May 28, 2010 - 5:28pm EST by
2010 2011
Price: 14.92 EPS $0.41 $0.50
Shares Out. (in M): 78 P/E 36.4x 29.8x
Market Cap (in $M): 1,162 P/FCF - -
Net Debt (in $M): -205 EBIT 43 59
TEV ($): 957 TEV/EBIT 18.7x 13.6x
Borrow Cost: NA

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 Investment Summary:

I am recommending a short position in Align Technologies (ALGN). Note that jared890 previously wrote up ALGN as a short.

Align designs and manufacturers one product, a clear aligner, and that product is highly discretionary and expensive. Although Align currently has a near-monopoly on the clear aligner market, the company is facing increased competition from several similar products that are priced at a 25-50%+ discount to Align's core product, while the company's North American market is already significantly penetrated. Trading at 30x 2010E P/E, the company's stock is priced for significant growth. Competition and the size of remaining market opportunity are likely to make that level of growth extremely challenging to achieve.

The Business and History:

Align Technology designs and manufactures the Invisalign system, a method for treating malocclusion, or the misalignment of teeth. Invisalign corrects malocclusion using a series of clear retainers that straighten teeth. Because it does not rely on the use of metal or ceramic brackets and wires, Invisalign reduces the aesthetic and other limitations associated with braces. The Invisalign system is regulated by the U.S. FDA as a Class II medical device. The company distributes its products through orthodontists and general practitioner dentists (GPs). The Invisalign system is sold in U.S., Canada, Europe, Asia-Pacific, Latin America, and Japan.

Align was founded in 1997 by two business school students, Zia Chishti and Kelsey Wirth, neither of whom had any dental background. They designed and patented the Invisalign system, and, following an internal dispute, both left the company. Zia then founded a new company, Orthoclear, that essentially made the exact same product but offered it to doctors at a lower price. In 2006, Align paid Orthoclear $20mm to shut down after losing ~20% market share in less than one year. As part of the agreement, Align had to take on all Orthoclear cases at no additional cost, which was an incremental $10-13mm. So, all-in, Align paid ~$30-33mm to get rid of Orthoclear. Align also settled patent litigation in August 2009 with Ormco, a competitor which specializes in wired orthodontic solutions, that resulted in Align paying Ormco's parent, Danaher, $100mm. A California District Court found that Align had infringed on 6 of Ormco's patents, and Ormco filed a motion for an injunction that would prevent Align from selling its Invisalign system until the related patents expired in January 2010.

Invisalign's primary advantage relative to braces is its appearance. The aligners are transparent and therefore more difficult to detect than traditional braces. This makes the method particularly popular among adults who want to straighten their teeth without the look of traditional metal braces, which are commonly worn by children and adolescents. In addition, the aligners are marketed as being more comfortable than braces. Due to the removable nature of the device, food can be consumed without the encumbrance of metallic braces. However, traditional braces are usually ~$1,000 less expensive than Invisalign.

Investment Thesis:

Align is facing increased competition from large and small competitors with similar but less expensive products, operates in a largely penetrated North American market and is unlikely to grow rapidly despite its high valuation.

Competition to Invisalign is increasing. The orthodontic industry has a number of competing products including traditional braces, clear braces (now available with a clear wire as well), braces on the inside of teeth (invisible) and other clear aligners. Other aligners are largely less sophisticated but one, Clear Correct, is reasonably comparable and Dentsply (a sophisticated $5bn company) has recently announced a new clear aligner product as well. Clear Correct announced several months ago that it is expanding its manufacturing capacity by 600% (it is currently a small start-up company doing $3-4mm in revenue). Clear Correct offers aligners for $999 while Invisalign's price is ~$1500 (to doctors). Clear Correct offers up to 32 trays, and the company claims that it can treat all of the same types of malocclusion that Invisalign can.

Dentsply's GAC division several weeks ago announced its new MTM (Minor Tooth Movement) product, which will likely be released in the next couple months (FDA approval pending). Dentsply recently marketed the new product at national and state orthodontist conventions with the marketing message "just like Invisalign, but cheaper." The MTM product is an up to ~10 tray system that will be able to treat most Class I cases of malocclusion and will perhaps be able to treat as much as 50% of Invisalign's cases. It is worth noting here that while the MTM product most directly competes with Invisalign Express (a 10-tray system), there is good reason to believe the MTM product will take share from Invisalign's core product (Invisalign Full) because a) Invisalign plays a game with its promotions such that doctors are incentivized to put cases that are perhaps more appropriate for Express in Full, b) MTM is less than 50% of the cost of Invisalign Full ($699 vs. $1,500) and c) doctors will likely use MTM with braces as a combination product - and with the price differential this combo makes much more sense with MTM vs. Invisalign Full.

One key benefit of Invisalign to doctors is the reduction in chair-time and ease of use: a doctor can take an impression and let a computer do the work. There are now computer-aided design (CAD) technologies that make braces/brackets treatment easier for doctors to plan and administer. Cadent and Orametrix (SureSmile) both have this technology, and it has not largely penetrated the dental community as it is quite new.

