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Align Technology 10-K 2005
Form 10-K for fiscal year ended December 31, 2004
Table of Contents
Index to Financial Statements

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

(Mark One)

  x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

 

OR

 

  ¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                          to                         

 

Commission file number: 0-32259

 

ALIGN TECHNOLOGY, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   94-3267295
(State or other jurisdiction
of incorporation or organization)
 

(I.R.S. Employer

Identification Number)

 

881 Martin Avenue

Santa Clara, California 95050

(Address of principal executive offices, including Zip Code)

 

(408) 470-1000

Registrant’s telephone number, including area code:

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.0001 par value

 

Indicate by check mark whether Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).  Yes  x    No  ¨

 

As of June 30, 2004, the last business day of the Registrant’s most recently completed second fiscal quarter, there were 47,825,000 shares of Registrant’s common stock outstanding, and the aggregate market value of such shares held by non-affiliates of Registrant (based upon the closing sale price of such shares on the NASDAQ National Market on June 30, 2004) was approximately $908,675,000. Shares of Registrant’s common stock held by each executive officer and director and by each entity or person that, to the Registrant’s knowledge, owned 5% or more of Registrant’s outstanding common stock as of June 30, 2004 have been excluded in that such persons may be deemed to be affiliates of the Registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

On February 28, 2005, 61,401,712 shares of Registrant’s common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of Registrant’s definitive Proxy Statement relating to its 2005 Annual Stockholders’ Meeting to be filed pursuant to Regulation 14A within 120 days after the Registrant’s fiscal year end of December 31, 2004 are incorporated by reference into Part III of this Annual Report on Form 10-K.

 



Table of Contents
Index to Financial Statements

ALIGN TECHNOLOGY, INC.

 

FORM 10-K

 

For the Year Ended December 31, 2004

 

TABLE OF CONTENTS

 

          Page

PART I

   3

Item 1.

  

Business

   3
    

Executive Officers of the Registrant

   15

Item 2.

  

Properties

   16

Item 3.

  

Legal Proceedings

   17

Item 4.

  

Submission of Matters to a Vote of Security Holders

   19

PART II

   20

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   20

Item 6.

  

Selected Consolidated Financial Data

   20

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   22
    

Risk Factors

   34

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   44

Item 8.

  

Consolidated Financial Statements and Supplementary Data

   45
    

Report of Management on Internal Control over Financial Reporting

   47
    

Report of Independent Registered Public Accounting Firm

   48

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   73

Item 9A.

  

Controls and Procedures

   73

Item 9B.

  

Other Information

   73

PART III

   73

Item 10.

  

Directors and Executive Officers of the Registrant

   73

Item 11.

  

Executive Compensation

   74

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management

   74

Item 13.

  

Certain Relationships and Related Transactions

   75

Item 14.

  

Principal Accountant Fees and Services

   75

PART IV

   76

Item 15.

  

Exhibits, Financial Statement Schedules

   76

Signatures

   82

Certifications

    


Table of Contents
Index to Financial Statements

PART I

 

In addition to historical information, this annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements include, among other things, statements concerning our expectations regarding the anticipated benefit of increased collaboration between orthodontists and general practitioner dentists on our revenue growth, our expectation that the percentage of revenue generated by general practitioner dentists in fiscal 2005 will represent a larger percentage of our revenue than revenue generated by orthodontists, our expectations regarding further expansion into North American and international markets, including initiating strategic moves in Asia, specifically in Japan, the number of new doctors we anticipate certifying in 2005, our expectation that sales and marketing and research and development expenses will increase in 2005 as well as other statements regarding our future operations, financial condition and prospects and business strategies. These statements may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or other words indicating future results. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the following discussion, and in particular, the risks discussed below under the subheading “Risk Factors” and in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or update these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

 

ITEM 1.    BUSINESS.

 

Our Company

 

Align Technology, Inc. was incorporated in April 1997 under the laws of the state of Delaware. We design, manufacture and market Invisalign, a proprietary method for treating malocclusion, or the misalignment of teeth. Invisalign corrects malocclusion using a series of clear, nearly invisible, removable appliances that gently move teeth to a desired final position. Because it does not rely on the use of metal or ceramic brackets and wires, Invisalign significantly reduces the aesthetic and other limitations associated with braces. Invisalign is appropriate for treating adults and teens with mature dentition. Align Technology received FDA clearance to market Invisalign in 1998.

 

Under the Corporate Information/Investor Relations section of our corporate website which can be accessed at either www.aligntech.com or www.invisalign.com, we make our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, our proxy statement on Form 14A related to our annual stockholders’ meeting and amendments to such reports available as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission. All such filings are available free of charge. The information in, or that can be accessed through, our web site is not part of this report.

 

Industry Background

 

Malocclusion

 

Malocclusion, the misalignment of teeth, is one of the most prevalent clinical dental conditions, affecting over 200 million individuals, or approximately 75% of the U.S. population. Approximately two million people annually elect treatment by orthodontists in the U.S., generating industry revenues of approximately $7 billion. While most individuals seek orthodontic treatment to improve their appearance, malocclusion may also be responsible for dental problems such as tooth decay, tooth loss, gum disease, jaw joint pain and headaches. Because of the compromised aesthetics, discomfort and other drawbacks associated with conventional orthodontic treatments, only a relatively small proportion of people with malocclusion seek traditional treatment.

 

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Traditional Orthodontic Treatment

 

Currently, dental professionals apply traditional techniques and principles of orthodontic treatment developed in the early 20th century. In the U.S., dental professionals treat malocclusion primarily with metal archwires and brackets, commonly referred to as braces. Occasionally, dental professionals attempt to improve treatment aesthetics by using ceramic, tooth-colored brackets or bond brackets on the inside, or lingual surfaces, of the patient’s teeth. Dental professionals also augment braces with elastics, metal bands, headgear and other ancillary devices.

 

The average treatment takes approximately 12 to 24 months to complete and requires several hours of direct dental professional involvement, or chair time. To initiate treatment, a dental professional will diagnose a patient’s condition and create an appropriate treatment plan. In a subsequent visit, the dental professional will bond brackets to the patient’s teeth with cement and attach an archwire to the brackets. Thereafter, by tightening or otherwise adjusting the braces approximately every six weeks, the dental professional is able to exert sufficient force on the patient’s teeth to achieve desired tooth movement. Because of the length of time between visits, the dental professional must tighten the braces to a degree sufficient to achieve sustained tooth movement during the interval. In a final visit, the dental professional removes each bracket and residual cement from the patient’s teeth.

 

Fees for traditional orthodontic treatment typically range between US $3,500 to $7,000 with a median fee of approximately $4,800; generally only a portion of the fees are reimbursed by insurance, if covered at all. In addition, dental professionals commonly charge a premium for lingual or ceramic alternatives. Fees are based on the difficulty of the particular case and on the dental professional’s estimate of chair time, and are generally negotiated in advance. A treatment that exceeds the dental professional’s estimate of chair time generally results in decreased fees per hour of chair time, or reduced profitability for the dental professional.

 

Limitations of Traditional Orthodontic Treatment

 

Although braces are generally effective in correcting a wide range of malocclusions, they are subject to many limitations and disadvantages. Conventional orthodontic treatment is associated with:

 

    Unattractive appearance.    Braces call attention to the patient’s condition and treatment. In addition, braces trap food, which can further compromise appearance. Braces can also result in permanent discoloration of teeth. Many adults associate braces with adolescence. As a result of these and other limitations, less than one percent of American adults with malocclusion elect traditional orthodontic treatment annually.

 

    Oral discomfort.    Braces are sharp and bulky and can abrade and irritate the interior surfaces of the mouth. The tightening or adjustment of braces results in root and gum soreness and discomfort, especially in the few days immediately following an orthodontic visit.

 

    Poor oral hygiene.    Braces compromise oral hygiene by making it more difficult to brush and floss. These problems can result in tooth decay and periodontal damage. Additionally, the bonding of brackets to teeth can cause permanent markings on the teeth.

 

    Inability to project treatment.    Historically, dental professionals have not had a means to model the movement of teeth over a course of treatment. Accordingly, dental professionals must rely on intuition and judgment to plan and project treatment. As a result, they cannot be precise about the direction or distance of expected tooth movement between patient visits. This lack of predictability may result in unwanted tooth movements and can limit the dental professional’s ability to estimate the duration of treatment. Because most orthodontic treatment is performed on a fixed price basis, extended treatment duration reduces profitability for the dental professional.

 

    Physical demands on dental professional.    The manipulation of wires and brackets requires sustained manual dexterity and visual acuity, and may place other physical burdens on the dental professional.

 

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    Root resorption.    The sustained high levels of force associated with conventional treatment can result in root resorption, which is a shortening of tooth roots. This shortening can have substantial adverse periodontal consequences for the patient.

 

    Emergencies.    At times, braces need to be repaired or replaced on an emergency basis. Such emergencies cause significant inconvenience to both the patient and the dental professional.

 

Due to the poor aesthetics, discomfort and other limitations of braces, relatively few people with malocclusion elect traditional orthodontic treatment. Accordingly, we believe there is a large unmet need for an orthodontic system that addresses these patient concerns. We also believe there is an unmet need among dental professionals for a treatment system that increases the predictability and efficiency of treatment and enhances practice profitability.

 

The Align Solution

 

Invisalign is a proprietary system for treating malocclusion. The Invisalign treatment process is comprised of several phases, the principal steps of which are: the creation of electronic treatment plans using ClinCheck and the manufacturing of Aligners. The complete Invisalign treatment process is described in greater detail under “Business—The Invisalign Treatment Process”.

 

ClinCheck.    ClinCheck is an internally developed computer modeling program that allows dental professionals to diagnose and plan treatment for their patients. We use a dental impression and a treatment prescription submitted by a dental professional to develop a customized, three-dimensional treatment plan that simulates appropriate tooth movement in a series of two-week increments. ClinCheck allows the dental professional to view this three-dimensional simulation with a high degree of magnification and from any angle. Accordingly, ClinCheck enables the dental professional to project tooth movement with a level of accuracy not previously possible.

 

Upon review of the ClinCheck simulation, the dental professional may immediately approve the projected treatment, or may provide us with feedback for modification. We reflect any requested adjustments in a modified simulation. Upon the dental professional’s approval of the ClinCheck simulation, we use the data underlying the simulation, in conjunction with stereolithography technology, to manufacture Aligner molds. A third party manufacturer in Mexico uses these molds to fabricate the patient’s Aligners.

 

Aligners.    Aligners are custom-manufactured, thin, clear plastic, removable dental appliances that are manufactured in a series to correspond to each two-week stage of the ClinCheck simulation. Aligners are customized to perform the treatment prescribed for an individual patient by dental professionals using ClinCheck. Each Aligner covers a patient’s teeth and is nearly invisible when worn. Aligners are commonly worn in pairs, over the upper and lower dental arches. Aligners are generally worn for consecutive two-week periods which correspond to the approved ClinCheck treatment simulation. After two weeks of use, the patient replaces them with the next pair in the series. This process is repeated until the final Aligners are used and treatment is complete. Upon completion of the treatment, the dental professional may, at his or her discretion, have the patient use an Invisalign retainer or go directly to a conventional retainer.

 

Benefits of Invisalign

 

We believe that Invisalign provides benefits to dental professionals and patients that have the potential to establish Invisalign as the preferred alternative to conventional braces.

 

Benefits to the dental professional

 

    Ability to visualize treatment and likely outcomes.    ClinCheck enables dental professionals to preview a course of treatment and the likely outcome of treatment in an interactive three-dimensional computer model. ClinCheck allows dental professionals to analyze multiple treatment alternatives before selecting the course of action they feel is most appropriate for the patient.

 

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    Begin using Invisalign with minimal additional training.    The biomechanical principles that underlie Invisalign are consistent with those of traditional orthodontics. Dental professionals can complete our initial training within two days. Subsequently, we provide additional clinical support and we encourage them to attend continuing education classes, seminars and workshops.

 

    Expanded patient base.    Currently, approximately two million people annually elect treatment by orthodontists in the U.S. These patients represent approximately 1 percent of the population of people with malocclusion. Of these, we estimate approximately 40 percent, or approximately 800,000 patients have mature dentition with mild to moderate malocclusion and are therefore potential candidates for Invisalign. We believe that Invisalign will allow dental professionals to attract patients who would not otherwise seek orthodontic treatment.

 

    Decreased dental professional and staff time.    Invisalign eliminates the need for time-intensive processes such as adjusting archwires during the course of treatment and removing the appliances at the conclusion of treatment. As such, use of Invisalign reduces dental professional and staff chair time and can increase practice throughput.

 

    Practice productivity.    We believe that as dental professionals move to a higher volume of Invisalign patients, the dental professionals will be able to better leverage their existing resources, including office space and staff time, resulting in an increase in daily patient appointments and practice productivity.

 

Benefits to the Patient

 

    Excellent aesthetics.    Aligners are nearly invisible when worn, significantly reducing the aesthetic concerns associated with conventional braces.

 

    Comfort.    By replacing the six-week adjustment cycle of traditional braces with two-week stages, Aligners move teeth more gently than conventional braces. Also, Aligners are thin, smooth and low in profile. As a result, Aligners are substantially more comfortable and less abrasive than conventional braces.

 

    Improved oral hygiene.    Patients can remove Aligners for tasks that are difficult with conventional braces, such as eating, brushing and flossing. We believe this feature has the potential to reduce tooth decay and periodontal damage during treatment, which may result from conventional braces.

 

    Potentially reduced overall treatment time.    Aligners control force by distributing it broadly over the exposed surfaces of the teeth. In addition, the ClinCheck simulation from which Aligners are produced is designed to reduce unintended and unnecessary tooth movements. Together, these factors may reduce overall treatment time relative to conventional braces.

 

    Potentially reduced root resorption.    We believe that controlling force and shortening treatment time has the potential to reduce the incidence of root resorption.

 

    Reduced incidence of emergencies.    Typically, a lost or broken Aligner is simply replaced with the next Aligner in the series, minimizing inconvenience to both patient and dental professional.

 

Limitations of Invisalign

 

In some instances, Invisalign may have certain limitations relative to conventional treatment. Aligners cost more to produce than conventional braces, and we charge dental professionals more than they generally pay for the supplies used in conventional treatment. Depending on the individual pricing policies of each dental professional, the cost of Invisalign to the patient may be greater than for conventional braces. Dental professionals must also incorporate our manufacturing cycle times into their overall treatment plan. Once a dental professional submits a case to us, there is generally a turn-around time of a month or more before the corresponding Aligners are delivered. Aligners may not be appropriate for all cases, such as severe malocclusion, which may require Aligners to be used in combination with conventional braces for optimal results. In addition,

 

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because Aligners are removable, treatment using Invisalign depends on patients wearing their Aligners as recommended. Some patients may experience a temporary period of adjustment to wearing Aligners that may mildly affect speech. In some instances, patients have experienced scratched or irritated gums, cheeks and lips and in some rare instances allergic reactions have occurred. We believe that these limitations are generally outweighed by the many benefits of Invisalign to both patients and dental professionals.

 

Our Target Market and Patient Base

 

Medical devices are classified into one of three classes based on the controls necessary to reasonably assure their safety and effectiveness. Class I or II devices require the manufacturer to submit a pre-market notification to the Food and Drug Administration, or the FDA, requesting permission for commercial distribution, which is known as 510(k) clearance. We obtained our 510(k) clearance in September 1998. Our 510(k) clearance allows us to market Invisalign to treat patients with any type of malocclusion with mature dentition. Individuals with mature dentition have fully erupted second molars and substantially completed jaw growth, which typically occurs between the ages of 11 and 15 years. We do not treat children whose teeth and jaws are still developing, as the effectiveness of Invisalign relies on our ability to accurately predict the movement of teeth over the course of treatment. Based on our clinical studies to date, we recommend that dental professionals use Invisalign as a complete treatment for a broad range of malocclusions and as a component of treatment for severe malocclusions.

 

As noted above, approximately two million people annually elect treatment by orthodontists in the U.S. These patients represent approximately one percent of the population of people with malocclusion. Of these, we estimate 40 percent, or more than 800,000 patients, have mature dentition and are therefore potential candidates for Invisalign.

 

Our market research indicates that the vast majority of people with malocclusion who desire treatment do not elect traditional treatment because of its many limitations. We believe that, since Invisalign addresses the primary limitations of braces, persons with malocclusion will be more likely to seek treatment. We believe that adults, who are particularly sensitive to the aesthetic limitations of traditional treatment, represent our most immediate and significant market expansion opportunity.

 

Commercial sales of Invisalign commenced in the U.S. in July 1999. As of December 31, 2004 approximately 250,000 patients worldwide are either currently in, or have completed, treatment using Invisalign. Internationally, we operate through three business units divided among the geographic regions of Europe, Asia-Pacific and Latin America. In 2004, international sales accounted for 9.9% of our net revenues.

 

In each of fiscal 2004, 2003 and 2002, no single customer accounted for 10% or more of our total revenues.

 

Business Strategy

 

Our objective is to establish Invisalign as the standard method for treating orthodontic malocclusion. Key elements of our strategy include the following:

 

Focus on education and customer support.    In order to build long-term relationships with our customers, we focus on delivering superior training, support and services. Each year, we provide numerous clinical education and training programs, which include certification classes, conference calls, seminars and workshops. By participating in these events, we believe that our customers will emerge with a better understanding of the product and its applicability, and with a greater awareness for starting and finishing Invisalign cases. We also maintain an online clinical education center which is intended to augment our training workshops, conference calls and seminars by enabling Invisalign-trained doctors to obtain continuing education credits and access a full range of case studies and best practices.

 

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Educate future orthodontists and general practitioners.    By educating dental students and orthodontic residents on the benefits of the Invisalign technique, we believe they will be more likely to use this technology in their future practices and offer Invisalign as a treatment option. Currently, we have incorporated the Invisalign technique into selected orthodontic and dental undergraduate curriculums. In 2005, we intend to continue the integration of Invisalign into the programs of additional universities and post-graduate institutions.

 

Stimulate demand for Invisalign treatment.    Our market research indicates that the vast majority of people with malocclusion who desire treatment do not elect traditional treatment because of its many limitations. By communicating the benefits of Invisalign to both dental professionals and consumers, we intend to increase the number of patients who seek orthodontic treatment annually. We advertise nationally using a broad marketing mix to drive consumer and dental professional demand and to reinforce the breadth of applicability of Invisalign. In October 2001, we expanded our training of dental professionals in our domestic market to include general practitioner dentists. As of December 31, 2004, we had trained approximately 29,700 dental professionals worldwide on the use and benefits of Invisalign.

