, approximately 35% of our market opportunity is outside of the U.S. and we continue to focus on expanding our international footprint. Within the quarter, we announced our expansion into Singapore and Austria. Entrance into these markets will further extend our international footprint following our successful launches in the UK, Ireland, Australia, New Zealand and Hong Kong in 2019 and Canada in 2018. Elsewhere in Europe, we have reopened shops in Germany and plan to launch into new locations in Europe, Latin America and Asia Pacific throughout the rest of the year and into next year. We also announced the partnership with Watsons in Asia, introducing our Smile shop concept to the leading health and beauty retailer’s location in Hong Kong. With over 78,00 stores in 13 Asian and European markets, Watsons is Asia's leading health and beauty retailer. They will also begin to carry our oral care products on shelf in their stores. As you can see, we've made great progress on our growth initiatives since the first quarter and we will continue to update you in the future quarters as we execute against them. Turning to progress on the cost side of the business. You'll recall that we've been focused across three key areas to rightsize our cost structure and we continue to make progress against those initiatives. These efforts were designed to keep us on track for adjusted EBITDA profitability in the fourth quarter of 2020. These efforts include the following. Continued advancement in automating our manufacturing and treatment planning operations to allow us to reduce our scrap and keep pace with consumer demand. Our second generation automation production platform is on track to be producing aligners by Q4 of this year. Second, continued discipline around the deployment of marketing and selling dollars, including the focus on pushing more demand through our existing Smile shop network and leveraging our referrals and aided awareness as demonstrated in the second quarter. In Q2, we saw and continue to see great performance against our long term sales and marketing targets as a percentage of revenue and we expect this trend to continue. And last, continued cost discipline across the business. As we've stated before, we believe streamlining our cost profile through operational efficiencies will not only improve our margin profile but more importantly, will provide up a consistently superior customer experience that meets our demand expectations. This in turn will drive customer satisfaction scores higher, which will increase referrals and thereby reduce our acquisition cost by creating a higher percentage of organic lead. It truly is a flywheel effect, which is why our member satisfaction is our true north star. Turning to the regulatory environment. As we noted in our last earnings call, we are well positioned in our continued efforts to protect the access to care that consumers want and deserve. We continue to see more states passing teledentistry friendly laws and refusing to pass laws that put barriers to access to care. In addition, we continue to see growth in the adoption and use of teledentistry by the dental and orthodontic industries. COVID-19 has made our lawmakers and the medical communities, including the dental and orthodontic communities, acutely aware of the need for telehealth and teledentistry to be proactively permitted. In summary, the foundational work we have done to position the company to execute against the global opportunity is continuing to pay off. In the second quarter, we achieved strong results driven by the strength of our teledentistry platform along with the flexibility and agility of our business model. All the competitive moats that we often speak of, our complete end-to-end vertical integration with our med-tech platform, omni channel approach, capitive financing program and our strong brand equity with consumers, continue to showcase their collective strength in this most recent quarter. On growth, we're making great progress against our initiatives, including broadening our customer acquisition channels, expanding our share of the key market and continuing our international expansion. On cost, we’ll remain on track to achieve adjusted EBITDA profitability by Q4 of this year, which is enabled by our manufacturing automation initiatives. Our sales and marketing leverage is demonstrating Q2 and our continued cost discipline across the business. Lastly, with greater acceptance and adoption of teledentistry, we are uniquely positioned to continue gaining market share. We remain laser focused on our mission to democratize access to a smile each and every person loves, and making it affordable and convenient for everyone. Our most recent quarter keeps us well on our way to achieving that mission. None of this would be possible without the support of our team members, club members and investors. And we thank all of you for your support as we work to capture this massively underserved market. And now I'll turn the call over to Kyle who will provide a detailed overview of our Q2 results and our financial outlook. Kyle?

