Align Technology, Inc. (ALGN) Q3 2012 Earnings Report, Transcript and Summary

Welcome to the Align Technology Q3 2012 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, Shirley Stacy of Align Technology. Ms. Stacy, you may begin.

Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate and Investor Communications. Joining me today is Tom Prescott, President and CEO; and Ken Arola, Vice President and CFO. We issued preliminary third quarter financial results press release today on Marketwire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 12 months. A telephone replay will be available today by approximately 5.30 pm Eastern Time through 5.30 pm Eastern Time on October 25. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 400990 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information that the presenters discuss today will include forward-looking statements, including without limitation statements about Align's future product, product outlook and the expected financial results for the fourth quarter of fiscal year 2012. These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly. These and other results are set forth in more detail in our Form 10-K for the fiscal year ended December 31, 2011. These forward-looking statements reflect beliefs, estimates and predictions as of today and Align expressly assumes no obligation to update any such forward-looking statements. Please also note that on this conference call we will provide listeners with several financial metrics determined on a non-GAAP basis for comparisons to previous quarters. Most of these items, together with the corresponding GAAP numbers and the reconciliations to the comparable GAAP financial measures, where practical, are contained in today's financial results press release, which we have posted on our website at investor.aligntech.com under financial releases, and have been furnished to the SEC on Form 8-K. We encourage listeners to review these items. In addition the possibility of an impairment charge which could result in a substantial reduction against goodwill and a commensurate charge against earnings could have a material adverse impact on the company’s preliminary results. We have posted a set of GAAP and non-GAAP historical financial statements, including the corresponding reconciliations and our third quarter conference call slides on our website at investor.aligntech.com under quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Techology’s President and CEO, Tom Prescott. Tom?

Thanks Shirley. Good afternoon everyone. On the call today, I’ll provide an overview of preliminary third quarter results and discuss the performance of our two operating segments Invisalign clear aligners and scanner and CAD/CAM services. As Shirley discussed these results are preliminary based on the outcomes of our goodwill impairment analysis which is currently incomplete. Ken will cover these circumstances and a discussion of our preliminary Q3 financial results as well as outlook for Q4 in more detail. I’ll come back with a few closing comment and open up the call to questions. Q3 revenue of 136.5 million increased 8.4% year-over-year and yet decreased 6.3% sequentially. Despite a strong summer season for Invisalign teenager cases, which increased 21% sequentially and year-over-year, our third quarter revenue was slightly lower than our outlook. Q3 is historically a slower period for North American GP dentists who have fewer days in office due to vacations as well as for International doctors who typically take extended summer holidays, especially in southern Europe. This year summer seasonality was more pronounced in North America and as a result, we did not see the expected ramp in Invisalign cases for GPs and Orthodontists. This softness has continued through October and is reflected in our Q4 guidance, which despite that slowdown, still projects a healthy annual growth rate for the company overall, with volume growth of at least 16%. We’re taking a complete look at our results, including demand for our products and analyzing the industry and the markets in which we operate. We are evaluating a lot of data, much of which is conflicting, and none of which supports a fundamental decrease in demand for Invisalign. On the one hand, data such as the surprisingly strong, recent consumer sentiment ratings, as well as the uptick in visitors to…

Thanks Tom. Before we get in the preliminary results for the quarter, I will begin by discussing the status of our goodwill impairment testing. The discontinuation of Align’s distribution relationship with Straumann in Europe and North America and the decline in results of operations of the Company’s Scanner and CAD/CAM Services reporting unit triggered the risk that the goodwill associated with the acquisition of Cadent might be impaired. As a result, we are currently conducting a step one test as of September 30, 2012, to assess whether goodwill, which had a carrying value of $135.3 million as of September 30, 2012, is impaired. We expect to complete the step one impairment test prior to filing our Form 10-Q for the third quarter of 2012. If the results of our step one analysis indicates an impairment, we will conduct a step two evaluation to determine the amount of the non-cash impairment charge, if any. If step two cannot be completed prior to filing our Form 10-Q for the third quarter, we may estimate a range of potential impairment and may record an estimated non-cash charge in the third quarter of 2012. Any difference between an estimate and the final step two evaluation would be recorded in the fourth quarter 2012. Any difference between an estimate and the final step to evaluation will be recorded in the fourth quarter of 2012. Before I move on to the third quarter financial results, I like to remind everybody that there are several items we exclude from a GAAP results when we report non-GAAP results. These include acquisition and integration related cost, amortization of intangible assets, and severance and benefits cost for the New Jersey consolidations. In my comments today, I will not review the total dollars excluded for non-GAAP gross margin, operating expenses and…

