Description

Align Technology, Inc (NASDAQ: ALGN) designs, manufactures and markets the Invisalign System, a method for treating malocclusion, the misalignment of teeth. The Invisalign system corrects malocclusion through a series of clear, removable appliances that move teeth to a desired final position.

ALGN is a company that produces a single product with a high ASP and is very discretionary. The company has issued heavily back end loaded guidance which implicitly assumes a recovery in the consumer. While not key to our thesis, a new competitor has entered the market with a perfect substitute priced materially below the Invisalign system. We believe that ALGN will have trouble meeting guidance is likely to disappoint street expectations.

This is not the time for highly discretionary consumer purchases. LCA-Vision Inc (NASDAQ: LCAV), which operates laser vision correction centers, is down 91% from its peak on 7/5/2007 and trades at 6.3x forward earnings. Mentor Corp (NYSE: MNT), which makes a broad array of plastic surgery products, is down 45% from its peak on 8/7/2007 and trades at 18.5x forward earnings. ALGN is priced at 25.7x forward P/E, 2x EV / Sales and 13.2x EV / EBITDA. We value ALGN at $8.00, or 24% below current the current price, which we base on a 26x our forward earnings and 1.5x EV/Sales.

The Product

ALGN has a fundamentally good product that addresses the adult malocclusion market. Prior to ALGN, adults with crooked teeth had the option of metal braces or crooked teeth. The system works by a doctor taking an impression of a patient’s teeth and sending that impression to ALGN. ALGN then creates a series of up to 64 “aligners” that are worn for periods of two weeks at a time to slowly correct crooked teeth. The product is particularly appealing to dentists as this allows dentist to capture a revenue stream that hitherto only orthodontists received.

The system had a blended ASP to the dentist of $1,386 per case in 1q08. The retail price for consumers is between $4,500 to $6,000. Importantly, almost no insurance plans cover the Invisalign system leaving the company exposed to the consumers’ appetite and ability to spend their declining disposable income. Sales of the product are primarily advertising driven.

The Bull Case

The sell-side estimates that malocclusion affects 2/3 of the US population and that the addressable market is potentially 1-2% or 1-2 million people per year. In 2007, ALGN shipped 202,880 cases, i.e., the street believes that ALGN can grow significantly from the market penetration the US in addition to growth in international markets.

The Bear Case

This is a big-ticket, discretionary purchase that a consumer makes when he wants to look better. Although ALGN was able to grow revenue in the 2001-2002 downturn, this was primarily through market expansion. Beginning in 2000, ALGN moved from primarily an orthodontist distributed company into the general practitioner dental channel. However, the company missed nearly every estimate thrown its way as utilization rates at doctors declined. The stock declined from $18.06 on 1/29/2001 to a low of $1.30 on 11/13/2002.

Unfortunately, ALGN has largely penetrated the dentist channel in the last 6 years and international revenue (16% of total revenue; mostly Western Europe) is too small to provide the same boost as the GP dentist channel did in 2001-2002 time frame.

A high percent of purchases are financed. Although the company and the street admit they do not have accurate data on the financing, former ALGN sales reps admit that part of their pitch to doctors was that if a patient said the he could not afford the system then to tell the patient to put the purchase on a home equity line of credit (HELOC); banks are slashing HELOCs at unprecended rates do to problems in the housing market. The largest dental lender in the space is GE’s CareCredit subsidiary; GE is drawing back on its consumer lending due to internal problems. According to the latest Senior Loan Officer Opinion survey by the Federal Reserve and almost every newspaper we read, access to consumer credit is being tightened across the board.

Management’s guidance is significantly back end loaded and implicitly relies on a recovery in discretionary consumer spending. Management is expecting FY2008 revenue of between $320 to 330 million, up 13% to 16% year-over-year. However, guidance for FY2q08 is only $78.8 to 81.5 million, up 4% year-over-year. This guidance implies that ALGN will be able to grow revenue by 18% year-over-year in the second half of 2008 despite an increasingly strained consumer.

On top of this, ALGN has guided that it will spend ahead on its advertising in 2q08 in order to secure lower rates before the presidential election advertising and the Olympic advertising begin in earnest. This is why ALGN is guiding for such low EPS in 2q08 of 4-6c v prior street estimates of 12c. We can understand this from a business perspective but we have difficult reconciling this EPS guidance with revenue guidance. Consumer demand is advertising driven. How can ALGN have a large increase in spending with anemic sales growth in 2q08 followed by a large decrease in advertising concomitant with 18% sales growth in 2h08?

From this fact pattern, we believe there is a high probability that ALGN misses sales and earnings estimates in 3q08 and 4q08.

New Competition

ClearCorrect Systems initiated a general launch for its products in late May. Prior to this point, ClearCorrect was only offered through a limited number of dentists. According to the FTN Midwest note from July 10, 2008, ClearCorrect is initially focusing its doctor recruitment efforts in the Southwest US. ClearCorrect is competing on price by offering doctor’s between ¼ to 1/3 off of ALGN prices.

Doctors don’t appear to have a high degree of loyalty to the ALGN system and there are not large switching costs.

• Loyalty: between 2004-2006, ALGN lost market share to Orthoclear, a company founded by a disgruntled former ALGN employee, that competed primarily on price.
• Switching costs: for either ALGN or a competitor, a doctor simply takes a mould of the patient’s teeth and sends that mold to the company to make a series of teeth trays).

Valuation

ALGN has traded well below 1.5 EV/Sales twice in the past:

·         In 2002 when utilization rates dropped due to the 2001-2002 recession.

·         In 2005 when ALGN was competing against Orthoclear for market share.

Given that the consumer headwinds facing ALGN are at least as severe in the 2001-2002 recession and that ALGN is facing a competitor, we feel that ALGN should trade no more than 1.5 EV / Sales. This would imply a share price of no more than $8.10.

The street is willing to pay 26x 2008 the consensus estimate of 40c. Giving the company the benefit of the doubt, ALGN might be able to earn 30c this year. Assuming no multiple contraction whatsoever, this would imply a price of $7.80.

Taking an average of these two methods, we believe that ALGN should be valued at no more than $8.00.

Risks

·         Takeout risk: takeouts in the healthcare sector are historically between 4-7x trailing sales. We view this risk as somewhat mitigated by short life of ALGN’s patents (7-8 years) and the ease with which two competitors – Orthoclear and ClearConncet Systems – have had with engineering perfect substitutes to the Invisalign System.

·         Economic recovery: ALGN may well outperform expectations to the extent that large-ticket, consumer-discretionary purchases recovery.

·         Patents: ALGN successfully leverage its IP in the legal system to

·         International expansion: International revenue constituted 16% of revenue and international revenue grew 32% year-over-year. To the extent that ALGN is successful in penetrating new markets, the company may be successful in offsetting weakness in the US.

Catalysts

·         Earnings disappoint.

·         Success of ClearConnect’s product.

Catalyst