[Kyle Wailes:]

Thank you, David. As David mentioned, we're pleased with our accomplishments over the course of the quarter and since the quarter ended, notwithstanding the continued fluidity and challenges of the overall operating environment. Similar to the first quarter, the flexibility of our business model served us well in Q2. As David alluded to earlier, in Q2, we made great progress against our growth initiatives and remain on track to achieve our adjusted EBITDA profitability target, both of which continue us on our path to our long term revenue, growth and margin targets. Turning to our results for the quarter. Revenue for the quarter was $107 million, which represents a decrease of 45% over the second quarter of 2019. This decrease was primarily driven by 53% year-over-year decrease in aligner shipments, which came in at 57,136. As discussed in our Q1 call, we shipped 10,500 orders in April and averaged approximately 23,000 shipments between May and June, very close to the 22,000 run rate that we discussed on our Q1 call. If demand over the past 30 days hold steady, in Q3, we expect to ship between 83,000 and 87,000 aligner orders. Again, this is our prediction based on demand over the past 30 days and assumes no material changes in the current COVID operating environment. ASP came in at $1,817, which increased by approximately 3% year-over-year and is getting a slight benefit from deferred revenue over lower initial case starts. As we previously discussed, I would expect this to be closer to $1,770 for the remainder of the year. One additional note on revenue. In Q2, we saw our cancellations increase from 5.3% to 6.5% of gross aligner revenue. Given this, we are increasing our go forward cancellation reserve by 1.2% to 6.5% and have reserved that number in the second quarter. We do not believe this increase will be permanent. However, we want to be conservative given the uncertainty of our operating environment. Now turning the SmilePay. In Q2 2020, 67% of our members elected to purchase using SmilePay, which is flat to Q2 2019. This percentage was also held steady since Q2. Overall, SmilePay has continued to perform well and our delinquency rate in Q2 and since Q2 were flat to prior quarters. Because we keep the credit card on file and have a low monthly payment, we expect SmilePay to continue to perform well. Our success rate on credit card attempts, which is a proxy for monthly payments assume no degradation. Further, since that same time, we've seen only 2% of customers requesting a payment deferral, which is up from 1% as of our last earnings call. Turning to expenses and margins. Gross margin for the quarter was 54%. Sequentially, gross margin was down by approximately 1,500 basis points. This decline is largely attributable to the following areas. First, we had a decrease in unique aligner orders shipped quarter-over-quarter, while mid course correction and refinement shipments were equal to the average of the prior four quarters. As a reminder, MCC and refinement shipments are based off of demand from four to six months ago when volume was higher. What this implies is that we needed team members, direct materials and fixed assets to ship out MCC and refinement aligners without the associated revenue, because there is no revenue associated with an MCC or refinement. We've had approximately an 800 basis point impact on gross margin in Q2. Second, we had a higher percentage of impression kits compared to previous quarters. Normalizing for impression kit increases, gross margin would have been 700 basis points higher. Lastly, retail represented the higher percentage of gross margin given the lower initial shipments, which had a 200 basis point impact on gross margin. We expect gross margin to trend back to historical levels as normalized volumes return. And we do not expect any change to the long-term gross margin target of 85% that we have previously provided. Additionally, as we have previously cited, we continue to focus on streamlining our manufacture facilities. And as David indicated earlier, will remain on track for the rollout of second generation automation machines by Q4 of this year. Completing this rollout is a key component of our adjusted EBITDA positive goal in Q4. Marketing and selling expenses came in at $35 million or 32% of net revenue in the quarter compared to 72% of net revenue in Q1. Sequentially, marketing and selling as a percentage of revenue declined by approximately 55%. As discussed in our Q1 call, we started to see improvement in sales and marketing as a percentage of revenue in February and we are pleased to see this trend continue in Q2. This affirms our belief in the cycle resistant nature of our business model, and demonstrates the leverage in sales and marketing spend that we have discussed historically. Importantly, and as David highlighted earlier, even with this reduced spend, approximately 60% of club members who purchased aligners in Q2 were new leads. This is close to where we have been historically, but achieved after reduced sales and marketing spend and reflects the sustainability of lower sales and marketing spend to support our revenue growth going forward. Lastly, it is important to point out that we have also seen strong performance in sales and marketing since the quarter. However, I would not expect the remainder of 2020 to be comparable to the second quarter in terms of sales and marketing as a percentage of net revenue. But we do expect to perform well against the long-term targets that we have previously provided as we start to track closer to them in the quarters to come. General and administrative expenses were $69 million in Q2 compared to $91 million in Q1 2020. G&A expenses were down $22 million sequentially. To give more insight into the savings we