Thanks Ken. In summary, the team here at Align is as excited about the future as I have ever seen them and it's easier for me to understand why. That’s over thousand enthusiastic customer participating in a large commercialization pilot, if you are hearing the SmartTrack is the biggest innovation in Invisalign technology ever and when combined with the G3 and G4 steps which perceive them enables treatment of far more complex cases with greater patient comfort. We are in the process of bringing our APAC distribution back in-house, gaining greater confidence and our ability to drive the business in our fastest growing geographies in the world. Where we staging growth in Europe even in regions like the UK where austerity programs and slow-to-zero growth at the norm. We continue to do well with our scanner business in North America where our direct sales model is successfully leveraging our Invisalign resources. In China, we continue to see strong Invisalign growth and remain bullish on its long-term potential. And around the world, we continue to gain share in the important teenager market. We are not satisfied with recent quarter or Q4 guidance. We yet know they describe the business growing volume over 16% annually with huge head remaining for expansion. We intend to continue on with good execution of our important strategic initiatives and have the confidence we will deliver great results for our customers and their patients, our shareholders and our committed employees. I look forward to seeing you at trade shows and investor events over the next few months as well as reporting back to you with our progress in the quarter. And with that let’s get right to the Q&A.

(Operator Instructions) Our first question comes from the line of Matt Dolan with Roth Capital Partners. Please proceed with your question.

First, I just wanted to dig into what you are seeing on the growth side of the equation first, I think if we look back to I think few years ago you struggled out of the summer and there was some execution issues then, I think you may have referred to here again. Normally you guys have a lot of visibility into the upcoming quarter, so what can you tell us on a go forward basis about either stability or I think you said in your prepared remarks there is renewed interest in Q4 despite what sounds like has been a pretty slow September and October?

Well the first thing I will refer back to is the kind of this dichotomy that is existed between the channels checks, we and others have done and they are still showing strong consumer interest yet not necessarily translating into Invisalign case starts. What I say, we have seen some renewed activity now into October a bit and we believe that will start to generate. The second thing I think if you are referring back to couple of years ago, we do expect Europe to contribute more towards growth in Q4 where we did not have that outlook say in Q4 of two years ago. So, again we think the business is healthy, we wish we had all the answers, I think there is probably few maybe broader secular trends going on in dentistry that others have called out, but what we are going to try to do is just make sure that the activity in the offices turns into case starts and that’s what we are focused on.

So, I guess maybe just to clarify, I think you guys did say that you felt like there is a renewed interest in Q4 even though October was slow. Again is this something maybe did the promotions that came early in Q2 pulled some revenue that you otherwise would have thought you had into earlier in the year. What gives you that thought that things are picking up later this quarter.

We are sitting here on the 17th and as we are managing actively, we are hearing a lot of activity in the offices, patients are coming back in the offices and I will contrast that with two year ago when we still did not have what seem like positive activity even when we went to our call in October. And that in fact did not pick up until late in mid to late November or early December. So, we see the signs f good activity. Doctors are reporting, calendars are filling up again and there are a lot of good signs. We will watch that closely, that is reflected in our view going forward.

And then the second topic, I wanted to make sure we touched on was on the earning guidance side of the equation. Obviously revenues are expected to be flat, it looks like really the measure difference quarter-to-quarter here into Q4 is the gross margin. I know you mentioned freight cost, but that it seems like international has been relatively flat or even down as a percentage of sales. So, why the 200 basis point hit their which is big part of the delta between the two periods.