 

Improving the collaboration and referral relationships between orthodontists and GPs.    We have two customer channels: the orthodontist and the general practitioner dentist, or GP. We have historically generated a majority of our revenues from orthodontists. There exists, however, a significantly greater number of GPs in North America than orthodontists. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, and possess a unique opportunity to educate these patients and introduce them to Invisalign. GPs also have the ability to refer appropriate cases to orthodontists and, in certain instances, may choose to treat less complex cases themselves. We are committed to improving the collaboration and referral relationships between orthodontists and GPs. We believe that improved collaboration is beneficial to the orthodontist and the GP and will accelerate growth in Invisalign cases and consequently increase our revenues. In addition, although we expect that orthodontists will continue to treat the majority of complex cases and continue to drive research for expanding Invisalign applications, we expect that the percentage of revenue generated by GPs will increase, largely due to the fact that there are significantly more GPs than orthodontists. In 2005, we expect that GPs will generate a majority of our revenue. We believe this expected increase in the number of cases treated by GPs will result in an increase in the overall market for Invisalign as patients that would not have otherwise sought orthodontic treatment are introduced to Invisalign by GPs. Information regarding risks related to our expectation that orthodontists and GPs will collaborate may be found in Part II, Item 7 of this Report on Form 10-K under the heading “Risk Factors.”

 

Expand and enhance manufacturing capability.    Our manufacturing operations are designed to produce large numbers of custom Aligners at a high level of quality. To improve cost efficiency, we conduct labor intensive processes in relatively low-wage countries. We believe that our existing facilities are adequate to meet current requirements and that additional or substitute space will be available as needed to accommodate any expansion of operations. Our proprietary software underlies our manufacturing process. By continually developing this software and other manufacturing processes, we plan to increase the level of production automation. Increased automation will enhance production capacity and reduce both unit costs and production times.

 

Extend and defend technology leadership.    Invisalign represents a significant technological advancement in orthodontics. Our issued U.S. patents broadly cover the Invisalign® system, including digital modeling and manipulation of scanned patient data, treatment planning, and fabrication of dental appliances, among others. We continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws. Information regarding risks associated with failure to protect our proprietary technology and our intellectual property rights may be found in Part II, Item 7 of this Report on Form 10-K under the heading “Risk Factors.”

 

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Expand utilization within clinician practices.    Invisalign can be used to provide complete treatment for patients with mature dentition over a broad range of malocclusions. In addition, we believe that Invisalign can be incorporated into many treatment plans for severe malocclusion, including severe crowding treated either with or without extraction and treatment requiring orthognathic surgery. We initiated new studies in fiscal 2004 with universities worldwide to further explore these treatments as we continue to make additional improvements to our product.

 

Manufacturing

 

We produce highly customized, highly precise, medical quality products in volume. To do so, we have developed a number of proprietary processes and technologies. These technologies include complex software solutions, computed tomography, known as CT scanning, stereolithography and automated Aligner fabrication.

 

We rely on two vendors who are each the sole source of the polymer and resin used in our manufacturing process. In the event that either of these vendors becomes unable for any reason to supply us with their respective products, we would experience a manufacturing disruption while we qualify and obtain an alternate source.

 

As of December 31, 2004, we employed a manufacturing staff in the U.S. and Costa Rica of approximately 539 people. Manufacturing is coordinated in Santa Clara, California. Digital dental modeling is processed in our 63,000 square foot facility in San Jose, Costa Rica. The operations team in Costa Rica creates ClinCheck treatments using simulation software. We outsource the fabrication and packaging of Aligners to a contract manufacturer based in Juarez, Mexico. Information regarding risks associated with our manufacturing process and foreign operations may be found in Part II, Item 7 of this Report on Form 10-K under the heading “Risk Factors.”

 

The Invisalign Treatment Process

 

The Invisalign treatment process comprises the following five stages:

 

Orthodontic diagnosis and transmission of treatment data to us.    In an initial patient visit, the dental professional determines whether Invisalign is an appropriate treatment. The dental professional then prepares a treatment data package which consists of a polyvinyl-siloxane, or PVS, impression of the relevant dental arches, x-rays of the patient’s dentition, photographs of the patient, a bite impression depicting the relationship between the patient’s upper and lower dental arches and an Invisalign treatment planning form, or prescription. The impression is a critical component of Invisalign as it depicts the three-dimensional geometry of the patient’s teeth and hence forms the basis for our computer models. An impression requires the patient to bite into a viscous material. This material hardens, capturing the shape of the patient’s teeth. The prescription is also a critical component of Invisalign, describing the desired positions and movement of the patient’s teeth. The dental professional sends the treatment data to our Santa Clara facility.

 

Preparation of three-dimensional computer models of the patient’s initial malocclusion.    Upon receipt, we use the treatment data to construct digital models of the patient’s dentition. Using CT scanning, we scan the PVS impression to develop a digital, three-dimensional computer model of the patient’s current dentition. We then transmit this initial computer model together with the dental professional’s prescription and supplemental materials electronically to our facilities in Costa Rica.

 

Preparation of computer-simulated treatment and viewing of treatment using ClinCheck.    In Costa Rica we transform this initial digital model into a customized, three-dimensional treatment plan that simulates appropriate tooth movement in a series of two-week increments. This simulation is then reviewed for adherence to prescribed clinical, treatment and quality standards. Upon passing review, the simulation is then made available to the prescribing dental professional via ClinCheck, which is available on our websites located at www.invisalign.com and www.aligntech.com. The dental professional then reviews the ClinCheck simulation

 

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and determines whether to ask us to make adjustments. By reviewing and amending the treatment simulation, the dental professional retains control over the treatment plan and, thus, participates in the customized design of the Aligners. At this point, the dental professional may also invite the patient to review ClinCheck, allowing the patient to see the projected course of treatment. The dental professional then approves the proposed treatment and, in doing so, engages us for the manufacture of corresponding Aligners.

 

Construction of molds corresponding to each step of treatment.    We use the approved ClinCheck simulation to construct a series of molds of the patient’s teeth. Each mold is a replica of the patient’s teeth at each two-week stage of the simulated course of treatment. These molds are fabricated at our Santa Clara, California manufacturing facility using stereolithography that we have adapted for use in orthodontic applications.

 

Manufacture of Aligners and shipment to the dental professional.    From these molds, our contract manufacturer in Mexico fabricates Aligners by pressure-forming polymeric sheets over each mold. The Aligners are then trimmed, polished, cleaned and packaged. Following final inspection, the Aligners are shipped directly to the prescribing dental professional. We ship all of the Aligners in a single batch. In certain cases, dental professionals may use Invisalign in conjunction with clear attachments bonded to the patient’s teeth. These attachments are used to increase the force applied to a tooth or teeth in circumstances where the Aligners alone may have difficulty in effecting the desired movement. In certain cases, we provide an aligner-like template to the dental professionals to aid the placement of bonding attachments to the patient’s teeth. Also, in cases where interproximal reduction, or IPR, is requested by the dental professional, we provide an IPR prescription form, quantifying the amount of space to be created through enamel reduction, location, and timing of IPR.

 

Throughput Management

 

Because we manufacture each case on a build-to-order basis, we do not build inventories. As a result, we must conservatively build manufacturing throughput for anticipated demand. To increase throughput, we must improve the efficiency and increase the scale of our manufacturing processes.

 

In order to increase the efficiency of our manufacturing processes, we focus our efforts on software development and the improvement of rate-limiting processes, or bottlenecks. We continue to upgrade our proprietary, three-dimensional treatment-planning software to enhance computer analysis of treatment data and to reduce time spent on manual and judgmental tasks for each case, thereby increasing the efficiency of our technicians in Costa Rica. We are also continuing the development of automated systems for the fabrication of Aligners conducted in Mexico. In order to scale our manufacturing capacity, we continue to invest in facilities and capital equipment.

 

Quality Assurance

 

Align’s quality system is in compliance with the Food & Drug Administration’s Medical Device regulations, 21CFR Part 820, and Health Canada’s Medical Device Regulations. We are certified to EN ISO 13485:2003, internationally recognized standards for Medical Device manufacturing and ISO 13485:1996, recognized standards of the Council of Canada. Align has a formal, documented quality system by which quality objectives are defined, understood and achieved. Systems, processes and procedures are implemented to ensure high levels of product and service quality. We monitor the effectiveness of the quality system based on internal data and direct customer feedback and strive to continually improve our systems and processes, taking corrective action, as needed.

 

Since we custom manufacture Aligners on a build-to-order basis, we do not offer refunds on our products. Because each ClinCheck and each Aligner is unique, we inspect 100% of the product at various points in the manufacturing process, to ensure that the product meets our customers’ expectations. Aligners are subject to the Invisalign product warranty, which covers defects in materials and workmanship. Our materials and workmanship warranty is in force until the Invisalign case is completed. In the event the Aligners fall within the

 

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scope of the Invisalign product warranty, we will replace the Aligners at our expense. Our warranty is contingent upon proper use of the Aligners for the purposes for which they are intended. If a patient chooses not to wear the Aligners, and as a result, requests additional Invisalign treatment, the dental professional pays the additional expense of the replacement Aligners.

 

The Invisalign product warranty does not provide any assurances regarding the outcome of treatment using Invisalign. Actual treatment results may deviate significantly from the approved ClinCheck treatment plan. Deviations not covered under warranty have typically been the result of unpredictable biological factors, such as variations in bone density or tooth topography and abnormal jaw growth. Warranty treatment requires that the dental professional submit new impressions of the patient’s dentition to us. We use the impressions to create a new ClinCheck treatment plan for the dental professional to approve, from which a successive series of Aligners will be produced that will allow the patient to finish treatment.

 

In the event that a dental professional wishes to effect additional adjustments to a patient’s treatment when the actual treatment results are in accordance with the approved ClinCheck treatment plan, the dental professional may request a case refinement or additional Aligners. Our pricing policy includes the future delivery of one case refinement in the price of each case and offers additional case refinements at the dental professional’s expense. In addition, should a dental professional request a replacement for a lost Aligner, we charge the dental professional for the cost of the replacement Aligner.

 

Sales and Marketing

 

We market Invisalign by communicating Invisalign’s benefits directly to dental professionals through our training and certification programs and by direct mail campaigns and to consumers with a nationwide advertising campaign. Based on our experience with advertising and commercial sales in our test markets, we believe that making consumers aware of Invisalign as a new treatment alternative generates significant demand for Invisalign. In order to serve anticipated demand, we are training a broad base of dental professionals.

 

Professional Marketing

 

Our sales and support staff has been engaged in marketing Invisalign to orthodontists since July 1999. In 2001, we began marketing Invisalign to general practitioner dentists in our domestic market. We provide training, certification, marketing and clinical support to orthodontists and general practitioner dentists in the U.S. and Canada, which we consider our domestic market, and internationally.

 

As of December 31, 2004, we had trained approximately 29,700 dental professionals worldwide to use Invisalign. Of those dental professionals trained, approximately 70% are dental professionals in our domestic market (United States and Canada). Within our domestic market, we have trained approximately 7,700 orthodontists and approximately 13,800 general practitioner dentists. Our sales and orthodontic teams conduct training primarily in a workshop format. The key topics covered in training include Invisalign applicability, instructions on filling out the Invisalign prescription form, clinical tips and techniques, guidance on pricing and instructions on interacting with our ClinCheck software and the many other features of our website.

 

Invisalign relies on the same orthodontic principles that apply to traditional treatment, and we present our training material in a manner consistent with dental professionals’ training and experience. Our success in training a large number of dental professionals confirms our belief that training represents a minimal barrier to adoption for most dental professionals.

 

After training, sales representatives follow up with the dental professional to ensure that their staff is prepared to handle Invisalign cases. Such follow up may include assisting the dental professional in taking dental impressions, establishing an Internet connection and familiarizing them with our website. Sales representatives may also provide practice-building assistance, including helping the dental professional to market Invisalign to

 

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prospective patients through direct mail or other forms of media. Many dental professionals have commenced promotional activity in their local region with our assistance.

 

There are over 131,000 active general practice dentists in the U.S. and Canada. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, and possess a unique opportunity to educate these patients and introduce them to Invisalign. GPs also have the ability to refer appropriate cases to orthodontists and, in certain instances, may choose to treat less complex cases themselves. We are committed to improving the collaboration and referral relationships between orthodontists and GPs.

 

Consumer Marketing

 

Our national consumer marketing efforts primarily focus on television advertising and are supported by other advertising media and public relations. We advertise nationally using a broad marketing mix to drive consumer and dental professional demand.

 

Our experience indicates that prospective patients seek information from six primary sources:

 

    an orthodontist;

 

    a general practice dentist;

 

    direct-to-consumer mail advertising and public relations efforts;

 

    other Invisalign patients;

 

    our toll-free support line (1-800-INVISIBLE); and

 

    our website, which can be accessed at either www.invisalign.com or www.aligntech.com.

 

Our marketing efforts have generated substantial consumer interest directed toward our telephone support line and our website. Our telephone support line and our website not only provide consumers with information on Invisalign, but also allow us to channel consumer interest to dental professionals. We have outsourced the telephone support function to a national call center operator.

 

Research and Development

 

Prior to commercial launch in July 1999, our research and development strategy had three primary objectives: developing the Invisalign product, establishing the ability of Invisalign to treat malocclusion and developing software and processes to enable the manufacturing of Aligners in volume. Since our commercial launch, our research and development effort has focused on extending the range of dental applicability of Invisalign, enhancing the software used in the manufacturing process and enhancing our Invisalign system product lines. Our research and development expenses were $15.8 million for fiscal 2004 and $13.1 million for each of fiscal 2003 and 2002.

 

In an effort to demonstrate Invisalign’s broad treatment capabilities, a series of clinical case studies and articles have been published that highlight the applicability of Invisalign to malocclusion cases, including those of severe complexity. We are also undertaking post-marketing studies and making additional technological improvements to the product and manufacturing process. Our product development team is testing enhanced materials and a number of complementary products that we expect will provide additional revenue opportunities.

 

Intellectual Property

 

We believe our intellectual property position represents a substantial business advantage. As of December 31, 2004, we had 56 issued U.S. patents, 82 pending U.S. patent applications, and numerous foreign issued patents, as well as pending foreign patent applications.

 

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We continue to pursue further intellectual property protection through U.S. and foreign patent applications and non-disclosure agreements. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws. We cannot be certain that patents will be issued as a result of any patent application or that patents that have been issued to us or that may be issued in the future will be found to be valid and enforceable and sufficient to protect our technology or products. Information regarding risks associated with failure to protect our proprietary technology and our intellectual property rights may be found in Part II, Item 7 of this Report on Form 10-K under the heading “Risk Factors.”

 

Competition

 

We compete for the attention of dental professionals with manufacturers of traditional orthodontic appliances (or wires and brackets), which include 3M Company, Sybron Dental Specialties and Dentsply International, Inc. We also compete directly with established companies that manufacture and distribute products that are similar in use to Invisalign, including the product called Red, White & Blue manufactured and distributed by Ormco Orthodontics, a wholly owned subsidiary of Sybron Dental Specialties. In the future, we may face competition from early stage and more mature companies who enter our target markets to manufacture and distribute products that are similar in use to Invisalign. Information regarding risks associated with increased competition may be found in Part II, Item 7 of this Report on Form 10-K under the heading “Risk Factors.”

 

We believe that in addition to price, the principal competitive factors in the market for orthodontic appliances include the following factors:

 

    aesthetic appeal of the treatment method;

 

    comfort associated with the treatment method;

 

    oral hygiene;

 

    effectiveness of treatment;

 

    ease of use; and

 

    dental professionals’ chair time.

 

We believe that Invisalign compares favorably with our competitors’ products with respect to each of these factors.

 

Government Regulation

 

FDA’s Quality System Regulation for Medical Devices.    The Invisalign Aligners are regulated as a Class I medical device by the Food and Drug Administration (“FDA”). Accordingly, our product development, manufacturing processes, packaging, labeling, handling, storage and distribution activities are subject to extensive regulations enforced by both state and federal regulatory authorities.

 

The Aligners are manufactured by The TECMA Group, LLC, a contract manufacturer based in Mexico. As a medical device company, we are required to ensure that our contract manufacturer complies with the FDA’s Quality System regulations. As a result, we have ensured that TECMA is registered with the FDA as a medical device manufacturer and its manufacturing processes comply with regulatory requirements. In addition, TECMA is certified to ISO 9000 standards and is subject to inspection by an independent ISO agency. TECMA has dedicated an area in its facilities and trained personnel for the manufacture and distribution of Invisalign. We conduct frequent visits to the Mexico facility to monitor TECMA’s performance and its compliance with regulatory requirements and we also perform independent audits of their quality system.

 

In November 1998, we received 510(k) pre-market clearance by the FDA for the Invisalign system, allowing us to market Invisalign in the U.S. The manufacture and distribution of Invisalign are subject to continuing oversight by the FDA, including routine inspections to determine compliance with Quality System

 

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regulations. Our facility is registered with the State of California as a medical device manufacturer and is subject to state inspections.

 

During inspections of our facility and those of our contract manufacturer, if the FDA determines that we or our contract manufacturer have failed to comply with the applicable FDA regulations, it can institute a wide variety of enforcement actions, ranging from a public Warning Letter to more severe sanctions, including but not limited to financial penalties, withdrawal of our right to market products and criminal prosecution.

 

Health Canada’s Medical Device Regulations.    We sell the Invisalign system throughout Canada. As such, we are required to comply with the Health Canada’s Medical Device Regulations and we believe we are in compliance with their regulations.

 

European Union’s MDD Requirements & ISO 13485.    In Europe, the Invisalign system is regulated as a custom device and as such, we follow the Medical Device Directives and are registered with an applicable Competent Authority in Europe. Our facilities are ISO 13485 certified, which facilitates commercialization of Invisalign in Europe and other countries outside of the United States.

 

Health Insurance Portability and Accountability Act of 1996.    Under the Health Insurance Portability and Accountability Act of 1996, or HIPAA, Congress mandated a package of interlocking administrative simplification rules to establish standards and requirements for electronic transmission of health information. Confidentiality of patient records and the circumstances under which these records may be maintained and released are subject to substantial regulations under the HIPAA Standards for Privacy of Individually Identifiable Health Information, referred to as the Privacy Standard, and other state laws and regulations. The Privacy Standard governs both the disclosure and the use of confidential patient medical information. Although compliance is principally the responsibility of the hospital, physician or other healthcare provider the law requires that we execute Business Associate Agreements with orthodontists and other healthcare professionals and comply with the Privacy Standard when we handle patient information and records. We have designed our service offerings to enable compliance with HIPAA and applicable corresponding state laws and regulations. Compliance with these laws and regulations is costly. Our success may be dependent on the success of healthcare participants in dealing with HIPAA requirements and the Privacy Standard. Additionally, the HIPAA Security Standard, which goes into effect in April 2005, requires that we implement safeguards that reasonably and appropriately protect the confidentiality, integrity, and availability of the electronic protected health information that we create, receive, maintain or transmit pursuant to our Business Associate Agreements with health care professionals. Compliance with the Security Standard could require complex changes in our internal systems and could be costly.