observed over the course of the quarter, G&A expenses in April were down 12% from March, down 7% in May and down another 10% in June. Year-to-date, our monthly G&A expense has declined to an average of 7% per month since December. We plan to continue to stay vigilant with cost control throughout the remainder of the year and beyond, and you can expect to see continued leverage from this line item. In Q2, we had a onetime non-cash charge of $25 million associated with lease abandon impairment of long lived assets. This non-cash charge was mostly associated with the closure of our manufacturing facility in Kyle, Texas and the consolidation of several floors at our headquarters in Nashville, Tennessee, along with the impairment of right of use assets and leasehold improvements at SmileShops that we closed in the quarter. Given the uncertainty of our operating environment and the shift to work from home, we made the strategic decision to align our rent costs with the current needs of the business. We’re also ensuring we have sufficient capacity to support future growth. Additionally, in Q2, we had $4 million in other store closure expenses, mostly associated with short term lease termination fees and other store closure expenses. Other expenses include interest of $10 million, tax benefit of $1.4 million, loss on extinguishment of debt of $13.8 million associated with the refinancing of our JPM debt facility and other gains of $1.8 million, which is mostly associated with currency gains and losses. All of the above produces a Q2 net loss of $95 million compared to $107 million net loss in Q1 2020. Of this $95 million net loss in Q2, $43 million is associated with one time charges as noted above. Moving to the balance sheet. We ended the second quarter with $389 million in cash and cash equivalents. Cash from operations for the second quarter was negative $15 million, which represents 78% improvement in our cash burn rate quarter over quarter. Cash spent on investment for the second quarter was $20 million, mainly associated with leasehold improvements, capitalized software and building our manufacturing automation. Cash spent on investing decreased $8 million quarter over quarter. Free cash flow for the second quarter, defined as cash from operations plus cash from investing was negative $35 million, which represents 64% improvement in our cash burn rate quarter over quarter. In closing, as David mentioned, our performance in the second quarter reflects strength of our teledentistry platform, along with the flexibility and agility of our business model. That was in the context of our COVID-19 recovery efforts and our traction towards our long-term growth and margin targets. The unprecedented events of COVID-19 provided a number of learnings about our business, and have enabled us to emerge from this crisis even more well positioned in the global clear aligner market. Although, we won't be providing full year 2020 guidance until we better understand consumer behaviors in the months ahead, I would like to reiterate a few key highlights. We've been encouraged by the level of recent demand at very efficient levels of sales and marketing spend. As stated previously, in Q3, assuming no changes in the COVID environment, we expect to ship between 83,000 and 87,000 initial aligner orders, which is consistent with demand over the past 30 days. On cost of goods sold, we're making good progress on manufacturing automation and achieving our goal by the fourth quarter of 2020. As we stated last quarter, we believe streamlining our cost profile through operational efficiencies will not only improve our margin profile but more importantly, will provide a consistently superior customer experience that meets our demand and expectations. On sales and marketing, you’ll recall that our SmileShops function primarily as fulfillment centers, not as sources of demand generation. Accordingly, in the second quarter, we're able to very quickly pivot to an impression kit only business and continue to serve new and existing club members with minimal disruption. This reinforces the importance of a differentiated omni channel approach with kits in SmileShops, and positions us well for a future where virtual healthcare will be ever more important and prevalent. Since Q2, we've had a controlled approach to reopening our SmileShops, and we expect that to continue for many months. Today, we have 71 shops open in 57 cities across eight countries. The flexibility of our SmileShop model provides us the opportunity to rebuild a much leaner SmileShop network compared to pre-COVID, thereby, enhancing the margin profile of our business. As stated previously, we're still tracking to be adjusted EBITDA positive by Q4 of this year. On liquidity, we're well positioned with almost $400 million of cash on our balance sheet. This gives us ample liquidity to manage through a protracted COVID environment or alternatively to spend faster in a higher growth environment. Lastly, I would like to reemphasize that our long term objectives have not changed. We remain laser focused on providing the best club member experience, and our mantra remains to drive controlled and profitable growth. We remain the low cost provider with brand presence and no pricing pressure and an increasingly favorable climate for telehealth. As we've said in previous quarters and as recently demonstrated, we will continue to make strategic investments in the professional channel, international growth and in penetrating new demographics to drive controlled growth, while also executing against their profitability goals. We look forward to continuing to update you on progress on days and weeks to come. Thank you everyone for joining today. And with that, I'll turn the call back over to the operator for Q&A.