Even excluding the forthcoming competition, there is not a "huge untapped market opportunity" that management claims in investor presentations. Invisalign (and clear aligners generally) can only be used in mild to moderate cases of malocclusion. In the U.S., approximately 2.1mm people elect treatment by orthodontists, 1.2mm have mild to moderate malocclusion, and ~300K of those individuals have mature dentition (adults and teens). There are some instances when Invisalign can be used in younger teens (see new Teen product described below), but Invisalign's target market is this ~300K cases annually. Invisalign is currently at a run-rate of 200K North American cases/year, or 67% penetration of the entire U.S. market by number of cases. Separately, there are approximately 9,000 orthodontists in North America, and Align has trained 9,010 orthodontists since its founding in 1997 - so it has essentially fully penetrated the market by number of orthodontists. But analysts and the market seem to buy into huge long-term growth for the company. The truth is massive growth hasn't been there for the company for years. North American 2005-2009 revenue CAGR has only been 6%. 2006 was a tough year because of Orthoclear's impact, and then the company saw outsized growth in 2007 as many doctors came back to Align after Orthoclear shutdown. Note that Invisalign is now later in the adoption cycle than it was in the 2005-2009 period.

While the company's international growth has been quite strong, it is not overly concerning. International revenues grew 33% in 2008 and 16% in 2009 revenue growth, but the segment only represents ~23% of total revenue. There is no reason that I can tell (and management agrees) why this would take off all of sudden. International markets currently include Europe, Asia Pacific, Latin America and Japan. Management has a slide in their corporate presentation on potential China growth, which notes revenue might be meaningful in 3-5 years.

As a sign that continued growth has become an issue, last year Align implemented a new "Proficiency Program." The program required that doctors perform a minimum of 10 cases/year in order to maintain their Invisalign certification. If a doctor failed to perform 10 cases, he or she would be required to pay for the introductory training classes again. By management's own admission, this was an effort to keep orthodontists and dentists "in the game." This new policy created an uproar within the dental community. As an example, the California Dental Association stated that it would drop its sponsorship of Invisalign unless Align withdrew its Proficiency policy or proved that performing over 10 cases/year had a material effect on the quality of care. According to a key representative of the California Dental Association, "I would almost bet my career that Align will not be able to prove that performing 10 versus 5 cases improves the quality of care." The company experienced a boost in sales from some doctors trying to satisfy the new policy, but that sales booster is likely coming to a screeching halt since the company pulled a 180 and scrapped its proficiency program in April 2010. While I'll give the management team credit for finally coming around and eliminating this program, doctors had such a visceral reaction to it that, based on several conversations and other diligence, I believe a meaningful number of doctors were so enraged by the policy (they hated the idea of having their hand forced) that they're more likely to continue to look to other providers for an aligner product. While management continues to deny that Densply's entry into the aligner market with its MTM product had anything to do with their decision to eliminate the proficiency program, it seems very likely to me that it was a factor.

One risk that I have focused on is the potential for mass adoption of Invisalign amongst teenagers, and after numerous conversations with doctors and an analysis of recent trends I believe this risk is contained. The company introduced a product, Invisalign Teen, in 2008 that is aimed at younger teens who have traditionally used braces. While this product does serve a previously underserved portion of the market, adoption is not going gangbusters. In 4Q09 vs. 3Q09, cases were +4%, lower than the sequential increase in Invisalign Full, which was +7%. In 1Q10 vs. 4Q09, cases were DOWN 10% while the sequential increase in Invisalign Full was +5%. Note that Teen is also growing off of a very small base. A number of doctors have said that they have been offering Teen to adults (because of the 4-6 free aligners, price promotions and better functionality - largely better root movement with 'Power Ridges'), so there is reason to believe the Teen growth since the product's inception isn't even as good as the company's numbers. As of the end of 2008, Align estimated that 10-15% of Invisalign Full cases were being done on teens. Ten to fifteen percent of total Invisalign cases at the end of 2008 equates to 20-30K cases/yr. At end of 2009, the Teen product was at a run rate of 25K cases/yr. So the adoption amongst teens has not been robust since the new Teen product was introduced.

One key factor that is simply inescapable is that clear aligners are removable and, thus, require the patient to be compliant and wear the aligner 23hrs+ per day. Teenagers often can not be trusted to be compliant. Invisalign tried to get around this hurdle with compliance indicators, but doctors will tell you that while that is a step in the right direction, the treatment still runs a huge risk. If a teenager is non-compliant and keeps having to fall back to a previous stage aligner, his or her teeth will be moving back and forth. This can result in significant problems with a teenager's bite. Essentially, it's OK to move teeth in one direction, but when they start moving back and forth, back and forth, that can cause serious problems. For this reason, a number of doctors have told me they would never put their own children in the Teen product.

It's worth noting that several members of management have been selling stock recently, including the CEO who sold $4.3mm in February (albeit around $18/share).

In sum, ALGN stock is currently trading at 30x 2010E P/E, which I believe is materially overvalued given the company's competitive position and likely growth. Management is guiding to 10-20% long-term revenue growth, yet the company has not grown at such robust rates in years. Align's North American 2005-2009 revenue CAGR was only 6%. Align had a tough year in 2006 because of the Orthoclear impact, and the company saw outsized growth in 2007 as many doctors came back to Align after Orthoclear shutdown. That was the company's last material surge in growth. Given the high valuation, lack of robust growth prospects and increasing competitive pressures, I believe ALGN is an attractive short opportunity.


- Lower growth through the rest of 2010 as a result of the termination of the Proficiency Program
- Impact on growth and margins from Dentsply's MTM product which will be launched in 1-2 months
- Continued impact of other competitors including Clear Correct
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