Freight, as we ship more and more products internationally the cost of get the product over there with the volume that we are looking at on a historical basis and the growth on the international business we are expecting that to grow nicely again this year. And given where we are, we are expecting our freight cost to be up on a sequential basis over Q3. If you think about Q3, volumes were down in Europe as is typically are. So, when you go in sequential basis Q3 to Q4 you have a greater impact of freight for those international shipments. Also with the shipments that are growing faster in the Asia-Pac region again that picked up additional freight cost to get product over to Asia-Pac as appose to Europe.

Our next question comes from the line of Glen Santangelo with Credit Suisse. Please proceed with your question.

Tom. I just had one to talk to you about the weakness in the case shipment growth this quarter. Now if you look at kind of where the weakness was, it seems like North American GPs was clearly the worst segment down the most sequentially we actually had positive growth in on the North American orthodontic community and international did somewhere in the middle. Is there something to be said here about the trend that the general practitioner in 3Q that you think can reverse itself in 4Q or do you feel like just give us some feedback on what your sales guys are telling you about what they are seeing in the market?

Let me break that into two pieces, first about maybe what happened and second about how we see it going forward. First in terms of what we saw playing out in Q3 and I think you chronicled this pretty well. I think in the GP there was a softness, there was a slowdown, there has been reports of especially in the higher value procedures area on both LA, New York, some of the higher value procedures like full mouth restorations (inaudible) that really slowing down significantly. So, in general with GP practices even our higher volume customers which of all the groups really slowed down the most. They tend to react more to patient traffic coming in and kind of people asking for procedures rather than initiating those conversation. So, when patients are more passive or when traffic goes down, they tend to pull back and don't compensate by initiating more they literally just pull back a bit more. So, it's a different reaction, for the Ortho the specialist they are used to dealing with referral whether it came from own efforts or from a GP that they work with and they are used to jump in on those points of interest whether it's a first call or a patient coming in is really seriously considering.

Tom I appreciate all of that detail and we haven’t had the chance to work on our model but just kind of looking at the guidance that you have given for 4Q, it kind of assumes that you are looking at maybe flattish case shipment growth. So, just want to be clear on what you are saying because it sounds like October started off kind of sluggish but yet in your answer to my question you just sort of said you starting to see a little bit of a pickup in activity and so in terms of case shipment growth what are you building into expectations on a sequential basis in Q4?

As Ken described well, the softness that we saw for September and into October that’s the basis of our October shipments, what shipping to patients and customers right now. And when that soft or obviously October shipments therefore revenues are little softer. We have seen in year's where Q4 can finish very strongly, the first thing that has to happen is activity in office (inaudible). It recently is stronger than it was in September as we reported and so I think there is what we can’t get to September volume, that anchors October shipments for all practical purposes, but we do see building on that as we leave October with growing receipts in November and December.

Our next question comes from the line of Brandon Couillard with Jefferies & Company. Please proceed with your question. Brandon Couillard - Jefferies & Company: Tom to what degree to you think coming back on the market with Ortho products may have had an impact in the third quarter in terms of the case volumes?

We actually as we look at that pretty hard we have done some survey work from a variety of sources and our data show that we are still nicely taking share from all categories of brackets, traditional, etcetera and that’s in teen and adult. So, we think if [GSE] products going back on which is a good thing, they are an important part of this industry and that was a tough deal for them. But that’s probably coming out of the height of somebody else in the bracket and wire side does not appear to be a factor for us. Brandon Couillard - Jefferies & Company: Have you finalized your plans in terms of how you expect to handle the U.S. medical device excise tax that goes into effect next year, and to what degree do you think you will be able to pass that onto incremental pricing or expense reductions if at all.

I’d say like every other medical device company we are working our tails off to both prepared systems and capabilities to be able to do this, even though there is no rule making in place yet at [TRF]. So, I think the simple fact is we are working on all our options and I’d say that that’s still process in place and we will talk about it much more fully when we do guidance and our view of how we are going to handle all this time next quarter. Brandon Couillard - Jefferies & Company: Any chance you can give us the inventory balance at the end of the third quarter and then what CapEx was in the third quarter and then it looks like a much bigger number in terms of CapEx for the fourth quarter that I’d have anticipated given some of the facility relocations etcetera, winding down now here. Just where do we stand on two fronts.