[Operator:]

Thank you, we will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Alex Nowak with Craig-Hallum Capital Group. Please proceed with your questions.

[Alex Nowak:]

Great. Good afternoon, everyone. Based on what you're seeing so far in July and August. Would you expect gross margins to be in a similar range here as Q3? And perhaps just provide some more color on the MCC and the refinement aligner shipments, and what can ultimately be done to limit the amount of correction shipments needed on a go forward basis?

[Kyle Wailes:]

Yeah. Happy to -- this is Kyle. So, David, why don’t I take that one and you can jump in as well. So to answer the first questions looking at Q3 gross margin. I would say if you look at our volumes that we've guided to between 83,000 and 87,000 for the quarter that's really at the midpoint of Q1 and Q2. And so when you look at the volume based on that in addition to MCCs and refinements as a percentage of total aligner shipped trending back in line with historical norms, we would expect Q3 likely to be in the low to mid 60s. And as we return to normal volume, trending back towards that low to mid 70s but ultimately, no change to the longer term targets that we put out there historically.

[Operator:]

Thank you. Our next question comes from the line of Michael Ryskin with Bank of America. Please proceed with your questions.

[Michael Ryskin:]

Thanks. I want to -- just going to keep it to one, but I want to ask about sort of the 3Q outlook and some of the -- some of what happened during the quarter. If we just sort of back to where you were in the late May and June, you were kind of talking about 40,000 to low 40s in terms of shipments for 2Q. So clearly, some real improvement towards the end there. And then if you kind of take that and prorate it to 3Q, doesn't seem like you're really expecting that much of a pickup. So could you give us an indication of how it kind of evolved over the May and June timeline? What you've seen since then? Is there -- you're commenting on how consistent was the recent demand. Are you seeing any continued pick up and acceleration from there or is it still sort of working through some of the softness in the channel?

[David Katzman:]

Yeah, so, what we talked about on the Q1 call. So we shipped 10,500 orders in April. We averaged approximately 23,000 shipments between May and June. And so that's very close to the 22,000 run rates in terms of demand that we talked about on the Q1 call. Now it is better than our expected shipment target off of that 22,000. So we were able to perform better than expectation on shipments but came in line slightly better with expectations and what we had talked about on our first quarter call. You know, I think just given the uncertainty of the overall operating environment, what we're really saying is if we look at the past 30 days and assume that our demands hold steady as a result of that, we'd expect to be between 83,000 and 87,000 aligner orders or aligner shipments within Q3 and that's on average about 28,500 per month.

[Operator:]

Thank you. Our next question comes from the line of Robbie Marcus with JP Morgan. Please proceed with your questions.

[Robbie Marcus:]

Thanks. Not to beat a dead horse here, but maybe I could follow up on the last question. What did you see year-over-year for aligner shipments in June? What did you see in July? And what's that assuming in August and September? Are you seeing any impact from some of these flare ups? And if you could just break out in second quarter and what you expect in third quarter within those numbers, and how that splits up in U.S. and outside the U.S.? Thanks.

[David Katzman:]

So in terms of U.S. versus outside the U.S., that's not something that we're breaking out yet. I would expect in future quarters as it starts to become a bigger piece of the business, we'll start to break that out and report on it separately but we're not there yet. In terms of month to month, I think if you look at the commentary that we provided, we're talking about averages between May and June. So we averaged 23,000 between those two months. There's lots of puts and takes on a month to month basis but I don't think it's really indicative of overall demand trending from May into June, it's really better to look at what happened over the average of those prior two months. Obviously, if you look at July in particular, that's really based off of what we've provided, which is that 28,500 on average, which is pretty close to what we've seen over the past 30 days and representative of July. As we sit here today and we look at the expectation off of that, there's obviously a lot of uncertainty just given the overall operating environment. And so, we're looking at the past 30 days and extrapolating that forward. And based on that, we're expecting to be in that 83,000 to 87,000 reach. So hopefully that's helpful.