 

Other Federal and State Laws.    As a participant in the health care industry we are subject to extensive and frequently changing regulation under many other laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. Furthermore, our health care service provider customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

 

Laws regulating medical device manufacturers and health care providers cover a broad array of subjects. For example, the confidentiality of patient medical information and the circumstances under which such information may be released for inclusion in our databases, or released by us to third parties, are subject to substantial regulation by state governments. These state laws and regulations govern both the disclosure and the use of confidential patient medical information and are evolving rapidly. In addition, provisions of the Social Security Act prohibit, among other things, paying or offering to pay any remuneration in exchange for the referral of patients to a person participating in, or for the order, purchase or recommendation of items or services that are subject to reimbursement by, Medicare, Medicaid and other similar federal or state health care payment programs. Most states have also enacted illegal remuneration laws that are similar to the federal laws. These laws are applicable to our financial relationships with, and any marketing or other promotional activities involving,

 

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our dental professional customers. Finally, various states regulate the operation of an advertising and referral service for dentists, and may require registration of such services with a state agency as well as compliance with various requirements and restrictions on how they conduct business and structure their relationships with participating dentists. Violations of any of these laws or regulations could subject us to a variety of civil and criminal sanctions.

 

Employees

 

As of December 31, 2004, we had approximately 969 employees, approximately 413 of whom were employed in the U.S., 461 in Costa Rica, 52 in Europe, 22 in Russia, 9 in Latin America, 11 in Asia/Pacific and 1 in the United Arab Emirates. As of December 31, 2004, of our U.S. employees, approximately 89 were employed in manufacturing, 93 were employed in various management, administrative and operations support positions, 74 were marketing and customer support staff, 98 were employed in sales, 33 were employed in engineering and 26 were employed in research and development.

 

Executive Officers

 

The following table sets forth certain information regarding our executive officers as of March 3, 2005:

 

Name


   Age

  

Position


Thomas M. Prescott

   49    President and Chief Executive Officer

Eldon M. Bullington

   53    Vice President, Finance and Chief Financial Officer

Roger E. George

   39   

Vice President, Legal and Corporate Affairs

General Counsel and Corporate Secretary

Len M. Hedge

   47    Vice President, Operations

David S. Thrower

   40    Vice President, Global Marketing

Patricia L. Wadors

   40    Vice President, Human Resources

Cecilia Claudio

   50    Vice President, Engineering and Chief Information Officer

Robert D. Mitchell

   43    Vice President, World Wide Sales and Customer Care

Rok Sribar

   40    Vice President, Research & Development

 

Thomas M. Prescott has served as our President and Chief Executive Officer and as a member of our Board of Directors since March 27, 2002. Prior to joining us, Mr. Prescott was President and Chief Executive Officer of Cardiac Pathways, Inc., a publicly-traded medical device company, from May 1999 until its acquisition by Boston Scientific in August 2001. Mr. Prescott then worked as a consultant for Boston Scientific Corporation until January 2002. Prior to working at Cardiac Pathways, Mr. Prescott held various sales, general management and executive roles at Nellcor Puritan Bennett, Inc. from April 1994 to May 1999. Mr. Prescott serves as a director of Interventional Rhythm Management, Inc., a privately held company.

 

Eldon M. Bullington has served as our Vice President of Finance and Chief Financial Officer since October 2002. Mr. Bullington was previously Vice President, Finance and Chief Financial Officer of Verplex Systems, Inc, an electronic design automation company, from January 2002 until October 2002. Prior to that, Mr. Bullington spent two years as the Vice President and Chief Financial Officer at Cardiac Pathways, Inc., until it was acquired by Boston Scientific in August 2001. Prior to Cardiac Pathways, Mr. Bullington was Vice President and Chief Financial Officer at Saraide, Inc. from September 1998 to March 1999. He also served in executive financial management roles at Verifone, Inc. and Radius, Inc.

 

Roger E. George has served as Vice President, Legal and Corporate Affairs, and General Counsel and Corporate Secretary since July 2002. Prior to joining Align, Mr. George was the Chief Financial Officer, Vice President of Finance and Legal Affairs and General Counsel of SkyStream Networks, a privately held broadband and broadcast network equipment company. Prior to SkyStream, Mr. George was a partner at Wilson Sonsini Goodrich & Rosati, P.C. in Palo Alto, California.

 

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Len M. Hedge has served as our Vice President, Operations since March 2002, and served as our Vice President of Manufacturing from January 1999 to March 2003. Mr. Hedge served as Vice President of Operations for Plynetics Express Corporation, a rapid-prototyping and stereolithography services supplier, from December 1996 to December 1998. From October 1991 to December 1996, Mr. Hedge worked at Beckman Instruments Corporation as Manager for Prototype Manufacturing and Process Development.

 

David S. Thrower has served as our Vice President, Global Marketing since August 2002. Prior to joining Align, Mr. Thrower served as Senior Vice President of Global Marketing and Sales for BioSource International, a publicly-held life science reagent company, from October 2000 until July 2003. Prior to BioSource, Mr. Thrower served as Senior Vice President, Global Marketing at GN ReSound, Inc. a hearing and communications device company, from July 1998 until December 1999. Mr. Thrower also has previous experience in large and small independent management consulting firms, including five years with Boston-based Bain & Company.

 

Patricia L. Wadors has served as our Vice President, Human Resources since January 2004. Prior to joining Align, Ms. Wadors spent eight years Applied Materials in both Human Resources and Operations. Her last position at Applied Materials was Senior Director of Human Resources for the PDC Product Group. Prior to Applied Materials, Ms. Wadors held Human Resources positions at Merck Pharmaceutical, Viacom International and Calvin Klein Cosmetics.

 

Cecilia Claudio has served as our Vice President, Engineering and Chief Information Officer since September 2004. Prior to joining Align, Ms. Claudio was Executive Vice President and Chief Information Officer of Zurich Financial Services, an insurance-based financial services provider and the parent company of Farmers Insurance Group, Inc., where Claudio served as Senior Vice President and Chief Information Officer from 1998 to 2003. Prior to this, Ms. Claudio held information technology and computer service positions at Xerox, Mervyn’s, The Gap and Olivetti Worldwide. Ms. Claudio is the named Executive-in-Residence at Clearstone Venture Partners, a venture capital firm investing in California-based technology innovation. In addition, Ms. Claudio currently serves on the Board of Directors of Sybase, Inc.

 

Robert D. Mitchell has served as our Vice President, Worldwide Sales and Customer Care since July 2004. Prior to joining Align, Mr. Mitchell spent 16 years at Bloomington, IN-based Cook Incorporated, a leading designer, manufacturer and global distributor of minimally invasive medical device technology for diagnostic and therapeutic procedures. At Cook, Mr. Mitchell held a number of senior management positions and spent several years working outside of the United States as a Sales and Marketing Director. Most recently, Mr. Mitchell was the Vice President and Director for Global Sales and Marketing—Radiology, Cardiology, Vascular Surgery, Critical Care, Surgical.

 

Rok Sribar has served as our Vice President, Research & Development since February 2005. Prior to joining Align, Mr. Sribar spent eight months at Symbol Technologies, an enterprise mobility company, where he was Vice President, responsible for company-wide Product Lifecycle Management. Prior to this, Mr. Sribar spent four years with Sun Microsystems, most recently as Senior Director responsible for company-wide Product Lifecycle Process and related business systems. From 1994 to 2000, Mr. Sribar worked for General Electric Company, most recently at GE Medical Systems, where he was Manager of Digital X-Ray Detectors Engineering organization.

 

Our executive officers are appointed by the Board of Directors and serve until their successors have been duly appointed and qualified or until their earlier resignation or removal. There are no family relationships among any of our directors or executive officers.

 

ITEM 2.    PROPERTIES.

 

Our headquarters are located in Santa Clara, California. We lease approximately 110,000 square feet of space where we house our manufacturing, customer support, software engineering and administrative personnel. We lease our Santa Clara facilities under three leases, which expire in June 2010. The combined monthly base

 

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rent for the Santa Clara facilities is approximately $235,000. Commencing July 1, 2005, however, the combined monthly rent will be reduced to approximately $61,000. In addition to the amended lease terms, on the first day of each calendar month on and after July 1, 2005, $10,575 will be deducted from the $1,269,000 security deposit previously paid by us to the lessor and such amount will be applied against the monthly base rent for the Santa Clara facilities. Upon the occurrence of certain events, we will lease an additional 15,704 square feet of space at our Santa Clara facilities for a monthly rent of $25,000.

 

We operate a facility in San Jose, Costa Rica. The facility comprises approximately 63,000 square feet of manufacturing and office space. The monthly rent for the Costa Rica facility is approximately $53,000. The lease for this facility expires at the end of 2008.

 

Our European headquarters are located in Amsterdam, The Netherlands. The facility comprises approximately 11,000 square feet of office space. The monthly rent for the Amsterdam facility is approximately $27,000. The lease for this facility expires in 2014.

 

We operate a facility in Moscow, Russia. The facility comprises approximately 6,000 square feet of office space where we conduct certain research and development activities. The monthly rent for the Russian facility is approximately $17,000. The lease for this facility expires on April 10, 2005, and we do not expect to purchase or lease property in Moscow, Russia after this time.

 

We believe that our existing facilities are adequate to meet current requirements and that additional or substitute space will be available as needed to accommodate any expansion of operations.

 

ITEM 3.    LEGAL PROCEEDINGS.

 

On February 2, 2005, we filed a multi-claim lawsuit in San Francisco County Superior Court against defendants OrthoClear, Inc., OrthoClear Holdings, Inc., Muhammad Ziaullah Chishti, Bao Tran, Peter Riepenhausen, Joe Breeland, Jeff Tunnell, Christopher Kawaja, and Charles Wen. Among other things, the complaint alleges tort, contract, statutory and common law causes of action arising from OrthoClear and the individual defendants’ alleged plan to unlawfully utilize Align’s intellectual property, confidential information and employees. The complaint also alleges that OrthoClear, Chishti and other defendants are in breach of contractual obligations, statutory law and common law for attempting to intentionally interfere and disrupt our ongoing business operations and improperly gain access to our customer relationships and trade secrets. The complaint seeks injunctive relief and monetary damages in an amount to be determined.

 

On February 15, 2005, OrthoClear, Chishti, Riepenhausen, Breeland, Tunnell, Kawaja and Wen filed a multi-claim cross-complaint against Align, Thomas Prescott, Roger George, Eldon Bullington, David Thrower, Patricia Wadors, Gil Laks and Kelsey Wirth (collectively, the “Align Parties”) alleging conspiracy, breach of contract, libel, slander, unjust enrichment, intentional interference with prospective economic advantage, and unfair competition. The cross-complaint seeks injunctive relief and monetary damages in an amount to be determined.

 

On February 18, 2005, the Court granted our request for and issued a Temporary Restraining Order (“TRO”) prohibiting OrthoClear and the individual OrthoClear defendants from engaging, assisting, or participating, directly or indirectly, in soliciting, inducing to leave, recruiting, or encouraging any current Align employee or consultant to terminate or alter his or her employment or business relationship with Align or attempting to do the same. The Court also granted our request and issued a TRO prohibiting OrthoClear and the individual OrthoClear defendants from disclosing, using, lecturing upon or publishing any of our proprietary information without our express prior written permission. In addition, in response to a cross-application for TRO filed by certain OrthoClear defendants, the Court enjoined Chishti and the Align Parties from disparaging each other in such a manner as to violate the mutual non-disparagement clause contained in the Separation Agreement between Align and Chishti dated as of March 27, 2002. The Court also enjoined the Align Parties from advising any Align

 

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employee or consultant that he or she will be subject to criminal charges or a civil lawsuit if that person elects to change his or her employment status with Align, unless Align has good cause to believe criminal conduct has been or will be committed or that a civil cause of action will lie against the employee or consultant. The Court also required the Align Parties to refrain from taking any actions inconsistent with Federal or State securities laws relating to the issuance or redemption of Align stock. The Court scheduled an Order to Show Cause hearing why a Preliminary Injunction should not be issued in accordance with the terms of the TRO for March 8, 2005. On March 1, 2005, the Court signed a Stipulated Preliminary Injunction Order, whereby the Court ordered that the March 8th hearing date be vacated and further ordered that the express terms of the TRO remain in place until the earlier of (i) trial, (ii) written agreement of the parties or further Court order setting an earlier termination, or (iii) as to the preliminary injunction regarding non-solicitation or recruiting of Align employees or consultants only, October 27, 2005. Align denies the allegations in the Cross-Complaint, and will vigorously defend against such claims. No trial date has been set in the case.

 

On January 6, 2003, Ormco Corporation (“Ormco”) filed suit against us in the United States District Court for the Central District, Orange County Division, asserting infringement of U.S. Patent Nos. 5,447,432, 5,683,243 and 6,244,861. The complaint seeks unspecified monetary damages and injunctive relief. On February 18, 2003, we answered the complaint and asserted counterclaims seeking a declaration by the Court of invalidity and non-infringement of the asserted patents. In addition, we counterclaimed for infringement of our U.S. Patent No. 6,398,548, seeking unspecified monetary damages and injunctive relief. Ormco filed a reply to our counterclaims on March 10, 2003 and asserted counterclaims against us seeking a declaration by the Court of invalidity and non-infringement of U.S. Patent No. 6,398,548. We responded to Ormco’s counterclaims on April 2, 2003. We amended our counterclaim to add Allesee Orthodontic Appliances, Inc. (“AOA”), a wholly-owned subsidiary of Ormco, as a counterdefendant in regard to our counterclaim of infringement of U.S. Patent No. 6,398,548. The Court then permitted Ormco to amend its Complaint and permitted us to amend our counterclaim to add an additional patent each. Ormco filed a first amended complaint for infringement of U.S. Patent No. 6,616,444 on October 15, 2003. On October 27, 2003, we filed an answer to Ormco’s first amended complaint and a counterclaim for invalidity and non-infringement of U.S. Patent No. 6,616,444 and for infringement of U.S. Patent No. 6,554,611.

 

In connection with these claims, the Court granted five motions for summary judgment that we filed. First, on May 14, 2004, the Court granted our motion for summary judgment of non-infringement, finding that our Invisalign system does not infringe any of the asserted Ormco patents (5,477,432, 5,683,243, 6,244,861 and 6,616,644). Second, on July 2, 2004, the Court granted in part our motion for summary judgment of infringement, finding that Ormco and AOA infringe certain, but not all, claims of our patents Nos. 6,398,548 and 6,554,611 through the manufacture and sale of Red, White & Blue appliances. Third, on August 26, 2004, the Court granted our motion for summary judgment of invalidity of Ormco’s asserted patents claims (5,477,432, 5,683,243, 6,244,861 and 6,616,644). As noted above, the Court earlier found that we do not infringe these patents. In addition, the Court also denied Ormco’s motion for summary judgment seeking a finding of invalidity of our asserted patent claims (6,398,548 and 6,554,611). Fourth, the Court granted our summary judgment motion that our asserted patent claims are not invalid based on the evidence currently before the Court. Although the Court granted that motion, it reopened discovery on two additional invalidity arguments Ormco asserted. Fifth, the Court also granted our summary judgment motion that our patents are not unenforceable and granted Ormco’s summary judgment motion that Ormco did not willfully infringe our patents.

 

On December 20, 2004, we filed a further summary judgment motion that our asserted claims are not invalid based on Ormco’s new evidence. Ormco filed a counter-summary judgment motion that our asserted claims are invalid based on this new evidence. The motions were heard by the Court on February 7, 2005. On February 24, 2005, the Court granted our motion in part, confirming the validity of all of the asserted claims of our 6,554,611 patent and two of the asserted claims of our 6,398,548 patent. The Court also granted Ormco’s motion in part, finding certain claims of our 6,398,548 patent to be invalid in view of prior use evidence. At this stage, only our remedies for Ormco’s adjudged infringement remain at issue.

 

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Litigating claims of these types, whether or not ultimately determined in our favor or settled by us, is costly and diverts the efforts and attention of our management and technical personnel from normal business operations. Any of these results from litigation could adversely affect our results of operations and stock price. From time to time, we have received, and may again receive, letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe any such rights that have been brought to our attention, there may be other more pertinent proprietary rights of which we are presently unaware.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

There were no matters submitted to a vote of security holders during the fourth quarter of fiscal 2004.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES.

 

(a)    Price Range of Common Stock

 

Our common stock is listed on The NASDAQ National Market under the symbol “ALGN.” Public trading of our common stock commenced on January 26, 2001. Prior to that date, there was no public market for our common stock. The following table shows, for the periods indicated, the high and low per share closing prices of our common stock, as reported by The NASDAQ National Market:

 

     High

   Low

Year Ended December 31, 2004:

             

Fourth quarter

   $ 16.34    $ 8.97

Third quarter

   $ 18.72    $ 13.90

Second quarter

   $ 22.80    $ 17.36

First quarter

   $ 21.79    $ 16.69

Year Ended December 31, 2003:

             

Fourth quarter

   $ 18.61    $ 12.85

Third quarter

   $ 14.30    $ 10.45

Second quarter

   $ 12.60    $ 5.75

First quarter

   $ 6.13    $ 2.63

 

On March 1, 2005, the last reported sale price of our common stock on The NASDAQ National Market was $7.40 per share. As of February 28, 2005 there were approximately 319 holders of record of our common stock.

 

We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

The information required by this item regarding equity compensation plans is incorporated by reference to the information set forth in Item 12 of this Annual Report on Form 10-K.

 

ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA.