Inventories at the end of September were basically $15 million of which about 13 million or so of that was related to the scanner business that we have been building up some inventory here in preparation for a move in Israel which we actually just completed. So, as far as your other question on CapEx, in quarter four we have about guidance was about 12 million or so of CapEx, and that has to do with some additional equivalent or buying to put down in the facility in Juarez to handle increased capacity over time here as well as some of the outfitting of some facilities cost and stuff like that improvement point of view. As far as CapEx this quarter, we spent I think there was about $6 million or so CapEx in Q3. And again that was mostly related to manufacturing equipment.

Our next question comes from the line of Steve Beuchaw with Morgan Stanley. Please proceed with your question.

Tom, given what we are looking at now for the fourth quarter revenue, looking like it's into the single digits on an organic basis growth. Can you just walk us through the steps that get you back to the 15 to 25% growth that you are looking for over the longer term? Your confidence is clearly not shaken here, so just walk us through the macro new features any sort of recover drivers in the business that you think you can quantify to get us to 25.

I will reinforce that I don’t feel we’re recovery mode. Certainly and that’s satisfied with our results in Q3 or the guidance we have given in Q4 the profile has been running with, but we are not in recover mode at all. The drivers as we said before this business won’t be perfect and it won’t be perfectly linear and we have demonstrated both of those here. So, the reality is we have adoption grows, core utilization grows among say orthodontist in a non-linear way. When we bring out new technologies that the earliest adopters that highest volume user the most technique sense of users who get a chance to get after it and then they start trying those new features on more and more kinds of cases. So, we can now really precisely deliver force systems and do it in a way that’s better for the patients and doc. So, we expect over the next couple of years we expect that to reinforce core adoption and I’ll remind you we have given even as where we are which we have done pretty well. We are still a very small player in unit and unit share and we have tons of head room in virtually every orthodontic indication. So, our goal is looking at a graph on our wall is making sure we grow penetration.

And then just one big picture. The business it seems like year-on-year was down a couple of million on a basis on 11.5 so down 1.5. I think the expectations are just to be a real growth market but the environment is evolving pretty quickly, you have the three maybe five new competitors on the market next year, but of course you have an advantage position being one of the bigger players in the market. Is that a business that you can get to grow double-digits next year or other extreme is something like what we have seen in this quarter and with the expectations for price to come down effectively next quarter is that more of an appropriate way to think about it. Is this more of a driver for the aligner business. Can you help us parse out the different pieces there?

Two things, first of all we believe an have reinforced that this is a very strategic part of very early evolution, major evolution in the dental industry and being able to be at chair side, capture digital data, to be able to bring a wider set of applications to the dentist or the specialist is a very big deal and with few exceptions, for 27 years and they built a significant install base and can sell into that with upgrades. There are very few companies today that I say standalone on a scanner base have got big business. We have got one of the biggest install bases out there but we still think we are getting started. Overtime we believe this on its own merits can be a very successful business and return to growth. I mean it is pretty lumpy right now given uncertainty and all of those things, and even more so in Europe. But we believe that the kind of growth rates to identify data and other third parties are there to be had but we have taken a longer term view of this business. The second part of that is you asked about Invisalign, I’m not going to quote the numbers here but we continue to see a substantial amount of our incoming cases now done by scans, at the meaningful number and growing very nicely every single quarter. I’d just say friction goes down for everybody involved, the patient, the doctor in a practice and Align in so many ways is faster, better, cheaper, easier, more precise. Aligner seem to fit better, the whole cycle of case to shipment is faster, and that’s the trend it's continuing. The second thing is the doctors that use, take all the Orthos that have put scanners in, there is a meaningful number of increased cases, they are doing more than every other cohort around them, whether they were of small low volume and medium volume or a high volume Ortho. On average they are doing a significantly greater number of cases on a quarterly or annual basis and that’s just again from reducing (inaudible). We are in the early stages of it, but there is a lot of positive signs and we are in this for the long-term.

Our next question comes from the line of Jeremy Feffer with Cantor Fitzgerald. Please proceed with your question.