[Operator:]

Thank you. Our next question comes from the line of Jon Block with Stifel. Please proceed with your question.

[Jon Block:]

I'll ask one maybe in two part. I guess the first is, Kyle, just the goal of EBITDA positive by the fourth quarter. What the implied gross margin in that assumption? I mean, quite honestly, if you were in the 70s this quarter, you would have been pretty darn close in 2Q. So maybe you can just be more specific, EBITDA positive by 4Q assumed what from a GM perspective? And then, David, just -- I think I want to get the international number, maybe just talk through the international business. What markets have been the most promising? How do you see the international contribution going forward? And maybe as a byproduct of that, when should we expect international to surpass 10% of sales. Thanks, guys.

[Kyle Wailes:]

Yeah, sounds good, David, you want to take the international part first and then I can add some commentary on, on gross margin?

[David Katzman:]

Sure. Jon, as we open up these countries whether it's Asia or Continental Europe, we're pretty much seeing pent up demand like saw in the U.S. when we started six years ago. The consumers are aware of the product. They're looking for convenience and cost savings. So when we open up, there's this pent up demand and we come out of the gate pretty strong. We saw that in Singapore where our shop was booked up, we opened a second shop. Germany, we opened late as COVID started and we had to shutdown so we just reopened there. We're opening up two more shops. We opened up in Berlin. We're opening up in Frankfurt and Munich next. So we expect the same thing. Now look, we overinvest in these countries to make sure we get some awareness. So sales and marketing costs are a little bit high. But overall, within 12 months we expect these countries to be contributing profitability to EBITDA. So there is an investment aspect and then they should be contributing to profitability. As far as reporting, Kyle, can handle that. But I assume it's probably going to be either Q4 or Q1 of next year. Is that right, Kyle, breaking it out?

[Kyle Wailes:]

Yeah, I think, that's the current expectation. Obviously, that could change. But as we sit here today, that's what we're expecting. And then on the first part of the question around sort of gross margin. Here's what I'd say broadly Jon around profitability. So our focus really hasn't changed. We're still focused on controlled and profitable growth. As we said last quarter, we could be profitable off of our revenue today. But our objective is to really balance the overall near term growth with profitability at the same time. And that's the balance of being a growth company like SDC. And so, as you look at profitability in Q4, I think as we demonstrated in the second quarter, there's lots of levers to that, right? Even with a lower gross margin. As you saw in the second quarter, sales and marketing was very efficient. We're getting great leverage out of G&A. And so, as I said, if you look at our volumes that we talked about for the third quarter, I would expect the gross margin in the low to mid 50s based on that, as volumes return to more normalized levels beyond that. And I would expect those margins to trend back to where it's been historically, which has been in the low to mid 70s. And as we demonstrated, there's lots of levers outside of that to achieve that profitability in the fourth quarter with sales and marketing as one and G&A as another, as we talked about and demonstrated in the second quarter.

[Operator:]

Thank you. Our next question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question.

[Nathan Rich:]

I wanted to ask you on the professional channel strategy. Could you maybe lay out like how many practices that you guys have partnered with or in so far across the different kind of opportunities that you laid out? And then looking at Smile Brands partnership, can you talk about that model and what the economics of that look like from your standpoint?