 

The following discussion and analysis of our selected consolidated financial data should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

 

The following tables set forth the selected consolidated financial data for each of the years in the five-year period ended December 31, 2004. The selected consolidated financial data is qualified in its entirety and should be read in conjunction with the Consolidated Financial Statements and related Notes thereto set forth on pages 50 to 72 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 22. We have derived the consolidated statements of operations data for the years ended December 31, 2004, 2003 and 2002 and the balance sheet data as of December 31, 2004 and December 31, 2003 from the consolidated audited financial statements included elsewhere in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended December 31, 2001 and 2000 and the balance sheet data as of December 31, 2002, 2001 and 2000 were derived from the consolidated audited financial statements that are not included in this Annual Report on Form 10-K.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

(in thousands, except per share data)

(unaudited)

 

     Year Ended December 31,

 
     2004

    2003

    2002

    2001

    2000

 

Consolidated Statement of Operations Data:

                                        

Total revenues

   $ 172,830     $ 122,725     $ 69,698     $ 44,808     $ 6,741  
    


 


 


 


 


Gross profit (loss)

   $ 115,304     $ 71,160     $ 24,707     $ (2,022 )   $ (13,510 )
    


 


 


 


 


Profit (loss) from operations

     9,765       (19,937 )     (72,935 )     (100,769 )     (81,115 )

Other income (expense), net

     (3 )     (101 )     116       1,730       (7,633 )
    


 


 


 


 


Net profit (loss) before provision for income taxes

     9,762       (20,038 )     (72,819 )     (99,039 )     (88,748 )

Provision for income taxes

     994       84       —         10       —    
    


 


 


 


 


Net profit (loss)

     8,768       (20,122 )     (72,819 )     (99,049 )     (88,748 )

Dividend related to beneficial conversion feature of preferred stock

     —         —         —         (11,191 )     (53,516 )
    


 


 


 


 


Net profit (loss) available to common stockholders

   $ 8,768     $ (20,122 )   $ (72,819 )   $ (110,240 )   $ (142,264 )
    


 


 


 


 


Net profit (loss) per share available to common stockholders, basic

   $ 0.15     $ (0.35 )   $ (1.52 )   $ (2.61 )   $ (25.64 )
    


 


 


 


 


Shares used in computing net profit (loss) per share available to common stockholders, basic

     59,963       57,758       47,878       42,247       5,548  
    


 


 


 


 


Net profit (loss) per share available to common stockholders, diluted

   $ 0.14     $ (0.35 )   $ (1.52 )   $ (2.61 )   $ (25.64 )
    


 


 


 


 


Shares used in computing net profit (loss) per share available to common stockholders, diluted

     64,089       57,758       47,878       42,247       5,548  
    


 


 


 


 


     December 31,

 
     2004

    2003

    2002

    2001

    2000

 

Consolidated Balance Sheet Data:

                                        

Working capital

   $ 61,886     $ 39,737     $ 41,160     $ 62,172     $ 18,273  

Total assets

     130,712       102,202       92,856       118,218       70,561  

Total long-term liabilities

     25       1,849       3,837       980       1,455  

Convertible preferred stock and preferred stock warrants

     —         —         —         —         130,691  

Stockholders’ equity (deficit)

   $ 85,739     $ 62,976     $ 64,347     $ 97,827     $ (84,674 )

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

The following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

 

Overview

 

Align Technology, founded in April 1997, designs, manufactures and markets Invisalign, a proprietary method for treating malocclusion, or the misalignment of teeth. Invisalign corrects malocclusion using a series of clear, nearly invisible, removable appliances that gently move teeth to a desired final position. Because it does not rely on the use of metal or ceramic brackets and wires, Invisalign significantly reduces the aesthetic and other limitations associated with braces. Invisalign is appropriate for treating adults and teens with mature dentition. Align Technology received FDA clearance to market Invisalign in 1998, and we began commercial operations in July 1999.

 

The Invisalign product is manufactured in phases. The initial step in our manufacturing process is the creation of electronic treatment plans using ClinCheck, an internally developed computer-modeling program. These treatment plans are developed in our operations facility in Costa Rica and are transmitted electronically back to the prescribing dental profession via ClinCheck. ClinCheck allows dental professionals to simulate treatment in three dimensions by modeling two-week stages of tooth movement. Upon the dental professional’s approval of the ClinCheck simulation, we use the data underlying the simulation, in conjunction with stereolithography technology, to manufacture Aligner molds. A third party manufacturer in Mexico uses these molds to fabricate Aligners. Aligners are thin, clear plastic, removable dental appliances that are manufactured in a series to correspond to each two-week stage of the ClinCheck simulation. Aligners are customized to perform the treatment prescribed for an individual patient by dental professionals using ClinCheck. After the Aligners are produced, the third party manufacturer ships the finished products to our customers.

 

We have two customer channels: the orthodontist and the GP. We have historically generated a majority of our revenues from orthodontists. There exists, however, a significantly greater number of GPs in North America than orthodontists. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, and possess a unique opportunity to educate these patients on the benefits of oral care and introduce them to Invisalign. GPs also have the ability to refer appropriate cases to orthodontists and may choose to treat less complex cases themselves. We are committed to improving the collaboration and referral relationships between orthodontists and GPs. We believe that improved collaboration is beneficial to the orthodontist and the GP and will accelerate growth in Invisalign cases and consequently increase our revenues. In addition, although we expect that orthodontists will continue to treat the majority of complex cases and continue to drive research for expanding Invisalign applications, we expect that the percentage of revenue generated by GPs will increase, largely due to the fact that there are significantly more GPs than orthodontists. In 2005, we expect to generate the majority of our revenue from GPs. We believe the expected increase in the number of cases treated by GPs will result in an increase in the overall market for Invisalign as patients that would not have otherwise sought orthodontic treatment are introduced to Invisalign by their GPs.

 

Sales to orthodontists and GPs in our domestic market represented approximately 90% of our total revenue during fiscal 2004. We expect to continue to increase our penetration into our domestic market. We will also focus our efforts towards the expansion of our international markets. In fiscal 2005, we expect to increase our infrastructure and support in key countries in Europe and initiate strategic moves in Asia, specifically in Japan, in order to take advantage of this emerging opportunity.

 

Clinical education and ongoing training are critical to our customers’ success with Invisalign. We certify several thousand new orthodontists and GPs to use Invisalign annually, and we certified approximately 4,200 orthodontists and GPs during fiscal 2004, and we expect to certify approximately 4,000 during fiscal 2005. Additionally, we share product enhancements, treatment tips and techniques, and clinical research data with our

 

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customers on an ongoing basis through continuing education in the form of hundreds of provider workshops, study clubs and online educational centers. This information ensures that our customers understand Invisalign’s expanding applications and best uses, and feel confident about treating more of their patients with Invisalign.

 

Net revenue for the year ended December 31, 2004 was $172.8 million, an increase of 41% as compared to the year ended December 31, 2003. The increase was driven primarily by an increase in the number of cases submitted for the domestic general practitioner channel. Revenues during the fourth quarter of fiscal 2004 were reduced by approximately $1.9 million as a result of our case refinement policy change described below. In certain instances, adjustments to a patient’s teeth are made in the final stages of orthodontic treatment. To make these final adjustments and move a patient’s teeth to the final desired position, dental professionals may elect to use Invisalign as a finishing treatment tool and order newly manufactured Aligners. These newly manufactured Aligners, or “case refinement”, are not provided with the Aligners produced as part of the initial treatment plan and are manufactured only upon the request of the dental professional if final adjustments are desired. Align’s case refinement policy allows doctors to order one case refinement as part of their original lab fee, provided they submit the order prior to the point in time when the case is deemed completed, or the “case expiration”. Prior to the policy change announced in the fourth quarter of 2004, Align deemed the case expiration date to occur on the 90th day after the expected end of treatment. Under the new policy, the case expiration date is deemed to occur on the 180th day after the expected end of treatment. Gross profit percentage increased in fiscal 2004 to 67% from 58% for fiscal 2003. The increase was primarily attributable to improved fixed cost absorption related to increasing volumes and continued manufacturing process improvements in both our treatment operations facility in Costa Rica and in the aligner fabrication process.

 

We recently filed a multi-claim lawsuit against one of our founders and certain former employees. Among other things, the lawsuit alleges tortious and illegal actions arising out of the defendants’ plan to unlawfully utilize our intellectual property, confidential information and employees. In addition, the lawsuit alleges that the defendants are in breach of contractual obligations, statutory law, and common law, for the purpose of attempting to intentionally interfere and disrupt our on-going operations and improperly gain access to our customer relationships and trade secrets. On February 15, 2005, OrthoClear, Chishti and certain other defendants filed a multi-claim cross-complaint against Align and certain of our executive officers, senior management and a director alleging conspiracy, breach of contract, libel, slander, unjust enrichment, international interference with prospective economic advantage and unfair competition. See Part I Item 3 of this Form 10-K for a more complete summary of this legal proceeding. We are in the early stages of evaluating the impact, if any, the events underlying this litigation may have on our business, competitive position in the market, our ability to retain our sales representatives and other matters related to the sale of our product. In addition, although this lawsuit is in the early stages, litigation of this type, whether or not ultimately determined in our favor or settled by us, is costly and diverts the efforts and attention of our management and technical personnel from normal business operations. As a result, this litigation could adversely affect our results of operations and cause a decline in our stock price.

 

Changes to previously announced fiscal 2004 fourth quarter and fiscal year-end results

 

On January 26, 2005, we announced our results for the fourth quarter and fiscal year ended December 31, 2004. Subsequent to that date, we adjusted the cost of revenues for the quarter and year ended December 31, 2004 to include an additional $383,000 resulting from asset impairment charges identified by the Company relating to manufacturing fixed assets at our international manufacturing facility. Net profit for the quarter and year ended December 31, 2004 was reduced by $383,000 and there was no change to basic or diluted earnings per share.

 

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Set forth below is a reconciliation of our reported results from our January 26, 2005 press release to amounts reported in the Annual Report on Form 10-K which reflects the adjustment (in thousands):

 

For the year ended December 31, 2004


   Previously
Announced


   Increase
(Decrease)


    Reported
in Annual
Report


Consolidated Statement of Operations Data:

                     

Cost of revenues

   $ 57,143    $ 383     $ 57,526

Gross profit

     115,687      (383 )     115,304

Profit from operations

     10,148      (383 )     9,765

Net profit

   $ 9,151    $ (383 )   $ 8,768

 

Set forth below is a reconciliation of our reported fourth quarter results from our January 26, 2005 press release to amounts reflected in Item 8, Consolidated Financial Statements and Supplementary Data, Quarterly Results of Operations, which reflects the adjustment (in thousands):

 

For the quarter ended December 31, 2004


   Previously
Announced


   Increase
(Decrease)


   

Reported
in Annual

Report


Consolidated Statement of Operations Data:

                     

Cost of revenues

   $ 14,578    $ 383     $ 14,961

Gross profit

     29,077      (383 )     28,694

Profit from operations

     1,039      (383 )     656

Net profit

   $ 1,504    $ (383 )   $ 1,121

 

Results of Operations

 

Comparison of Years Ended December 31, 2004 and 2003:

 

Revenues.    Invisalign product revenues by channel and other revenue, which represented training and sales of ancillary products, for the year ended December 31, 2004 and 2003 are as follows:

 

     Year Ended December 31,

  

Increase*


  

Percentage
Increase


 

(Amounts in $ million)


       2004    

       2003    

     

Domestic:

                           

Orthodontic

   $ 86.1    $ 72.1    $ 14.0    19 %

GP

   $ 62.0    $ 31.5    $ 30.5    97 %

International

   $ 16.4    $ 11.7    $ 4.7    40 %
    

  

  

  

Total Invisalign

   $ 164.5    $ 115.3    $ 49.2    43 %

Other revenue

   $ 8.3    $ 7.4    $ 0.9    12 %
    

  

  

  

Total Revenue

   $ 172.8    $ 122.7    $ 50.1    41 %
    

  

  

  


*   Primary reasons for increase:    For the year ended December 31, 2004, growth in the domestic orthodontic and general practitioner channels over fiscal 2003 resulted primarily from higher case volumes driven by an increase in the number of participating clinicians and utilization within the general practitioner practices. Higher product sales during fiscal 2004 as compared to fiscal 2003 also benefited from increased promotional advertising campaigns and sales initiatives in effect during fiscal 2004.

 

Cost of revenues.    Cost of revenues for the year ended December 31, 2004 was $57.5 million compared to $51.6 million for the year ended December 31, 2003. Cost of revenues includes the salaries for staff involved in production, the cost of materials and packaging, shipping costs, depreciation on the capital equipment used in the production process, training costs and the cost of facilities. Also included in cost of revenues are stock-based compensation expenses of $0.9 million and $2.6 million for the years ended December 31, 2004 and 2003,

 

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respectively. Gross profit for the year ended December 31, 2004 was $115.3 million or 67% of revenue, compared to a gross profit of $71.2 million or 58% of revenue for the year ended December 31, 2003. The higher gross profit for the year ended December 31, 2004 as compared to the year ended December 31, 2003 is primarily attributable to improved fixed cost absorption related to increasing volumes, continued manufacturing process improvements in both our treatment operations facility in Costa Rica and in the aligner fabrication process.

 

Sales and marketing.    Sales and marketing expenses for the year ended December 31, 2004 were $55.9 million compared to $43.7 million for the year ended December 31, 2003. Sales and marketing expenses include sales force compensation (combined with travel related costs and expenses for professional marketing programs), conducting workshops and market surveys, advertising and dental professional trade show attendance. Sales and marketing expenses include stock-based compensation expenses of $0.7 million and $2.2 million for the years ended December 31, 2004 and 2003, respectively. The increase in sales and marketing expense of $12.2 million for the year ended December 31, 2004 as compared to the year ended December 31, 2003 resulted primarily from an increase in spending of $4.4 million related to incremental headcount in our North American sales and marketing work force, $0.9 million related to North America sales force training, $2.7 million related to our international workforce and outside services, and $5.9 million related to increases in media, advertising costs, marketing promotions and other related expenses. The increase in spending was partially offset by the decrease of $1.5 million in stock-based compensation expense. The increases during fiscal 2004 have been consistent with our marketing and sales initiatives and we expect these initiatives to continue in fiscal 2005. Accordingly, we expect sales and marketing expense to increase during fiscal 2005 as we continue to invest in sales force staffing, new media programs, web site enhancements, direct-to-consumer advertising and clinical education.

 

General and administrative.    General and administrative expenses for the year ended December 31, 2004 were $33.9 million compared to $34.3 million for the year ended December 31, 2003. General and administrative expenses included salaries for administrative personnel, outside consulting services, legal expenses and general corporate expenses. General and administrative expenses include stock-based compensation expenses of $2.7 million and $7.1 million for the years ended December 31, 2004 and 2003, respectively. The $0.4 million decrease in general and administrative expenses for the year ended December 31, 2004 as compared to the year ended December 31, 2003 was primarily due to the decrease in stock-based compensation expense of $4.4 million and legal fees of $2.4 million. The decrease in litigation spending was primarily due to the settlement charge of $2.1 million included in general and administrative expenses for the year ended December 31, 2003 related to the conclusion of the Discus arbitration proceedings. The decreased expenses for the year ended December 31, 2004 as compared to the year ended December 31, 2003 was partially offset by increases of $4.2 million in payroll expenses related to additional headcount and $2.1 million in general corporate expenses.

 

Research and development.    Research and development expenses for the year ended December 31, 2004 were $15.8 million and $13.1 million for the year ended December 31, 2003. Research and development expenses include the costs associated with software engineering, the cost of designing, developing and testing our products and conducting clinical and post-marketing trials. We expense our research and development costs as they are incurred. Research and development expenses included $1.6 million and $3.2 million of stock-based compensation for the years ended December 31, 2004 and 2003, receptively. The increase in research and development for the year ended December 31, 2004 as compared to the year ended December 31, 2003 of $2.7 million resulted from increased spending of $3.2 million for product improvement initiatives and the $1.1 million severance charge related to the departure of our vice president of engineering, partially offset by a $1.6 million decrease in stock-based compensation expense. For the fiscal 2005, we expect to increase research and development spending for new products, conducting clinical research and product improvement initiatives.

 

Interest and other income (expense), net.    Interest income was $0.7 million for the year ended December 31, 2004 as compared to $0.5 million the year ended December 31, 2003. Interest and other expense was $0.7 million the year ended December 31, 2004 as compared to $0.9 million the year ended December 31, 2003. Interest and other income (expense), net, includes interest income earned on cash balances, interest expense on

 

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debt, foreign currency translation gains and losses for the dollar against other currencies related to international businesses and other miscellaneous charges.

 

Income tax provision.    Income tax provision for 2004 and 2003 was $1.0 million and $0.1 million, respectively. Our effective tax rate was 10.2% and 0.42% for fiscal 2004 and 2003, respectively. Our expected effective tax rate for fiscal 2005 is 10.0%. As of December 31, 2004, we had aggregate federal and state net operating loss carryforwards of $324.2 million. As of December 31, 2004, we have recorded a full valuation allowance for our existing net deferred tax assets due to uncertainties regarding their realization. We have aggregate federal and state research tax credit carryforwards of $6.9 million as of December 31, 2004. The federal and state net operating loss carryforwards expire beginning in the year 2017 for federal and 2005 for state purposes, if not utilized. Utilization of the federal net operating losses and credit carryforwards may be limited by the change of ownership provisions contained in Section 382 of the Internal Revenue Code. The federal research credit carryforwards expire beginning in the year 2017, if not utilized. The state research credit carryforward does not expire.

 

Stock-based compensation.    In connection with the grant of stock options to employees and non-employees prior to 2001, we recorded deferred stock-based compensation as a component of stockholders’ equity. Deferred stock-based compensation for options granted to employees is the difference between the fair value of our common stock on the date such options were granted and their exercise price. For stock options granted to non-employees, the fair value of the options, estimated using the Black-Scholes valuation model, is initially recorded on the date of grant. As the non-employee options vest, we remeasure the remaining unvested options, with the change in fair value from period to period represented as a change in deferred compensation. This stock-based compensation is amortized as charges to operations over the vesting periods of the options. For fiscal 2004 and 2003, we recorded amortization of deferred compensation of $5.1 million and $12.8 million, respectively.

 

We recorded expenses of $0.4 million and $1.3 million for fiscal 2004 and 2003, respectively, related to options granted to non-employees after January 26, 2001.

 

Historically, we have accelerated the vesting of options to several employees in connection with severance packages. These accelerations were accounted for as a charge to the consolidated statements of operations. We recorded $0.4 million for fiscal 2004 related to the departure of our vice president of engineering, and we recorded $1.0 million for fiscal 2003 related to certain other executives. This charge is equal to the intrinsic value of the options which was calculated as a difference between the exercise price of the accelerated options and the fair value of the common stock on the date of acceleration.

 

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Comparison of Years Ended December 31, 2003 and 2002:

 

Revenues.    Invisalign product revenues by channel and other revenue, which represented training and sales of ancillary products, for the year ended December 31, 2003 and 2002 are as follows:

 

     Year Ended December 31,

  

Increase*


  

Percentage
Increase


 

(Amounts in $ million)


       2003    

       2002    

     

Domestic:

                           

Orthodontic

   $ 72.1    $ 48.7    $ 23.4    48 %

GP

   $ 31.5    $ 9.5    $ 22.0    232 %

International

   $ 11.7    $ 5.5    $ 6.2    113 %
    

  

  

  

Total Invisalign

   $ 115.3    $ 63.7    $ 51.6    81 %

Other revenue

   $ 7.4    $ 6.0    $ 1.4    23 %
    

  

  

  

Total Revenue

   $ 122.7    $ 69.7    $ 53.0    76 %
    

  

  

  


*   Primary reasons for increase:    For the year ended December 31, 2003, growth in the domestic orthodontic and general practitioner channels over fiscal 2002 resulted primarily from higher case volumes driven by an increase in the number of participating clinicians, with the highest percentage increase resulting from the general practitioner channel.