I just wanted to come back to pricing very quickly. This is once again we saw average revenue per case down. I know lot of its tied to promotional activities, volume rebates. Where does this trend go as we look into next year? Obviously the promotions with this quarter, (inaudible) obviously done a great job in driving volume growth. Is there a point where you are worried about slowing down the promotional activities and seeing a slowdown in volume growth or how do you think about overall pricing going into the next year or so.

I’d just start out by saying pricing has been very stable for us over the past number of years. We haven’t changed prices for a number of year's now on our products and we have chosen to do is at various points in time pointed promotions. So, over the long-term we think it's a good opportunity to be a growth driver in the business. We are run our advantage program for the doctors on the consistent basis on a year-over-year, we see doctors continuing to move up overtime in the number of cases that they are doing. Some quarters they move faster than other, this last quarter the biggest impact ASPs from a promotional point of view is certainly the teams of various promotion on a sequential basis and the other piece that you didn’t mention was really the foreign exchange rates that they moved pretty quickly from Q2 to Q3. Our view is that we will continue to look at promotions at appropriate times in the year for the business on the Invisalign as well as the iTero side of the business for example the 4,000 off promotion running in quarter four that will stimulate more placements of scanners in the marketplace.

And on the competitive side, are you guys seeing any pickup inactivity from any of the newer entrance in the clear aligner space?

No, not really, I mean we watched this very, very carefully and I think if there is a little, so we are more than holding share for the other small players that are out there in clear aligner and Ortho. In GP, we may have had a little leakage we think call it that against Clear Correct we think, frankly Q1 and Q2 especially among lower volume GPs. And we think most of that was price driven maybe through group on and stuff like that. But we don't see any kind of longer term trends and we have not seen a kind of traction among consistent users from any other player. We see trial from time to time and then based with the features they don't have and can’t get and the capability that other players don't have the trend to revert back to Invisalign. So, that’s been the pattern where obviously trying to find the balance being confident and paranoid.

Our next question comes from the line of John Kreger with William Blair. Please proceed with your question.

Tom, we can just think about the growth that you have seen in recent months from a little bit different perspective. We certainly compare that it's been a tough environment in dental but, I think we also would have said that was probably the case a year ago or few quarters ago. So, if you think about what do you think is really going on from a broader perspective? Do you think there is less orthodontic starts going on across the market or maybe less uptick by orthodontist as the excitement on G3 and G4 as perhaps faded a bit. What is the bigger picture on market share?

So, first of all we had a very strong first half and we had a very strong Q1, and carried a lot of that into Q2 with AOO and all of that. So, I don't know if it was more patient driven or practice driven, I don't know and we struggled to find primary data in this area that’s useful. So, what we are left with is the data we can get from third parties our own several times a quarter bottoms up and top down views our own qualitative and quantitative research with groups of customers and it's a pretty mixed bag, but for whatever set of reasons in the summer the late summer and into September, it was just like the offices were less engaged and there was less traffic.

So, just a quick follow-up from our perspective G3 and G4 were very well received in the market. As you think about SmartTrack since this is new to us what do you think the significant is the SmartTrack relative to G3 and G4 more or less impactful?

We have our own views and we always have a set of metrics, we applied to any new major project innovation, product innovation and we track whether quarter-over-quarter, year-over-year how we are doing against whether it's case complexity we are measuring, getting more class two cases whether we are looking at that sort of adoptions within certain practices. So, we haven’t started those things, setup and we will see how it does, but one of the very clear points of feedback since May, for example when we did the earlier pilots the doctors that we are treating patients said I don't want to go back to old material please let me keep this. And then some of them were involved in the commercialization pilot in May.

And then one last one, if you think about the guidance you have given us for Q4, does that guidance assume a better lift in volumes in the second half of the quarter late October into November and December. Are you assuming more of a steady state with what you are seeing so far early days in the quarter?

John, we actually don't really comment on inter-quarter trend that we are looking that so what we are trying to point out in the call is that we saw the softness in September and into early October here, but on the contrary we are seeing activity in doctors office that’s still being pretty active, our sales force again is still active with the doctor based in, so our view is that as Tom said with activity picking up to help us as we go forward here.

Thank you every one for joining us today. Well this concludes our conference call. We look forward to seeing you at coming financial conferences in industry meetings. If you have any questions please contact Investor Relations. Thanks and have a great day.

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.