[David Katzman:]

Sure, I can take that one, Nathan. So when we announced this in January that we're getting into what we call the wholesale channel or professional channel, we were gathering interest, getting inbound calls, primarily from single office GPs, a few conversations with DSOs. But of the four go to market strategies that I talked about today, we only really had one and that was having a GP office start to brand SmileDirectClub within the office, let their existing customer base know that they can sell the product for the same price, offer the same SmilePay financing option. And all we ask them to do was take a scan or impression kit, we will handle the rest. So that -- and that's been going strong, but we've now put a team together. We announced Chris Thompson as our VP. He’s got real strong industry experience. He's built out the team. And this announcement that we made with Smile Brands is we’ve now added the three other legs to the store here. And so what's happening is we're now going to take our SmileShop, just like we have in CVS and Walgreens and we're going to put them inside, not every single office, they have 450 locations, but in key large demographic areas. So we'll operate out of two or three of their operatories they call them, where we'll have our team members, our small guys and shop managers Customers will still come through the Web site, the smiledirectclub and it'll have really three ways to decide to transact. Now that can buy an impression kit and start from home, they go to one of our SmileShops independent of a GP office, or if they want to see a GP or start their journey off at a GP office, they can they can go to one of our partner location. So we're very excited about that. And the other one that we talked about was these pop-up shops that are similar to a SmileBus. We have not done any of those as well. These are usually in smaller demographic markets, where it's just not large enough to have a full time shop. So we will rotate around to different dental offices within our network. We'll have three and five day events. The whole thing for this and why I think the DSOs partners are excited about this is that we can drive -- besides the fact that there's fees associated with it for doing the work of scanning or taking the impression, but we're driving new customers into these dental offices, which they're not used to seeing. The average GP office grows at single digits a year. And in this environment with COVID, it could be even less. We can fill these shops up to the tune of hundreds of patients every week. And what we're going to try to do is for our club numbers, even though they obviously have some relationship with a GP somewhere out there, but introduce them to a Smile Brands’ office. And hopefully, the service that they'll get from our Smile guys and from the people at the dental office, both convert and make that their new dental home. So very exciting for the DSO partners to be able to get that level of new customer acquisition opportunities. And for us, it’s credibility factor. We often hear that customers want to interact with the dental professional, not necessarily on our total industry platform but more in a brick and mortar setting. That's fine. It's out there now if they choose to do that. So I think in the inbound response that we’ve seen from this with these new opportunities, new go to market strategies, has been tremendous, especially in COVID environment. Most dental offices are down in revenue. They're not doing the same volumes of elective procedures that there were. So that everyone is looking for ways to increase revenue, increase patient count and we think that SmileDirectClub's offering is really tailor made for the GP office. So very excited about getting to work and getting those rolled out. And this has not happened yet to-date so it really starts in the next couple of weeks, all these initiatives that we talked about.

[Operator:]

Thank you. Our next question comes from the line of Courtney Owens with William Blair. Please proceed with your questions.

[Courtney Owens:]

Hi, guys, this is Courtney Owens on for John Kreger. So, one of the key growth drivers that you guys mentioned was with SmileDirectClub Teen offerings. I think you said that that's currently like 10% of shipment volume. I guess my question is kind of where do you guys see that percentage going over the long-term for the business? What are kind of like the puts and takes around increasing penetration in the teen market that you guys see? And then I guess like what investments are you making to be able to kind of service that market more so on like, more so clinically given the tenancy of those cases to be a bit more complex? Thanks.

[David Katzman:]

I think it's around 10% right now and in the future, we hope and we know it'll be higher than that. We have some targets that we're going to be shooting towards come Q4 and into 2021. But it is the largest segment worldwide. It's like Kyle said, 75% of case starts were done in the teen segment and we really focused on the adult segment when we launched over five years ago. We think the time is right now. The credibility of the telehealth platform it’s being -- it’s more widely accepted due to COVID. 24x7 coverage that we have over a brick and mortar office, including video chats with a dental professional. The partnership program that we just talked about with the GP offices. So if a parent wants their teen to start at a brick and mortar office by seeing the dentist initially and then using our telehealth platform, so they don’t have to go every month for office visits in this environment, it's very compelling. And so the timing was right. It was something we have been working towards anyways as we got our feet under us and also our treatment planning improvements that we've been making. We are looking at mixed dentition. We don't have that product today for the younger teen but that's something that we're going to be coming out with. But just overall more -- better treatment planning. Also, our in network insurance coverage that we keep talking about with all these insurance partners. There's a lot -- there's actually more insurance coverage for teen ortho than there is adult ortho, so that's also compelling to parents, our insurance coverage. So all of it circles back to a focus on a very important segment that we're very excited to launch and we’ve seen marketing activities around it, all kinds of reach outs to our GP partners for the teen market. Kyle, you want to add anything there?