 

Cost of revenues.    Cost of revenues for the year ended December 31, 2003 was $51.6 million compared to $45.0 million for the year ended December 31, 2002. Cost of revenues include the salaries for staff involved in production, the cost of materials and packaging, shipping costs, depreciation on the capital equipment used in the production process, under/over absorbed manufacturing capacity, training costs and the cost of facilities. Included in cost of revenues are stock-based compensation expenses of $2.6 million and $3.4 million for the year ended December 31, 2003 and 2002, respectively. The year ended December 31, 2002 included restructuring charges of $0.6 million. Gross profit for the year ended December 31, 2003 was $71.2 million or 58% of revenue, compared to a gross profit of $24.7 million or 35% of revenue for the year ended December 31, 2002. The higher gross profit for the year ended December 31, 2003 as compared to fiscal 2002 is primarily attributable to a combination of manufacturing process efficiencies, and improved fixed cost absorption related to increasing volumes.

 

Sales and marketing.    Sales and marketing expenses for the year ended December 31, 2003 were $43.7 million compared to $45.3 million for the year ended December 31, 2002. Sales and marketing expenses include sales force compensation (combined with expenses for professional marketing programs), conducting workshops and market surveys, advertising and attending dental professional trade shows. Sales and marketing expenses for the year ended December 31, 2003 and 2002 include stock-based compensation expenses of $2.2 million and $3.0 million, respectively. The decrease in sales and marketing expenses for the year ended December 31, 2003 as compared to the year ended December 31, 2002 resulted primarily from a decrease in spending of $2.3 million for international media and advertising and $1.7 million related to our restructuring of and reductions in our international sales and marketing work force. The year ended December 31, 2002 included restructuring charges of $1.2 million and no restructuring charges for the year ended December 31, 2003. The reduction of the international sales and marketing work force in fiscal 2003 and the restructuring charges in fiscal 2002 were part of the plan during the second half of fiscal 2002 to streamline worldwide operations. The decrease in sales and marketing expenses for the year ended December 31, 2003 as compared to the year ended December 31, 2002 were partially offset by an increase in spending of $3.9 million related to incremental headcount in our North American sales force and $0.5 million in incremental media and advertisement costs for the year ended December 31, 2003 as compared to the year ended December 31, 2002.

 

General and administrative.    General and administrative expenses for the year ended December 31, 2003 were $34.3 million compared to $39.3 million for the year ended December 31, 2002. General and administrative expenses included salaries for administrative personnel, outside consulting services, legal expenses and general

 

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corporate expenses. General and administrative expenses for the year ended December 31, 2003 and 2002 include stock-based compensation expenses of $7.1 million and $10.7 million, respectively. The decrease in general and administrative expenses for the year ended December 31, 2003 as compared to the year ended December 31, 2002 resulted primarily from a decrease in stock-based compensation of $3.6 million. Salary expense decreased in fiscal 2003 by $2.5 million related to reductions in the North American and international administrative work forces and restructuring charges decreased by $2.9 million to $0.5 million for the year ended December 31, 2003 as compared to $3.4 million for the year ended December 31, 2002. Additionally, depreciation, amortization and overhead expenses also decreased by approximately $3.4 million in fiscal 2003. Partially offsetting the decreases in spending were increases of $1.7 million in outside consultant costs and $3.6 million in incremental legal expenses related our litigation matters. Also offsetting the overall decrease in spending was a litigation settlement charge of $2.1 million included in general and administrative expenses for the year ended December 31, 2003 related to the conclusion of the Discus arbitration proceedings.

 

Research and development.    Research and development expenses for both the years ended December 31, 2003 and 2002 were $13.1 million. Research and development expenses included the costs associated with software engineering, the cost of designing, developing and testing our products and conducting clinical and post-marketing trials. We expense our research and development costs as they are incurred. Research and development expenses included $3.2 million of stock-based compensation for both the years ended December 31, 2003 and 2002, respectively.

 

Interest and other income (expense), net.    Interest and other income (expense) was ($0.1) million for the year ended December 31, 2003 and $0.1 million for the year ended December 31, 2002. Interest and other expenses increased by $0.2 million for the year ended December 31, 2003 compared to the year ended December 31, 2002. Interest income decreased by $0.4 million for the year ended December 31, 2003 as compared to the year ended December 31, 2002, primarily due to lower interest rates paid on cash, cash equivalent and marketable securities balances. Included in other expense is foreign currency translation gain, which increased $0.4 million for the year ended December 31, 2003 compared to the year ended December 31, 2002.

 

Stock-based compensation.    In connection with the grant of stock options to employees and non-employees prior to 2001, we recorded deferred stock-based compensation as a component of stockholders’ equity. Deferred stock-based compensation for options granted to employees is the difference between the fair value of our common stock on the date such options were granted and their exercise price. For stock options granted to non-employees, the fair value of the options, estimated using the Black-Scholes valuation model, is initially recorded on the date of grant. As the non-employee options vest, we revalue the remaining unvested options, with the change in fair value from period to period represented as a change in deferred compensation. This stock-based compensation is amortized as charges to operations over the vesting periods of the options. For the year ended December 31, 2003 and 2002, we recorded amortization of deferred compensation of $12.8 million and $16.0 million, respectively. Additionally, we recorded expenses of $1.3 million and $2.0 million for the years ended December 31, 2003 and 2002, respectively, related to options granted to non-employees.

 

We have accelerated the vesting of options to several employees in connection with severance packages. This acceleration was accounted for as a charge to the consolidated statements of operations. We recorded charges of $1.0 million and $2.2 million for the years ended December 31, 2003 and 2002, respectively. Each respective charge is equal to the intrinsic value difference between the exercise price of the accelerated options and the fair value of the common stock on the date of acceleration.

 

Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”) which requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. The accounting provisions of SFAS 123(R) are effective for reporting periods

 

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beginning after June 15, 2005. We will adopt SFAS 123(R) effective as of the third quarter of fiscal 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. See Note 2, Stock-based compensation, on page 59 for the pro forma net income and net income per share amounts, for fiscal 2002 through fiscal 2004, as if we had used a fair-value-based method similar to the methods required under SFAS 123(R) to measure compensation expense for employee stock incentive awards. Although we have not yet determined whether the adoption of SFAS 123(R) will result in amounts that are similar to the current pro forma disclosures under SFAS 123, we are evaluating the requirements under SFAS 123(R) and expect the adoption to have a significant adverse impact on our consolidated statements of income and net income per share.

 

Liquidity and Capital Resources

 

Historically, we have funded our operations with the proceeds from the sale of our common and preferred stock and from cash generated from sales of our product. As of December 31, 2004, we had $69.7 million of cash and cash equivalents and $0.3 million of restricted cash. We had an accumulated deficit of $291.8 million as of December 31, 2004.

 

Net cash provided by operating activities totaled $24.6 million and $12.1 million for the years ended December 31, 2004 and 2003, respectively. Net cash provided by operating activities for the year ended December 31, 2004 resulted primarily from operating profit and year over year changes in working capital. For the year ended December 31, 2003, net cash provided by operating activities resulted primarily from increases in accrued liabilities and deferred revenue, partially offset by operating losses.

 

Net cash used in investing activities totaled $6.0 million and $4.3 million for the years ended December 31, 2004 and 2003, respectively. For the year ended December 31, 2004, net cash used in investing activities resulted primarily from the purchase of property and equipment for capacity expansion and manufacturing improvements, including approximately $3.2 million for the implementation of the new version of our enterprise resource planning system and a new software application for our manufacturing process. Partially offsetting these purchases were proceeds from the sale of equipment and maturities of marketable securities during fiscal 2004. For the year ended December 31, 2003, net cash used in investing activities resulted primarily from the purchase of property and equipment for capacity expansion and manufacturing improvements and purchases of marketable securities, partially offset by maturities of marketable securities.

 

Net cash provided by financing activities was $6.1 million and $1.6 million for the years ended December 31, 2004 and 2003, respectively. For the year ended December 31, 2004, net cash provided by financing activities consisted of proceeds from the issuance of common stock, primarily from exercises of employee stock options, partially offset by payments on debt obligations related to the equipment-based term loan and capital lease obligations. For the year ended December 31, 2003, net cash provided by financing activities consisted of proceeds from the issuance of common stock, primarily from exercises of employee stock options, and proceeds from payment on stockholders’ notes receivable, partially offset by payments on debt obligations related to the equipment-based term loan and capital lease obligations.

 

In December 2003 we negotiated a $15.0 million revolving line of credit based on domestic accounts receivable which accrues interest at a rate of 0.5% above prime. Accessing the accounts receivable based revolving line of credit is restricted based on qualifying accounts receivable and compliance with certain loan covenants. We have not drawn down the revolving line of credit.

 

In December 2002, we obtained and accessed a $5.0 million equipment-based term loan, which accrues interest at a rate of 2.25% above prime. We did not drawn down on any new funds in fiscal 2004. As of December 31, 2004, the equipment-based term loan had an outstanding balance of $1.7 million. Principal payments are due in 36 monthly installments beginning in January 2003. Annual principal payment of $1.7 million is due for fiscal 2005.

 

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During the quarter ended December 31, 2004, we determined that we were out of compliance with our loan covenants for the accounts receivable-based revolving line of credit and equipment-based term loan requiring certain financial ratios and measurements to be maintained. The loan covenant requirements were amended as of January 28, 2005. As a result of the amendment, we are in full compliance with our loan covenants for the quarter ended December 31, 2004.

 

Contractual Obligations / Off Balance Sheet Arrangements

 

The impact that our contractual obligations as of December 31, 2004 are expected to have on our liquidity and cash flow in future periods is as follows:

 

     Total

   Payments Due by Period

       

Less than

1 Year


   1-3 Years

   3-5 Years

  

More than

5 Years


     (in thousands)

Equipment-based term loan, including current portion (1)

   $ 1,667    $ 1,667    $ —      $
 

  
   $ —  

Capital lease obligations, including current portion (1)

     187      187      —        —        —  

Operating lease obligations (2)

     5,969      2,736      3,092      141      —  

Computer support services

     613      613      —        —        —  

Manufacturing services

     1,000      1,000      —        —        —  
    

  

  

  

  

Total

   $ 9,436    $ 6,203    $ 3,092    $ 141    $ —  
    

  

  

  

  


(1)   Amounts represent the expected cash payments of our long-term debt and do not include any fair value adjustments.

 

(2)   In February 2005, we renewed our Santa Clara leases under more favorable terms beginning in July 2005. See Note 10—Subsequent Events to the consolidated financial statements.

 

We have no significant contractual obligations not fully recorded on our consolidated balance sheets or fully disclosed in the notes to our consolidated financial statements. We have no off-balance sheet arrangements as defined in the rules and regulations promulgated under the Securities Act.

 

As discussed under “Item 3—Legal Proceedings”, we are currently involved in litigation with OrthoClear, Inc., one of our founders and several former employees. This litigation is in its preliminary stages and it is not yet possible to determine its ultimate outcome. At this time we cannot estimate the impact this litigation may have on our future cash requirements.

 

We expect that our operating expenses will increase commensurate with an overall increase in the level of our business activity, including increased sales and the related costs of products sold, continuing efforts to automate our manufacturing processes, and development and improvements to our product. We also expect operating expenses to increase due to our consumer advertising campaign, dental professional marketing efforts, continued international sales and marketing efforts, increases in the size of our sales force and dental professional training staff, and increases in our research and development expenses as we develop new products and enhancements to Invisalign. In addition, we may use cash to fund acquisitions of complementary businesses or technologies. Our capital requirements depend on market acceptance of our products and our ability to market, sell and support our products on a worldwide basis. We believe that our current cash and cash equivalents will be sufficient to fund our operations for at least the next 12 months. If we are unable to generate adequate operating cash flows, we may need to seek additional sources of capital through equity or debt financing, collaborative or other arrangements with other companies, bank financing and other sources in order to realize our objectives and to continue our operations. There can be no assurance that we will be able to obtain additional debt or equity financing on terms acceptable to us, or at all. If adequate funds are not available, we could be required to delay our efforts to develop new software and increase the automation of our manufacturing process, execute our

 

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consumer marketing campaign and dental professional marketing efforts, develop clinical research and education plans, or to otherwise reduce our expenditures in general. Accordingly, the failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations and financial condition.

 

Critical Accounting Policies

 

Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires our management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, accounts receivable, legal contingencies and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition

 

We recognize revenue in accordance with SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and EITF 00-21. SAB No. 104 requires that four basic criteria must be met before revenue can be recognized: persuasive evidence of an arrangement exists; shipments have occurred; the fee is fixed and determinable; and collectibility is reasonably assured. Determination of whether persuasive evidence of an arrangement exists and whether delivery has occurred or services have been rendered involve management’s judgments based on whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. EITF 00-21 addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

 

Revenue from the sale of Invisalign and ancillary products is recognized upon product shipment, provided that no significant obligations remain, transfer of title has occurred and collection of the receivable is deemed probable. The costs of producing the ClinCheck treatment plan, which are incurred prior to the production of Aligners, are deferred and recognized as related revenues are earned. In certain instances, adjustments to a patient’s teeth are made in the final stages of orthodontic treatment. To make these final adjustments and move a patient’s teeth to the final desired position, dental professionals may elect to use Invisalign as a finishing treatment tool and order newly manufactured Aligners. These newly manufactured Aligners, or “case refinement”, are not provided with the Aligners produced as part of the initial treatment plan and are manufactured only upon the request of the dental professional if final adjustments are desired. Align’s case refinement policy allows doctors to order one case refinement as part of their original lab fee, provided they submit the order prior to the point in time when the case is deemed completed, or the “case expiration”. Prior to our policy change during the fourth quarter of fiscal 2004, we deemed the case expiration date to occur on the 90th day after the expected end of treatment. Under the new policy, the case expiration date is deemed to occur on the 180th day after the expected end of treatment.

 

From June 2001 through April 2003, we offered our dental professionals the opportunity, at the time of the creation of the initial treatment plan, to purchase at a discount a one-time, non-refundable case refinement. Revenue, in the amount of the stand-alone sales price of the undelivered element, is deferred until the earlier of shipment of the case refinement or, if case refinement was never requested, the point in time when the case is deemed completed, or “case expiration”. In cases where the dental professional did not purchase case refinement in advance, case refinement revenues, if any, are recognized when the new Aligners are shipped.

 

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We updated our domestic and international pricing policies in May 2003 and January 2004, respectively, to include the future delivery of one case refinement in the price of each case and to offer additional case refinements at a price of $125 each and at a comparable price internationally, which we believe represents its fair value based on competitive product offerings. Revenue deferrals associated with future case refinement after May 1, 2003 are $125 per case and a comparable price internationally after January 2004. This revenue deferral amount represents the fair value of a case refinement as determined in accordance with EITF 00-21, which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. These revenue deferrals will be recognized when the case refinement has been shipped or upon case expiration, whichever is earliest.

 

Service revenues earned for training of dental professionals and staff for Invisalign are recorded as the services are performed. Service revenues earned under agreements with third parties are based on negotiated rates, which are intended to approximate a mark-up on our anticipated costs.

 

We estimate and record a provision for amounts of estimated losses on sales, if any, in the period such sales occur. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded based upon historical discounts and rebates.

 

Warranty Expense

 

Aligners are subject to the Invisalign product warranty, which covers defects in materials and workmanship. Our materials and workmanship warranty is in force until the Invisalign case in completed. In the event the Aligners fall within the scope of the Invisalign product warranty, we will replace the Aligners at our expense. Our warranty is contingent upon proper use of the Aligners for the purposes for which they are intended. If a patient chooses not to wear the Aligners, and as a result, requests additional Invisalign treatment, the dental professional pays for the additional expense. The Invisalign product warranty does not provide any assurances regarding the outcome of treatment using Invisalign.

 

We generally warrant our products for a specific period of time against material defects. We accrue for estimated warranty costs upon shipment of products. We provide for the estimated future costs of warranty obligations in costs of goods sold when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that we expect to incur to repair or replace product which fails while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information on repair costs. Actual warranty costs could differ from the estimate amounts. On a quarterly basis, we review the accrued balances and update these balances based on historical warranty cost trends. Actual warranty costs incurred have not materially differed from those accrued. If we were required to accrue additional warranty cost in the future, it would negatively affect operating results.

 

Allowance for Doubtful Accounts

 

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. We periodically review these estimated allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance may be required which would negatively impact our operating results.

 

Accounting for long-lived assets

 

We assess the impairment of long-lived assets periodically in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors

 

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that could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the market capitalization relative to net book value. If these factors or their related assumptions change in the future, we may be required to record impairment charges which would negatively impact operating results.

 

Legal contingencies

 

We are currently involved in certain legal proceedings as discussed in Note 4 to our consolidated financial statements. Because of uncertainties related to both the potential amount and range of loss from pending litigation, management is unable to make a reasonable estimate of the liability that could result if there is an unfavorable outcome in these legal proceedings. As additional information becomes available, we will assess the potential liability related to this pending litigation and revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations and financial condition.

 

Deferred Tax Valuation Allowance

 

We have established a full valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

 

While we have considered potential future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the full valuation allowance, in the event that we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase net income in the period such determination was made.

 

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RISK FACTORS

 

We have only recently experienced significant revenue growth and achieved profitability. If we fail to sustain or increase profitability or revenue growth in future periods, the market price of our common stock may decline.

 

You should consider our business and prospects in light of the risks, expenses and difficulties encountered by a company in an early stage of operations. Since inception, we incurred significant operating losses and we have only achieved profitability since the fourth quarter of fiscal 2003. From inception through July 2000, we spent significant funds on organizational and start-up activities, recruiting key managers and employees, developing Invisalign and developing our manufacturing and customer support resources. We also spent significant funds on clinical trials and training programs to train dental professionals in the use of Invisalign.

 

We continue to incur significant operating expenses to:

 

    develop new software and increase the automation of our manufacturing processes;

 

    execute our consumer advertising campaign and dental professional marketing efforts;

 

    increase the size of our sales force and clinical education support staff;

 

    execute clinical research and education plans;

 

    develop technological improvements to our products;

 

    continue our international sales and marketing efforts;

 

    protect our intellectual property; and

 

    undertake quality assurance and improvement initiatives.

 

As noted above, we have only recently achieved profitability, and, as a result, to sustain or increase profitability in future periods, we will need to continue to increase our revenue, while controlling our expenses. We generated positive operating cash flow for the first time during fiscal year 2003, and we cannot be certain that we will be able to sustain or increase such positive cash flow from operations, from period to period, in the future. In fact, for fiscal 2005, we expect to increase our sales and marketing expenses as a result of several factors, including our consumer advertising campaign, dental professional marketing efforts, continued international sales and marketing efforts and increases in the size of our sales force and dental professional training staff. In addition, legal expenses associated with the OrthoClear litigation could result in an additional increase to our general and administrative expenses in fiscal 2005. Furthermore, we expect our cash and cash equivalents to decline in the first quarter of 2005 as we fund these and other business expenditures. Because our business is evolving it is difficult to predict our future operating results or levels of growth, and we may not be able to sustain our historical growth rates in future periods. If we do not sustain or increase profitability or revenue growth or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline.