[Kyle Wailes:]

No, David, I think you covered it well.

[Operator:]

Thank you. Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question.

[Steve Beuchaw:]

Two -- I apologize, these are kind of mundane questions relative to really good questions that have been coming out so far. But one is on shutting down the Kyle facility. Can you just talk about the thought process there and what in terms you might be getting out of run rate savings? I know it never really scaled up but just want to make sure we consider that in the model. And then two, maybe this is not so mundane. Can you talk about your go to market strategy in terms of the distribution of marketing dollars and how you evolved that over the last few months? One of the things that struck us is in some of the sort of channel work that we've seen, we haven't seen as much SmileDirect activity as we have in some past periods. But the volume certainly ramped back up. So it’d be really interesting to hear about how you're thinking about allocating marketing dollars, how that's evolving? Thank you much.

[Kyle Wailes:]

So look, our focus on Kyle, Texas has always been around redundancy. It's never been about capacity to support demand. And I think just given COVID, we took a step back and really reassessed all aspects of the business and Kyle was associated with that. And with the facility that we have here in Tennessee, we've got sufficient capacity to be able to meet not only current demand but future demand as well. And so as we looked at redundancies, especially given some of the recent natural disasters that have happened here in the Nashville area, we wanted the ability to leverage our existing team members that we have in the time of a disaster. And so we're looking at facilities that are closer to Tennessee where we can leverage that team member footprint in a much leaner way than what we could have done within Kyle, Texas as well. And so that was the decision behind ultimately closing down that facility and looking somewhere else.

[David Katzman:]

Yeah, I can take the marketing. So your question on distribution of marketing dollars, nothing's really changed as far as the actual distribution of those dollars. We're always been a paid digital social player with Facebook, Pinterest, Snapchat search. We also do a lot of advertising with influencers and a big TV component as well. What you've seen though is our total sales and marketing dollars, which got up to about 70% in some past quarters is down to 32% now with a long-term target of 45%. And what's happening here is the investments that we made over the last several years with close to 50% aided awareness is paying off now. So when COVID started back in mid-March and in April, we turned marketing off and we were still doing volumes of business. So that people recognized us as a telehealth platform. I could do it safely from home. I don’t have go in for routine visits. And so that paid off. And I think what we're seeing here is as we continue to advance here that our dollars are stretching further. And so we don't use many shops, people are willing to drive further so we're getting much higher utilization out of those shops. And with our aided awareness, our cost to require the customer has really dropped as well. So we believe that that will continue on in the future.

[Operator:]

Thank you. Our next question comes from the line of Laura Champine with Loop Capital Markets. Please proceed with your question.

[Laura Champine:]

Thanks for taking my question. I'd like to get a better sense of what role the SmileShops are going to play in the future. And so if we look at the quarterly shop count going from, I think 418 to 42, how much of a rebound should we look for in that count and over what timeframe?

[Kyle Wailes:]

So look, what I would say overall. So if you look at where the business is today, we've got 50% to 60% of the business today that's coming from kits and the remainder is coming from scans. If you look at that pre-COVID, that was 85% to 90% that was coming from scans. And if you look at that during COVID, it was over 90% that was coming from kits. And so I think overall what that really demonstrates is, one, of the importance of the omnichannel approach between kits and scans, but to just the overall flexibility of the model at the same time. We've talked about this a lot in the past and we’ve talked about it on the call as well. But just as a reminder, our shops don't drive demand, right? Our demand is coming from aided awareness, from referrals and from marketing. And the shops are really acting as fulfillment centers. So what we've learned, historically, based on the data that we have, is that people are willing to commute. Some people are willing to commute 30 to 45 minutes to get their appointments. There's 75 DMAs around the country that have a population of a million people or more. And we know that those are good targets for us to put a location in. So as we talked about today, we've got 71 locations open, that's across 57 cities in eight countries as well. But the main metrics that we're looking at around the shop right now is what is the incrementality to the profitability that we from DMA. So we look at the profitability where we only had kits in that DMA. We then reassess it as the open up the SmileShop as well. And we're looking at the incrementality associated with that. So if you look at the targets that we put out there, we've always discussed the plan in terms of getting to that 40% to 45% of sales and marketing that’s driving more leverage through our shops. In COVID overall, it's really enabled us to accelerate that. And so we're coming out of it with a much leaner footprint than we had pre-COVID and really driving to that 40% to 45%. So we're not giving a direct number as we sit here today but hopefully that gives some good guiderail as we think about those 75 DMAs and how we look at our -- driving marketing through the balance of the omni channel approach that we take.