 

We have a limited operating history and expect our future financial results to fluctuate which may cause volatility in our stock price.

 

We were incorporated in April 1997 and began sales of Invisalign in July 1999. Thus, we have a limited operating history, which makes it difficult to evaluate our future prospects. In addition, we expect our future quarterly and annual operating results to fluctuate as we focus on increasing our commercial sales. These fluctuations could cause our stock price to decline. Some of the factors that could cause our operating results to fluctuate include:

 

    the development and marketing of directly competitive products by potential competitors;

 

    changes in the timing of product orders;

 

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    unanticipated delays in production caused by insufficient capacity, any disruptions in the manufacturing process or the introduction of new production processes;

 

    inaccurate forecasting of revenue, production and other operating costs;

 

    costs and expenditures in connection with ongoing litigation; and

 

    increased expenses resulting from several factors, including increased headcount in our sales and marketing department.

 

To respond to these and other factors, we may need to make business decisions that could adversely affect our operating results. Most of our expenses, such as employee compensation and lease payment obligations, are relatively fixed in the short term. Moreover, our expense levels are based, in part, on our expectations regarding future revenue levels. As a result, if our revenue for a particular period falls below our expectations, we may be unable to adjust spending quickly enough to offset any unexpected shortfall in revenue growth or any decrease in revenue levels.

 

Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. You should not rely on our results for any one quarter as an indication of our future performance.

 

We are currently involved in litigation with several former employees stemming from our efforts to protect our intellectual property. This litigation may be costly and could distract our management and cause a decline in our results of operations and stock price.

 

We seek to diligently protect our intellectual property rights. On February 2, 2005 we filed a complaint against OrthoClear, Inc., OrthoClear Holdings, Inc., one of our founders and several former employees. Among other things, the complaint alleges tort, contract, statutory and common law causes of action arising from OrthoClear and the individual defendants’ alleged plan to unlawfully utilize our intellectual property, confidential information and employees. The complaint also alleges that OrthoClear, Chishti and other defendants are in breach of contractual obligations, statutory law and common law for attempting to intentionally interfere and disrupt our ongoing business operations and improperly gain access to our customer relationships and trade secrets. The complaint seeks injunctive relief and monetary damages in an amount to be determined. On February 15, 2005, OrthoClear, Chishti, Riepenhausen, Breeland, Tunnell, Kawaja and Wen filed a multi-claim Cross-Complaint against Align, Thomas Prescott, Roger George, Eldon Bullington, David Thrower, Patricia Wadors, Gil Laks and Kelsey Wirth alleging conspiracy, breach of contract, libel, slander, unjust enrichment, intentional interference with prospective economic advantage, and unfair competition. Although this lawsuit is in the early stages, litigating claims of this type, whether or not ultimately determined in our favor or settled by us, is costly and diverts the efforts and attention of our management and technical personnel from normal business operations. Any of these results from our litigation could adversely affect our results of operations and stock price.

 

In addition, we are currently a party to various other legal proceedings and claims. Management does not believe that the ultimate outcome of these other legal proceedings and claims will have a material adverse effect on our financial position or results of operations. However, in the Ormco litigation, there is no assurance that the court’s decision will not be overturned on appeal. In addition, litigation is subject to inherent uncertainties and unfavorable rulings could occur. An unfavorable ruling could include monetary damages or, in cases where injunctive relief is sought, an injunction prohibiting us from selling our products. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations of that period or future periods.

 

See Part I Item 3 of this Form 10-K for a summary of our material pending legal proceedings.

 

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Our information technology systems are critical to our business. System integration and implementation issues and system security risks could disrupt our operations, which could have a material adverse impact on our operations, sales and operating results.

 

We rely on the efficient and uninterrupted operation of complex information technology systems. All information technology systems are vulnerable to damage or interruption from a variety of sources. As our business has grown in size and complexity, the growth has placed, and will continue to place, significant demands on our information technology systems. To effectively manage this growth, we will need to continually upgrade and enhance our information systems to more effectively manage our operations.

 

In October 2004, we implemented a new version of our enterprise resource planning system and new software for our manufacturing execution system. Throughout 2005 we will integrate additional functionality into our manufacturing execution system, which will more efficiently integrate this system with our other system applications, such as customer facing and manufacturing tools. System upgrades and enhancements require significant capital expenditures and allocation of valuable employee resources. Delays in integration or disruptions to our business from implementation of these new or upgraded systems could have a material adverse impact on our financial condition and operating results.

 

In addition, experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. Furthermore, sophisticated hardware and operating system software and applications that we either internally produce or procure from third parties may contain defects in design and manufacture, including “bugs” and other problems that can unexpectedly interfere with the operation of the system. The costs to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions that may have a material adverse impact on our operations, sales and operating results.

 

While we believe we currently have adequate internal control over financial reporting, we are required to assess our internal control over financial reporting on an annual basis and any future adverse results from such assessment could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, (“Section 404”) and the rules and regulations promulgated by the SEC to implement Section 404, we are required to furnish a report to include in our Form 10-K an annual report by our management regarding the effectiveness of our internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management.

 

Management’s assessment of internal controls over financial reporting requires management to make subjective judgments and, because this requirement to provide a management report is newly effective, some of our judgments will be in areas that may be open to interpretation. Therefore our management report may be uniquely difficult to prepare and our auditors, who are required to issue an attestation report along with our management’s report, may not agree with management’s assessments. While we currently believe our internal control over financial reporting is effective, the effectiveness of our internal controls to future periods is subject to the risk that our controls may become inadequate because of changes in conditions, and, as a result, the degree of compliance of our internal control over financial reporting with the policies or procedures may deteriorate.

 

If we are unable to assert that our internal control over financial reporting is effective in any future period (or if our auditors are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price.

 

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We depend on the sale of Invisalign for the vast majority of our revenues, and if demand for Invisalign declines or fails to develop as we expect or if dental professionals or consumers do not adopt Invisalign in sufficient numbers or as rapidly as we anticipate, or if orthodontists and GPs do not collaborate as we expect, our revenue will decline.

 

We expect that revenue from the sale of Invisalign will continue to account for a substantial portion of our total revenue for the foreseeable future. Continued and widespread market acceptance of Invisalign by both dental professionals and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services or consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, or if orthodontists and GPs do not collaborate as we expect, our operating results could be harmed. Factors that could cause Invisalign not achieve market acceptance at the rate at which we expect, or at all, are described more fully below.

 

Dental professionals may not adopt Invisalign in sufficient numbers or as rapidly as we anticipate.

 

Our success depends upon increasing acceptance of Invisalign by dental professionals. Invisalign requires dental professionals and their staff to undergo special training and learn to interact with patients in new ways. In addition, because Invisalign has only been in clinical testing since July 1997 and commercially available only since July 1999, dental professionals may be reluctant to adopt it until more historical clinical results are available. Also, increasing adoption and cumulative use by dental professionals will depend on factors such as the capability, safety, efficacy, ease of use, price, quality and reliability of our products and our provision of effective sales support, training and service. In the future, unanticipated poor clinical performance of Invisalign could result in significant adverse publicity and, consequently, reduced acceptance by dental professionals. If Invisalign does not achieve growing acceptance in the orthodontic and GP communities, our operating results will be harmed.

 

Consumers may not adopt Invisalign in sufficient numbers or as rapidly as we anticipate.

 

In addition, our success depends upon the acceptance of Invisalign by a substantially larger number of dental professionals as well as potential patients to whom we are now actively marketing. Invisalign represents a significant change from traditional orthodontic treatment, and patients may be reluctant to accept it or may not find it preferable to conventional treatment. In addition, patients may not comply with recommended treatment guidelines for Invisalign, which could compromise the effectiveness of their treatment. We have generally received positive feedback from both dental professionals and patients regarding Invisalign as both an alternative to braces and as a clinical method for treatment of malocclusion, but a number of dental professionals believe that Invisalign is appropriate for only a limited percentage of their patients. Market acceptance will depend in part upon the recommendations of dental professionals, as well as other factors including effectiveness, safety, reliability, improved treatment aesthetics and greater comfort and hygiene compared to conventional orthodontic products. Furthermore, consumers may not respond to our direct marketing campaigns or we may be unsuccessful in reaching our target audience. Adoption by consumers may also be impacted by general macroeconomic conditions in North America and internationally, which fluctuate and could be affected by unstable global economic, political or other conditions.

 

The orthodontist and GPs may choose not to collaborate and referrals between orthodontists and GPs may not increase at the rate that we anticipate or at all.

 

Our success depends in part upon improving the collaboration and referral relationships between orthodontists and GP dentists. Although orthodontists have historically generated a majority of our revenues, there exists a significantly greater number of general practitioners in North America than orthodontists and we expect to generate the majority of our revenue from GPs in 2005. As the primary care dental provider, GPs have access to a greater number of patients than orthodontists, possess a unique opportunity to educate these patients and introduce them to Invisalign, have the ability to refer appropriate cases to orthodontists and, in certain instances, may chose to treat less complex cases themselves. If this collaboration and increase in referrals does not occur or occurs more slowly than we anticipate, our operating results could be harmed.

 

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We are dependent on our international manufacturing operations, which exposes us to foreign operational, political and other risks that may harm our business.

 

Currently, two of our key production steps are performed in operations located outside of the U.S. At our facility in Costa Rica, technicians use a sophisticated, internally developed computer-modeling program to prepare electronic treatment plans, which are transmitted electronically back to the U.S. These electronic files form the basis of our ClinCheck product and are used to manufacture Aligner molds. A third party manufacturer in Mexico fabricates Aligners and ships the completed products to our customers. Our costs associated with these operations are denominated in Costa Rican colons, Mexican pesos and U.S. dollars.

 

Our reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:

 

    political, social and economic instability;

 

    acts of terrorism and acts of war;

 

    difficulties in staffing and managing international operations; import and export license requirements and restrictions;

 

    controlling quality of the manufacturing process;

 

    interruptions and limitations in telecommunication services;

 

    product or material transportation delays or disruption;

 

    burdens of complying with a wide variety of local country and regional laws;

 

    trade restrictions and changes in tariffs;

 

    fluctuations in currency exchange rates; and

 

    potential adverse tax consequences.

 

If any of these risks materialize in the future, our operating results may be harmed.

 

Our success depends in part on our proprietary technology and if we are unable to successfully enforce our intellectual property rights, our competitive position may be harmed.

 

Our success will depend in part on our ability to maintain existing intellectual property and to obtain and maintain further intellectual property protection for our products, both in the U.S. and in other countries. Our inability to do so could harm our competitive position. As of December 31, 2004, we had 56 issued U.S. patents, 82 pending U.S. patent applications, and numerous foreign issued patents, as well as pending foreign patent applications.

 

We intend to rely on our portfolio of issued and pending patent applications in the U.S. and in other countries to protect a large part of our intellectual property and our competitive position. However, our currently pending or future patent filings may not result in the issuance of patents. Additionally, any patents issued to us may be challenged, invalidated, held unenforceable, circumvented, or may not be sufficiently broad to prevent third parties from producing competing products similar in design to our products. In addition, any protection afforded by foreign patents may be more limited than that provided under U.S. patents and intellectual property laws. We also rely on protection of our copyrights, trade secrets, know-how and proprietary information. We generally enter into confidentiality agreements with our employees, consultants and our collaborative partners upon commencement of a relationship with us. However, these agreements may not provide meaningful protection against the unauthorized use or disclosure of our trade secrets or other confidential information, and adequate remedies may not exist if unauthorized use or disclosure were to occur. See Part I Item 3 of this Form 10-K for a summary of the OrthoClear litigation. Our inability to maintain the proprietary nature of our

 

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technology through patents, copyrights or trade secrets would impair our competitive advantages and could have a material adverse effect on our operating results, financial condition and future growth prospects. In particular, a failure of our proprietary rights might allow competitors to copy our technology, which could adversely affect our pricing and market share.

 

If we infringe the patents or proprietary rights of other parties or are subject to a patent infringement claim, our ability to grow our business will be severely limited.

 

Extensive litigation over patents and other intellectual property rights is common in the medical device industry. We have been sued for infringement of third party’s patents in the past and, while these actions have been dismissed, we may be the subject of patent or other litigation in the future.

 

From time to time, we have received and may in the future receive letters from third parties drawing our attention to their patent rights. While we do not believe that we infringe upon any valid and enforceable rights that have been brought to our attention, there may be other more pertinent rights of which we are presently unaware. The defense and prosecution of intellectual property suits, interference proceedings and related legal and administrative proceedings could result in substantial expense to us and significant diversion of effort by our technical and management personnel. An adverse determination of any litigation or interference proceeding to which we may become a party could subject us to significant liabilities. An adverse determination of this nature could also put our patents at risk of being invalidated or interpreted narrowly or require us to seek licenses from third parties. Licenses may not be available on commercially reasonable terms or at all, in which event, our business would be materially adversely affected.

 

See Part I Item 3 of this Form 10-K for a summary of our material pending legal proceedings.

 

We currently rely on third parties to provide key inputs to our manufacturing process, and if our access to these inputs is diminished, our business may be harmed.

 

We currently outsource key portions of our manufacturing process. We rely on a third party manufacturer in Mexico to fabricate Aligners and to ship the completed product to customers. As a result, if this third party manufacturer fails to deliver its components or if we lose its services, we may be unable to deliver our products in a timely manner and our business may be harmed. Any difficulties encountered by the third party manufacturer with respect to hiring personnel, and maintaining acceptable manufacturing standards, controls, procedures and policies could disrupt our ability to deliver our products in a timely manner. Finding a substitute manufacturer may be expensive, time-consuming or impossible.

 

In addition, we are highly dependent on manufacturers of specialized scanning equipment, rapid prototyping machines, resin and other advanced materials. We maintain single supply relationships for many of these machines and materials technologies. Our growth may exceed the capacity of one or more of these manufacturers to produce the needed equipment and materials in sufficient quantities to support our growth. In the event of delivery delays or shortages of these items, our business and growth prospects may be harmed.

 

We have experienced rapid growth, and our failure to manage this growth could harm our business.

 

We have expanded rapidly since we commenced commercial sales in 1999. Our headcount increased from approximately 50 employees as of December 31, 1999 to approximately 969 employees as of December 31, 2004. This expansion will continue to place significant demands on our management and other resources and will require us to continue to develop and improve our operational, financial and other internal controls, both in the U.S. and internationally. In particular, rapid growth increases the challenges involved in a number of areas, including recruiting and retaining sufficient skilled personnel, providing adequate training and supervision to maintain our high quality standards, and preserving our culture and values. Our inability to effectively manage this level of growth could harm our business.

 

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If we lose our key personnel or are unable to attract and retain key personnel, we may be unable to pursue business opportunities or develop our products.

 

We are highly dependent on the key employees in our clinical engineering, technology development, sales and marketing personnel and management teams. The loss of the services of those individuals may significantly delay or prevent the achievement of our product development and other business objectives and could harm our business. Our future success will also depend on our ability to identify, recruit, train and retain additional qualified personnel, including orthodontists. Few orthodontists are accustomed to working in a manufacturing environment since they are generally trained to work in private practices, universities and other research institutions. Thus, we may be unable to attract and retain personnel with the advanced qualifications necessary for the further development of our business. Furthermore, we may not be successful in retaining our key personnel or their services. If we are unable to attract and retain key personnel, our business could be materially harmed.

 

We experience competition from manufacturers of traditional braces and expect aggressive competition from these and other companies who may introduce new technologies in the future.

 

Currently, our Invisalign product competes directly against a product called Red, White and Blue, which is manufactured and distributed by Ormco, a subsidiary of Sybron Dental Specialties. In addition, manufacturers of traditional braces, such as 3M Company, Sybron Dental Specialties and Dentsply International have substantially greater financial resources and manufacturing and marketing experience than we do and may, in the future, attempt to develop an orthodontic system similar to ours. Large consumer product companies may also enter the orthodontic supply market. Furthermore, we may face competition in the future from new companies that may introduce new technologies. We may be unable to compete with these competitors and one or more of these competitors may render our technology obsolete or economically unattractive. If we are unable to compete effectively with existing products or respond effectively to any products developed by new or existing competitors, our business could be harmed. For instance, on February 2, 2005 we filed a lawsuit against OrthoClear, Inc., OrthoClear Holdings, Inc., Zia Chishti and several former employees. We believe that OrthoClear intends to introduce and market a competitive product into the market place. Although we intend to vigorously defend our intellectual property rights and prevent OrthoClear from releasing any product that infringes on our intellectual property, if OrthoClear is ultimately successful in entering the market with a competitive product, our business could be harmed.

 

Complying with regulations enforced by the Food and Drug Administration (FDA) and other regulatory authorities is an expensive and time-consuming process, and any failure to comply could result in substantial penalties.

 

Our products are medical devices and are subject to extensive regulation in the U.S. and internationally. FDA regulations are wide ranging and govern, among other things:

 

    product design, development, manufacture and testing;

 

    product labeling;

 

    product storage;

 

    pre-market clearance or approval;

 

    advertising and promotion; and

 

    product sales and distribution.

 

Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:

 

    Warning letters, fines, injunctions, consent decrees and civil penalties;

 

    Repair, replacement, refunds, recall or seizure of our products;

 

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    Operating restrictions or partial suspension or total shutdown of production;

 

    Refusing our requests for 510(k) clearance or premarket approval of new products, new intended uses, or modifications to existing products;

 

    Withdrawing clearance or premarket approvals that have already been granted; and

 

    Criminal prosecution.

 

If any of these events were to occur, they could harm our business.

 

We must comply with facility registration and product listing requirements of the FDA and adhere to applicable Quality System regulations. The FDA enforces its Quality System regulations through periodic unannounced inspections. We have not yet been subject to an FDA inspection, and we cannot assure you we will successfully pass such an inspection in the future. Our failure to take satisfactory corrective action in response to an adverse inspection or our failure to comply with applicable manufacturing regulations could result in enforcement action, and we may be required to find alternative manufacturers, which could be a long and costly process.

 

Before we can sell a new medical device in the U.S., or market a new use of or claim for an existing product we must obtain FDA clearance or approval, unless an exemption applies. Obtaining regulatory clearances or approvals can be a lengthy and time-consuming process. Even though the devices we market have obtained the necessary clearances from the FDA, we may be unable to maintain such clearances in the future. Furthermore, we may be unable to obtain the necessary clearances for new devices that we intend to market in the future. Our inability to maintain or obtain regulatory clearances or approvals could materially harm our business.