[David Katzman:]

Yeah, Kyle. I just want to add one other thing to that too, because this new professional channel partnership that we have is going to help with that as well. We had shops in DMAs that were smaller than the million. We had shops DMAs over 500,000 population and part of that was because customers didn't want to transact and start their journey with a kit. So now the kit is definitely more popular in a COVID environment, people are really doing more e-commerce, they’re staying at home. However, with our partnership in these small rural areas, if someone doesn't want to do a kit, we're going to have a dental office in almost every single market, I don’t know if it’s a 30,000, 50,000 population, and we can send them in there. So we don't have that fixed cost. We don't have all that labor overhead. We're going to pay that dental professional for doing the scan, introduce that customer to their dental home, hopefully, they'll convert them. A lot of these dentists look at a customer lifetime value of almost $5,000. So new faces into the dental home are highly, highly regarded by dental office. So, I think we can supplement where we used to have a lot of shops with our new dental partnership in these smaller markets.

[Operator:]

Thank you. Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question.

[Brandon Couillard:]

Kyle, just quickly. Could you just speak to the uptick in cancellations in the second quarter? Why you think that occurred? And particularly why do you think the [Technical Difficulty] is in fact temporary?

[Kyle Wailes:]

Yeah, absolutely. So we saw the increase, as we talked about, it was about a 1% increase in total. So I would say a small increase overall. I think we thought really in the maturity of recent cohorts coming in, so as we were watching cohorts, cohorts mature over the past several months and just given the uncertainty of COVID, we wanted to increase that to be conservative. I think what gives us confidence is when we look broadly at the focus as a business that we have on Net Promoter Scores, David, talked about that really being our true north star. There's a lot of process improvements that we're making. So I'll give you a great example. We know the satisfaction of a member if we ship their aligners out. In two weeks, there is a lot higher than if they get shipped out in five or six weeks. And there's dozens of different data points like that across the entire funnel that give us confidence and that we'll be able to improve that over time. So we've increased it within the Q2 numbers and we're expecting that in the near future, but the belief still long-term is that we'll be back closer to that 5.3% that you've been at historically.

[Operator:]

Thank you. Our final question comes from the line of Chris Cooley with Stephens Inc. Please proceed with your questions.

[Chris Cooley:]

Just for me, would you speak to how integral you view the expansion into the professional or wholesale channel in terms of your success in penetrating the teen market, and arguably staving off some of the newer competition, which is trying to align with the dentistry channel in office? Just be curious your thoughts there on Smile Brands now but I'm assuming other partnerships will over time? Thank you.

[David Katzman:]

Yeah, I can take that one. Yeah, the professional channel I think enhances the team offering that we have, but it's not reliant, its success is not reliant upon. We believe our teen business has already started to increase where we’ve seen it and it's driven by more credibility, better product, shorter duration, less frequent visits, even if we weren't in the COVID environment, to have to take your teen every month or every couple of months to a dental office is not convenient. There's no question that this enhances it. But parents -- most of the parents, especially ones we're dealing with today, because we never had this professional channel opportunity in front of us, did not require their teen to start with in-person visit to a dentist. So I think it's going to provide lots of opportunities. But even without that, we believe that the teen -- the timing is right, like I said, for us to launch this teen initiative, and it will be successful with or without it.

[Operator:]

Thank you. We have reached the end of our question-and-answer session, and the conclusion of today's call. Thank you all for your participation. You may disconnect your lines at this time, and have a wonderful day.