 

If the security of our customer and patient information is compromised, patient care could suffer, and we could be liable for related damages, and our reputation could be impaired.

 

We retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that our facilities and infrastructure are perceived by the marketplace and our customers to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. If we fail to meet our clients’ expectations regarding the security of healthcare information, we could be liable for damages and our reputation could be impaired. In addition, patient care could suffer and we could be liable if our systems fail to deliver correct information in a timely manner. Our insurance may not protect us from this risk.

 

If compliance with healthcare regulations becomes costly and difficult for our customers or for us, we may not be able to grow our business.

 

Participants in the healthcare industry are subject to extensive and frequently changing regulations under numerous laws administered by governmental entities at the federal, state and local levels, some of which are, and others of which may be, applicable to our business. Furthermore, our healthcare provider customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

 

The healthcare market itself is highly regulated and subject to changing political, economic and regulatory influences. Regulations implemented pursuant to the Health Insurance Portability and Accountability Act (HIPAA), including regulations affecting the security and privacy of patient healthcare information held by healthcare providers and the business associates may require us to make significant and unplanned enhancements of software applications or services, result in delays or cancellations of orders, or result in the revocation of endorsement of our products and services by healthcare participants. The affect of HIPAA and newly enacted regulations on our business is difficult to predict, and there can be no assurance that we will adequately address

 

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the business risks created by HIPAA and its implementation or that we will be able to take advantage of any resulting business opportunities. Additionally, the HIPAA Security Standard, which goes into effect in April 2005, requires that we implement safeguards that reasonably and appropriately protect the confidentiality, integrity and availability of the electronic protected health information that we create, receive, maintain or transmit pursuant to our Business Associate Agreements with healthcare professionals. Compliance with the Security Standard could require complex changes in our internal systems and services and could be costly.

 

Extensive and changing government regulation of the healthcare industry may be expensive to comply with and exposes us to the risk of substantial government penalties.

 

In addition to medical device laws and regulations, numerous state and federal healthcare-related laws regulate our business, covering areas such as:

 

    storage, transmission and disclosure of medical information and healthcare records;

 

    prohibitions against the offer, payment or receipt of remuneration to induce referrals to entities providing healthcare services or goods; and

 

    the marketing and advertising of our products.

 

Complying with these laws and regulations could be expensive and time-consuming, and could increase our operating costs or reduce or eliminate certain of our sales and marketing activities or our revenues.

 

We face risks related to our international sales, including the need to obtain necessary foreign regulatory clearance or approvals.

 

We currently sell our products in Europe, Canada, the United Kingdom, Mexico, Brazil, Australia and Hong Kong, and may expand into other countries from time to time. We do not know whether orthodontists, dentists and consumers outside our domestic market will adopt Invisalign in sufficient numbers or as rapidly as we anticipate. In addition, sales of our products outside the U.S. are subject to foreign regulatory requirements that vary widely from country to country. The time required to obtain clearances or approvals required by other countries may be longer than that required for FDA clearance or approval, and requirements for such approvals may differ from FDA requirements. We may be unable to obtain regulatory approvals in one or more of the other countries in which we do business or in which we may do business in the future. We may also incur significant costs in attempting to obtain and maintain foreign regulatory approvals. If we experience delays in receipt of approvals to market our products outside of the U.S., if we fail to receive these approvals, we may be unable to market our products or enhancements in international markets in a timely manner, if at all.

 

Our business exposes us to potential product liability claims, and we may incur substantial expenses if we are subject to product liability claims or litigation.

 

Medical devices involve an inherent risk of product liability claims and associated adverse publicity. We may be held liable if any product we develop or any product that uses or incorporates any of our technologies causes injury or is otherwise found unsuitable. Although we intend to continue to maintain product liability insurance, adequate insurance may not be available on acceptable terms, if at all, and may not provide adequate coverage against potential liabilities. A product liability claim, regardless of its merit or eventual outcome, could result in significant legal defense costs. These costs would have the effect of increasing our expenses and diverting management’s attention away from the operation of our business, and could harm our business.

 

In fiscal 2004, the market price for our common stock was volatile.

 

The market price of our common stock could be subject to wide price fluctuations in response to various factors, many of which are beyond our control. The factors include:

 

    quarterly variations in our results of operations and liquidity;

 

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    changes in recommendations by the investment community or in their estimates of our revenues or operating results;

 

    speculation in the press or investment community concerning our business and results of operations;

 

    strategic actions by our competitors, such as product announcements or acquisitions;

 

    announcements of technological innovations or new products by us, our customers or competitors; and

 

    general market conditions.

 

In addition, the stock market in general, and the market for technology and medical device companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated to or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. In the past, class action litigation has often been brought against the issuing company following periods of volatility in the market price of a company’s securities. If a securities class action suit is filed against us in the future, we would incur substantial legal fees, and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.

 

Future sales of significant amounts of our common stock may depress our stock price.

 

A large percentage of our outstanding common stock is currently owned by a small number of significant stockholders. These stockholders have sold in the past, and may sell in the future, large amounts of common stock over relatively short periods of time. Sales of substantial amounts of our common stock in the public market by our existing stockholders may adversely affect the market price of our common stock. Such sales could create public perception of difficulties or problems with our business and may depress our stock price.

 

Changes in, or interpretations of, accounting rules and regulations, such as expensing of stock options, could result in unfavorable accounting charges.

 

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. Our accounting policies that recently have been or may be affected by changes in the accounting rules are as follows:

 

    revenue recognition;

 

    accounting for share-based payments; and

 

    accounting for income taxes.

 

In particular, the FASB recently enacted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”) which we will adopt effective the third quarter fiscal 2005. As a result, we expect that SFAS 123R will have a significant adverse effect on our reported financial results and may impact the way in which we conduct our business.

 

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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Quantitative Disclosures

 

We are exposed to market risks inherent in our operations, primarily related to interest rate risk and currency risk. These risks arise from transactions and operations entered into in the normal course of business. We do not use derivatives to alter the interest characteristics of our marketable securities or our debt instruments. We have no holdings of derivative or commodity instruments.

 

Interest Rate Risk.    We are subject to interest rate risks on cash and cash equivalents, available-for-sale marketable securities, existing long-term debts and any future financing requirements. Interest rate risks related to marketable securities are managed by monitoring maturities in our marketable securities portfolio. Our long-term debt at December 31, 2004 consists of outstanding balances on capital lease obligations of $0.2 million and a $1.7 million equipment-based term loan.

 

The fair value of our investment portfolio or related income would not be significantly impacted by changes in interest rates since the marketable securities maturities do not exceed fiscal year 2004 and the interest rates are primarily fixed. Our capital lease obligations of $0.2 million at December 31, 2004 carry fixed interest rates of 6.53% and 11.15% per annum, with principal payments due in 60 and 48 monthly installments, respectively, which began in 2000.

 

In December 2002, we obtained a $5.0 million equipment-based term loan which accrues interest at a rate of 2.25% above prime. In December 2002 we had drawn down $5.0 million from the equipment-based term loan. Principal payments are due in 36 monthly installments which began in January 2003.

 

The following table presents the future principal cash flows or amounts and related weighted average interest rates expected by year for our existing cash and cash equivalents, marketable securities and long-term debt instruments:

 

     Expected Maturity Date (as of December 31, 2004)

     2005

    2006

   2007

   2008

   2009

   Total

   Fair
Value


     (in thousands)

ASSETS:

                                                 

Cash and cash equivalents

   $ 69,659     $ —      $ —      $ —      $ —      $ 69,659    $ 69,659

Short-term marketable securities

     —         —        —        —        —        —        —  

Weighted average interest rate

     —         —        —        —        —        —        —  

LIABILITIES:

                                                 

Equipment-based term loan

   $ 1,667       —      $ —      $ —      $ —      $ 1,667    $ 1,667

Fixed rate debt lease obligation

     182       —        —        —        —        182      182

Weighted average interest rate

     6.5 %     —        —        —        —        —        —  

 

Qualitative Disclosures

 

Interest Rate Risk.    Our primary interest rate risk exposures relate to:

 

    A decrease in the value of available-for-sale securities if market interest rates increase;

 

    Our ability to pay long-term debts at maturity; and

 

    The impact of interest rate movements on our ability to obtain adequate financing to fund future operations.

 

We have the ability to hold at least a portion of the fixed income investments until maturity. As a result, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates on our short- and long-term marketable securities portfolio.

 

We manage interest rate risk on our outstanding long-term debts through the use of fixed rate debt. Management evaluates our financial position on an ongoing basis.

 

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Currency Rate Risk.    Our primary currency rate risk exposures relate to our decentralized or outsourced operations, whereby approximately $15.6 million of our annual expenses are related to operations outside the United States, denominated in currencies other than the U.S. dollar.

 

We do not hedge any balance sheet exposures or intercompany balances against future movements in foreign exchange rates. The exposure related to currency rate movements would not likely have a material impact on future net income or cash flows for the foreseeable future.

 

ITEM 8.    CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 

Quarterly Results of Operations

 

    Three Months Ended

 
    2004

  2003

 
    Dec. 31 (1)

  Sep. 30

  June 30

  March 31

  Dec. 31

  Sep. 30

    June 30

    March 31

 
   

(in thousands, except per share data)

(unaudited)

 

Revenues

  $ 43,655   $ 45,766   $ 44,204   $ 39,205   $ 36,502   $ 34,038     $ 29,225     $ 22,960  

Gross profit

    28,694     30,844     29,954     25,812     23,576     20,592       15,956       11,036  

Operating profit (loss)

    656     3,851     4,341     917     470     (1,748 )     (8,186 )     (10,473 )

Net profit (loss)

    1,121     3,318     3,772     557     452     (2,144 )     (7,759 )     (10,671 )

Net profit (loss) available to common stockholders

  $ 1,121   $ 3,318   $ 3,772   $ 557   $ 452   $ (2,144 )   $ (7,759 )   $ (10,671 )

Net profit (loss) per share available to common stock-holders, basic

  $ 0.02   $ 0.06   $ 0.06   $ 0.01   $ 0.01   $ (0.04 )   $ (0.13 )   $ (0.19 )

Shares used in computing per share amounts, basic

    60,744     60,319     59,692     59,091     58,398     57,948       57,489       57,189  

Net profit (loss) per share available to common stock-holders, diluted

  $ 0.02   $ 0.05   $ 0.06   $ 0.01   $ 0.01   $ (0.04 )   $ (0.13 )   $ (0.19 )

Shares used in computing per share amounts, diluted

    63,560     64,055     64,461     64,559     63,704     57,948       57,489       57,189  

(1)   Reflects an increase to cost of revenues and a decrease to net profit of $383,000 as compared to the results for the fourth quarter and year ended December 31, 2004 that we announced on January 26, 2005 and included in our financial statements filed with our Form 8-K for the fourth quarter and year ended December 31, 2004. The $383,000 increase to cost of revenues reflects asset impairment charges identified by management against manufacturing fixed assets at our international manufacturing facility. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview.

 

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REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER

FINANCIAL REPORTING

 

Management of Align is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Align’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. Internal control over financial reporting includes those policies and procedures that:

 

    pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

 

    provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

 

    provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the consolidated financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of Align’s internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

Based on its assessment and those criteria, management concluded that Align maintained effective internal control over financial reporting as of December 31, 2004.

 

Our management’s assessment of the effectiveness of Align’s internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as indicated in their report which appears immediately after this report.

 

/s/    THOMAS M. PRESCOTT        


Thomas M. Prescott

President and Chief Executive Officer

 

March 3, 2005

 

/s/    ELDON M. BULLINGTON        


Eldon M. Bullington

Vice President, Finance and Chief Financial Officer

 

March 3, 2005

 

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ALIGN TECHNOLOGY, INC. AND SUBSIDIARIES

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   48

Consolidated Balance Sheets

   50

Consolidated Statements of Operations

   51

Consolidated Statements of Shareholders’ Equity

   52

Consolidated Statements of Cash Flows

   53

Notes to Consolidated Financial Statements

   54

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Stockholders and Board of Directors of Align Technology, Inc. and subsidiaries:

 

We have completed an integrated audit of Align Technology, Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements and financial statement schedule

 

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the financial position of Align Technology, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)2 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing immediately above this report, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail,

 

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accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

PRICEWATERHOUSECOOPERS LLP

 

San Jose, California

March 3, 2005

 

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ALIGN TECHNOLOGY, INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

    December 31,

 
    2004

    2003

 

ASSETS

               

Current assets:

               

Cash and cash equivalents

  $ 69,659     $ 44,939  

Restricted cash

    303       439  

Marketable securities, short-term

    —         2,292  

Accounts receivable, net of allowance for doubtful accounts of $1,493 and $1,259 at December 31, 2004 and 2003, respectively

    28,809       21,265  

Inventories, net

    2,852       2,334  

Prepaid expenses

    4,219       4,097  

Other current assets

    992       1,748  
   


 


Total current assets

    106,834       77,114  

Property and equipment, net

    21,702       23,121  

Other assets

    2,176       1,967  
   


 


Total assets

  $ 130,712     $ 102,202  
   


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

               

Current liabilities:

               

Accounts payable

  $ 3,361     $ 3,095  

Accrued liabilities

    23,481       19,180  

Deferred revenue

    16,257       13,113  

Current portion of equipment-based term loan

    1,667       1,667  

Capital lease obligations

    182       322  
   


 


Total current liabilities

    44,948       37,377  

Equipment-based term loan, net of current portion

    —         1,667  

Other long term liabilities

    25       182  
   


 


Total liabilities

    44,973       39,226  
   


 


Commitments and contingencies (Note 4)

               

Stockholders’ equity:

               

Preferred stock, $0.0001 par value; Authorized: 5,000 shares at December 2004 and 2003; Issued and Outstanding: no shares at December 31, 2004 and 2003

    —         —    

Common stock, $0.0001 par value, Authorized: 200,000 shares at December 31, 2004 and 2003; Issued: 60,916 and 58,793 shares at December 31, 2004 and 2003, respectively; Outstanding: 60,876 and 58,753 shares at December 31, 2004 and 2003, respectively

    6       6  

Additional paid-in capital

    377,559       368,796  

Deferred stock-based compensation

    —         (5,219 )

Notes receivable from stockholders

    —         (17 )

Accumulated other comprehensive income (loss)

    (2 )     2  

Accumulated deficit

    (291,824 )     (300,592 )
   


 


Total stockholders’ equity

    85,739       62,976  
   


 


Total liabilities and stockholders’ equity

  $ 130,712     $ 102,202  
   


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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ALIGN TECHNOLOGY, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

Revenues:

                        

Invisalign

   $ 164,536     $ 115,278     $ 63,690  

Ancillary products and other services

     8,294       7,447       6,008  
    


 


 


Total revenues

     172,830       122,725       69,698  
    


 


 


Cost of revenues:

                        

Invisalign

     49,019       43,990       37,089  

Ancillary products and other services

     8,507       7,575       7,902  
    


 


 


Total cost of revenues

     57,526       51,565       44,991  
    


 


 


Gross profit

     115,304       71,160       24,707  
    


 


 


Operating expenses:

                        

Sales and marketing

     55,932       43,689       45,313  

General and administrative

     33,851       34,296       39,265  

Research and development

     15,756       13,112       13,064  
    


 


 


Total operating expenses

     105,539       91,097       97,642  
    


 


 


Profit (loss) from operations

     9,765       (19,937 )     (72,935 )

Interest income

     713       531       979  

Interest expense

     (271 )     (364 )     (162 )

Other expense

     (445 )     (268 )     (701 )
    


 


 


Net profit (loss) before provision for income taxes

     9,762       (20,038 )     (72,819 )

Provision for income taxes

     994       84       —    
    


 


 


Net profit (loss)

   $ 8,768     $ (20,122 )   $ (72,819 )
    


 


 


Net profit (loss) per share available to common stockholders, basic

   $ 0.15     $ (0.35 )   $ (1.52 )
    


 


 


Shares used in computing net profit (loss) per share, basic

     59,963       57,758       47,878  
    


 


 


Net profit (loss) per share, diluted

   $ 0.14     $ (0.35 )   $ (1.52 )
    


 


 


Shares used in computing net profit (loss) per share, diluted

     64,089       57,758       47,878  
    


 


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

For the years ended December 31, 2004, 2003 and 2002

(in thousands)

 

    Common Stock

  Additional
Paid-In
Capital


    Deferred
Stock-Based
Compensation


    Notes
Receivable
from
Stockholders


    Accumulated
Other
Comprehensive
Income (Loss)


    Accumulated
Deficit


    Total

 
    Shares

    Amount

           

Balances at December 31, 2001

  47,771       5     355,055       (48,324 )     (1,484 )     226       (207,651 )     97,827  

Net loss

  —         —       —         —         —         —         (72,819 )     (72,819 )

Net change in unrealized loss from available-for-sale securities

  —         —       —         —         —         (209 )     —         (209 )
                                                       


Comprehensive loss,

                                                        (73,028 )
                                                       


Sale of common stock upon the completion of private stock offering, net of issuance costs of $54

  9,579       1     18,145       —         —         —         —         18,146  

Issuance of common stock relating to employee stock purchase plan

  163       —       480       —         —         —         —         480  

Issuance of common stock upon exercise of stock options

  670       —       625       —         (3 )     —         —         622  

Repurchase of common stock contributed to the treasury

  (40 )     —       (170 )     —         —         —         —         (170 )

Repurchase of common stock

  (443 )     —       (410 )     —         263       —         —         (147 )

Payments on stockholder notes receivable

  —         —       —         —         401       —         —         401  

Interest accrued on stockholder notes receivable

  —         —       —         —         (69 )     —         —         (69 )

Cancellations, net of deferred stock compensation

  —         —       (13,289 )     12,735       —         —         —         (554 )

Amortization of deferred stock compensation

  —         —       —         16,584       —         —         —         16,584  

Charge for compensation expense on non-employee stock options

  —         —       2,010       —         —         —         —         2,010  

Charge for accelerated vesting of employee stock options

  —         —       2,245       —         —         —         —         2,245  
   

 

 


 


 


 


 


 


Balances at December 31, 2002

  57,700       6     364,691       (19,005 )     (892 )     17       (280,470 )     64,347  

Net loss

  —         —       —         —         —         —         (20,122 )     (20,122 )

Net change in unrealized loss from available-for-sale securities

  —         —       —         —         —         (15 )     —         (15 )
                                                       


Comprehensive loss

                                                        (20,137 )
                                                       


Issuance of common stock relating to employee stock purchase plan

  194       —       434       —         —         —         —         434  

Issuance of common stock upon exercise of stock options

  879       —       2,446       —         —         —         —         2,446  

Repurchase of common stock

  (20 )     —       (20 )     —         —         —         —         (20 )

Payments on stockholder notes receivable

  —         —       —         —         921       —         —         921  

Interest accrued on stockholder notes receivable

  —         —       —         —         (46 )     —         —         (46 )

Cancellations, net of deferred stock compensation

  —         —       (990 )     990       —         —         —         —    

Amortization of deferred stock compensation

  —         —       —         12,796       —         —         —         12,796  

Charge for compensation expense on non-employee stock options

  —         —       1,276       —         —         —         —         1,276  

Charge for accelerated vesting of employee stock options

  —         —       959       —         —         —         —         959  
   

 

 


 


 


 


 


 


Balances at December 31, 2003

  58,753     $ 6   $ 368,796     $ (5,219 )   $ (17 )   $ 2     $ (300,592 )   $ 62,976  

Net profit

  —         —       —         —         —         —         8,768       8,768  

Net change in unrealized loss from available-for-sale securities

  —         —       —         —         —         (4 )     —         (4 )
                                                       


Comprehensive net income

                                                        8,764  
                                                       


Issuance of common stock relating to employee stock purchase plan

  429       —       1,726       —         —         —         —         1,726  

Issuance of common stock upon exercise of stock options

  1,695       —       6,389       —         —         —         —         6,389  

Repurchase of common stock

  (1 )     —       (1 )     —         —         —         —         (1 )

Payments on stockholder notes receivable

  —         —       —         —         17       —         —         17  

Cancellations, net of deferred stock compensation

  —         —       (130 )     130       —         —         —         —    

Amortization of deferred stock compensation

  —         —       —         5,089       —         —         —         5,089  

Charge for compensation expense on non-employee stock options

  —         —       429       —         —         —         —         429  

Charge for accelerated vesting of employee stock options

  —         —       350       —         —         —         —         350  
   

 

 


 


 


 


 


 


Balances at December 31, 2004

  60,876     $ 6   $ 377,559     $ —       $ —       $ (2 )   $ (291,824 )   $ 85,739  
   

 

 


 


 


 


 


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

CASH FLOWS FROM OPERATING ACTIVITIES:

                        

Net profit (loss)

   $ 8,768     $ (20,122 )   $ (72,819 )

Adjustments to reconcile net profit (loss) to net cash provided by (used in) operating activities:

                        

Depreciation and amortization

     9,597       9,119       13,051  

Amortization of deferred stock-based compensation

     5,089       12,796       16,030  

Compensation expense for accelerated vesting of stock options

     350       959       2,245  

Stock-based compensation

     429       1,276       2,010  

Loss on retirement, disposal and impairment of fixed assets

     70       279       2,052  

Provision for doubtful accounts

     541       (86 )     229  

Non-cash interest income on notes receivable from stockholders

     —         (46 )     (69 )

Non-cash accretion on marketable securities

     (4 )     1       98  

Allowance for excess and obsolete inventory

     (210 )     (216 )     (86 )

Changes in operating assets and liabilities:

                        

Accounts receivable

     (8,085 )     (4,413 )     (5,439 )

Inventories

     (308 )     554       (323 )

Prepaid expenses and other current assets

     634       (940 )     (891 )

Accounts payable

     221       (246 )     (2,450 )

Accrued and other long term liabilities

     4,326       9,497       (313 )

Deferred revenue

     3,144       3,710       6,276  
    


 


 


Net cash provided by (used in) operating activities

     24,562       12,122       (40,399 )
    


 


 


CASH FLOWS FROM INVESTING ACTIVITIES:

                        

Purchase of property and equipment

     (9,061 )     (7,585 )     (8,112 )

Proceeds from sale of property and equipment

     858       65       —    

Restricted cash

     136       2,822       (2,538 )

Purchase of marketable securities

     (519 )     (7,684 )     (1,972 )

Maturities of marketable securities

     2,811       8,069       14,093  

Other assets

     (209 )     (21 )     41  
    


 


 


Net cash (used in) provided by investing activities

     (5,984 )     (4,334 )     1,512  
    


 


 


CASH FLOWS FROM FINANCING ACTIVITIES:

                        

Proceeds from issuance of common stock

     8,115       2,880       19,248  

Proceeds from payment on stockholders’ notes receivable

     17       921       401  

Repurchase of common stock

     (1 )     (20 )     (317 )

Proceeds from draw down of line of credit

     —         —         5,000  

Payments on line of credit

     (1,667 )     (1,666 )     —    

Payments on capital lease obligations

     (322 )     (516 )     (443 )
    


 


 


Net cash provided by financing activities

     6,142       1,599       23,889  
    


 


 


Net increase (decrease) in cash and cash equivalents

     24,720       9,387       (14,998 )

Cash and cash equivalents, beginning of year

     44,939       35,552       50,550  
    


 


 


Cash and cash equivalents, end of year

   $ 69,659     $ 44,939     $ 35,552  
    


 


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1    Organization

 

Formation and business of the Company

 

The Company was incorporated in April 1997 and is engaged in the development, manufacturing and marketing of Invisalign, used for treating malocclusion, or the misalignment of teeth. Invisalign uses a series of clear plastic “Aligners” to move the patients’ teeth in small increments from their original state to a final treated state. The Company began commercial operations in July 2000.

 

Note 2    Summary of Significant Accounting Policies

 

Basis of consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions have been eliminated in consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially and adversely from those estimates.

 

Fair value of financial instruments

 

The carrying amounts of the Company’s cash and cash equivalents, accounts receivable, accounts payable and other current liabilities approximate the fair value. The carrying value of marketable securities approximates their fair value as determined by market quotes. Based on borrowing rates currently available to the Company for debt with similar terms, the carrying value of its debt obligations approximates fair value.

 

Cash and cash equivalents

 

Cash equivalents are stated at cost, which approximates market value. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company invests primarily in money market funds and commercial paper, accordingly, these investments are subject to minimal credit and market risks.

 

Restricted cash

 

The Company’s restricted cash as of December 31, 2004 of $303,000 and December 31, 2003 of $439,000 was primarily comprised of security against leasing arrangements in Europe.

 

Short- and long-term marketable securities

 

Marketable securities are classified as available-for-sale and are carried at fair value. Marketable securities classified as current assets have scheduled maturities of less than one year, while marketable securities classified as non-current assets have scheduled maturities of more than one year. Unrealized holding gains or losses on such securities are included in accumulated other comprehensive income in stockholders’ equity. Realized gains and losses on sales of all such securities are reported in earnings and computed using the specific identification

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

cost method. Realized gains or losses and charges for other-than-temporary declines in value, if any, on available-for-sale securities are reported in other income or expense as incurred. The Company periodically evaluates these investments for other-than-temporary impairment.

 

Certain risks and uncertainties

 

The Company’s operating results depend to a significant extent on the Company’s ability to market and develop its products. The life cycles of the Company’s products are difficult to estimate due in part to the effect of future product enhancements and competition. The inability of the Company to successfully develop and market its products as a result of competition or other factors would have a material adverse effect on the Company’s business, financial condition and results of operations.

 

Financial instruments which potentially expose the Company to concentrations of credit risk consist primarily of cash equivalents and accounts receivable. The Company invests excess cash primarily in money market funds of major financial institutions, commercial paper and notes. The Company provides credit to customers in the normal course of business. Collateral is not required for accounts receivable, but ongoing evaluations of customers’ credit worthiness are performed. The Company maintains reserves for potential credit losses and such losses have been within management’s expectations. No individual customer accounted for 10% or more of the Company’s accounts receivable at December 31, 2004 and 2003, or net revenues in fiscal 2004, 2003 and 2002.

 

In the United States of America, the Food and Drug Administration (“FDA”) regulates the design, manufacture, distribution, preclinical and clinical study, clearance and approval of medical devices. Products developed by the Company may require approvals or clearances from the FDA or other international regulatory agencies prior to commercialized sales. There can be no assurance that the Company’s products will receive any of the required approvals or clearances. If the Company was denied approval or clearance or such approval was delayed, it may have a material adverse impact on the Company.

 

The Company has manufacturing operations located outside the United States of America. The Company currently relies on its manufacturing facilities in Costa Rica to create virtual treatment plans with the assistance of sophisticated software. In addition, the Company relies on third party manufacturers in Mexico to fabricate Aligners and to ship the completed product to the Company’s customers. The Company’s reliance on international operations exposes it to related risks and uncertainties, including; difficulties in staffing and managing international operations; controlling quality of manufacture; political, social and economic instability; interruptions and limitations in telecommunication services; product and/or material transportation delays or disruption; trade restrictions and changes in tariffs; import and export license requirements and restrictions; fluctuations in currency exchange rates; and potential adverse tax consequences. If any of these risks materialize, the Company’s international manufacturing operations, as well as its operating results, may be harmed.

 

The Company receives certain of its components from sole suppliers. Additionally, the Company relies on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill supply requirements of the Company could materially impact future operating results.

 

Inventories

 

Inventories are stated at the lower of cost or market. Cost is computed on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than the Company estimates, additional inventory provisions may be required.

 

Property and equipment

 

Property and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, which are: three years for computer software and hardware and five years for plant equipment, furniture, fixtures and equipment. Amortization of leasehold improvements is computed using the straight-line method over the estimated useful lives of the assets, or the remaining lease term, whichever is shorter. Upon sale or retirement, the asset’s cost and related accumulated depreciation are removed from the accounts and any related gain or loss is reflected in operations. Maintenance and repairs are charged to operations as incurred.

 

Development costs for internal use software

 

Costs relating to internal use software are accounted for in accordance with the provisions of Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1). In 2004, the Company implemented a new version of its enterprise resource planning system and new software for the Company’s manufacturing execution system and capitalized approximately $3,214,000 in related internal use software costs. As of December 31, 2004 and 2003, capitalized internal use software at cost was $4,416,000 and $1,202,000, respectively, and the associated accumulated amortization were $881,000 and $443,000 respectively. Capitalized software costs are amortized over the estimated useful lives of the software, which generally range from three to five years.

 

Impairment of long-lived assets

 

The Company identifies and records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets may not be recoverable. Recoverability is measured by comparison of the assets carrying amount to future net undiscounted cash flows the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value, as measured by the discounted future cash flows.

 

Product Warranty

 

Aligners are subject to the Invisalign product warranty, which covers defects in materials and workmanship. The Company’s materials and workmanship warranty is in force until the Invisalign case in completed. In the event the Aligners fall within the scope of the Invisalign product warranty, the Company will replace the Aligners at its expense. The Company’s warranty is contingent upon proper use of the Aligners for the purposes for which they are intended. If a patient chooses not to wear the Aligners, and as a result, requests additional Invisalign treatment, the dental professional pays for the additional expense. The Invisalign product warranty does not provide any assurances regarding the outcome of treatment using Invisalign.

 

The Company generally warrants its products for a specific period of time against material defects. The Company accrues for estimated warranty costs upon shipment of products. The Company provides for the estimated future costs of warranty obligations in costs of goods sold when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product which fails while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product failures as well as current information

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

on repair costs. Actual warranty costs could differ from the estimated amounts. The Company regularly reviews the accrued balances and updates based on historical warranty cost trends. Actual warranty costs incurred have not materially differed from those accrued. If the Company were to experience higher rates of warranty events, the Company would be required to accrue additional warranty costs, which would negatively affect its operating results.

 

The following table reflects the change in the Company’s warranty accrual during the years ended December 31, 2004 and 2003.

 

     (in thousands)

 

Warranty accrual, December 31, 2002

   $ 514  

Charged to costs and expenses

     2,004  

Actual warranty expenditures

     (1,656 )
    


Warranty accrual, December 31, 2003

     862  

Charged to costs and expenses

     2,651  

Actual warranty expenditures

     (1,897 )
    


Warranty accrual, December 31, 2004

   $ 1,616  
    


 

Allowance for Doubtful Accounts

 

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of the Company’s customers to make payments. The Company periodically reviews these estimated allowances, including an analysis of the customers’ payment history and information regarding the customers’ creditworthiness. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance may be required and would negatively impact the Company’s operating results.

 

Revenue Recognition

 

The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and Emerging Issues Task Force 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. SAB No. 104 requires that four criteria must be met before revenue can be recognized: persuasive evidence of an arrangement exists; shipments have occurred; the fee is fixed and determinable; and collectibility is reasonably assured. Determination of whether persuasive evidence of an arrangement exists and whether delivery has occurred or services have been rendered involve management’s judgments based on whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment.

 

Revenue from the sale of Invisalign and ancillary products is recognized upon product shipment, provided that no significant obligations remain, transfer of title has occurred and collection of the receivable is deemed probable. The costs of producing the ClinCheck treatment plan, which are incurred prior to the production of Aligners, are deferred and recognized as related revenues are earned. In certain instances, adjustments to a patient’s teeth are made in the final stages of orthodontic treatment. To make these final adjustments and move a patient’s teeth to the final desired position, dental professionals may elect to use Invisalign as a finishing

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

treatment tool and order newly manufactured Aligners. These newly manufactured Aligners, or “case refinement”, are not provided with the Aligners produced as part of the initial treatment plan and are manufactured only upon the request of the dental professional if final adjustments are desired. Align’s case refinement policy allows doctors to order one case refinement as part of their original lab fee, provided they submit the order prior to the point in time when the case is deemed completed, or the “case expiration”. Prior to the Company’s policy change during the fourth quarter of fiscal 2004, Align deemed the case expiration date to occur on the 90th day after the expected end of treatment. Under the new policy, the case expiration date is deemed to occur on the 180th day after the expected end of treatment. In certain instances, adjustments to a patient’s teeth are made in the final stages of orthodontic treatment. To make these final adjustments and move a patient’s teeth to the final desired position, dental professionals may elect to use Invisalign as a finishing treatment tool and order newly manufactured Aligners. These newly manufactured Aligners, or “case refinement”, are not provided with the Aligners produced as part of the initial treatment plan and are manufactured only upon the request of the dental professional if final adjustments are desired.

 

From June 2001 through April 2003, the Company offered its dental professionals the opportunity, at the time of the creation of the initial treatment plan, to purchase at a discount a one-time, non-refundable case refinement. Revenue, in the amount of the stand-alone sales price of the undelivered element, is deferred until the earlier of shipment of the case refinement or, if case refinement is never requested, the point in time when the case is deemed completed, or “case expiration”. In cases where the dental professional did not purchase case refinement in advance, case refinement revenues, if any, are recognized when the new Aligners are shipped.

 

The Company updated its domestic and international pricing policies in May 2003 and January 2004, respectively, to include the future delivery of one case refinement in the price of each case and to offer additional case refinements at a price of $125 each and at a comparable price internationally, which the Company believes represents its fair value based on competitive product offerings. Revenue deferrals associated with future case refinement after May 1, 2003 are $125 per case and a comparable price internationally after January 2004. This revenue deferral amount represents the fair value of a case refinement as determined in accordance with EITF 00-21, which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. These revenue deferrals will be recognized when the case refinement has been shipped or upon case expiration, whichever is earliest.

 

Service revenues earned for training of dental professionals and staff for Invisalign are recorded as the services are performed. Service revenues earned under agreements with third parties are based on negotiated rates, which are intended to approximate a mark-up on the Company’s anticipated costs.

 

The Company estimates and records a provision for amounts of estimated losses on sales, if any, in the period such sales occur. Provisions for discounts and rebates to customers are provided for in the same period that the related product sales are recorded based upon historical discounts and rebates.

 

Research and development

 

Research and development costs are expensed as incurred.

 

Advertising costs

 

The cost of advertising and media is expensed as incurred. For the years ended December 31, 2004, 2003 and 2002 advertising costs totaled $6,335,000, $5,003,000 and $5,993,000, respectively.

 

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Index to Financial Statements

ALIGN TECHNOLOGY, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Foreign currency

 

The Company uses the U.S. dollar as its functional currency for its foreign subsidiaries. Foreign currency monetary assets and liabilities are re-measured into U.S. dollars at current exchange rates and non-monetary assets are re-measured at historical rates. Revenues and expenses are re-measured at average exchange rates in effect during each period. Gains or losses from foreign currency re-measurement are included in other income (expense).

 

Income taxes

 

Income taxes are recorded under the liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

 

Stock-based compensation

 

The Company accounts for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations and complies with the disclosure requirements of SFAS 148, “Accounting for Stock-Based Compensation Transition and Disclosure an amendment of FASB Statement No. 123.” The following table illustrates the effect on net loss and net loss per common share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

 

     Year Ended December 31,

 
     2004

    2003

    2002

 
     (in thousands, except per share
amounts)
 

Net profit (loss), as reported

   $ 8,768     $ (20,122 )   $ (72,819 )

Add: Stock-based employee compensation expense included in reported net profit (loss), net of related tax effects

     5,956       13,378       18,784  

Deduct: Total stock-based employee compensation determined under fair value based method for all awards, net of related tax effects

     (17,933 )     (26,742 )     (29,350 )
    


 


 


Pro forma net loss

   $ (3,209 )   $ (33,486 )   $ (83,385 )
    


 


 


Basic net profit (loss) per common share:

                        

As reported

   $ 0.15     $ (0.35 )   $ (1.52 )
    


 


 


Pro forma

   $ (0.05 )   $ (0.58 )   $ (1.74 )
    


 


 


Diluted net profit (loss) per common share:

                        

As reported

   $ 0.14     $ (0.35 )   $ (1.52 )
    


 


 


Pro forma

   $ (0.05 )   $ (0.58 )   $ (1.74 )
    


 


 


 

Such pro forma disclosure may not be representative of future compensation cost because options vest over several years and additional grants are anticipated to be made each year.

 

59


Table of Contents
Index to Financial Statements

ALIGN TECHNOLOGY, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The value of options granted to employees is estimated on the date of grant using the minimum value method for shares issued prior to January 2001, the date of the Company’s initial public offering (IPO), and using the Black-Scholes option valuation model subsequent to the IPO with the following weighted assumptions:

 

       Year Ended December 31,

 
       2004

    2003

    2002

 

Risk-free interest rate

     3.44 %   3.02 %   3.03 %

Expected life

     5 years     5 years     5 years  

Volatility

     55.9 %   101.8 %   119.8 %

 

The fair value of the employees’ purchase rights under the Employee Stock Purchase Plan was estimated using the Black-Scholes option pricing model with the following assumptions:

 

       Year Ended December 31,

 
       2004

    2003

    2002

 

Risk free interest rate

     1.79 %   1.73 %   3.03 %

Expected life

     2 years     2 years     2 Years  

Expected volatility

     55.3 %   117.0 %   119.8 %

 

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees, or in Conjunction with Selling Goods and Services,” and Financial Accounting Standards Board Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan” (“FIN 28”).

 

Segments and Geographical Information

 

The Company reports segment data based on the management approach which designates the internal reporting that is used by management for making operating decisions and assessing performance as the source of the Company’s reportable operating segments. During all periods presented, the Company operated in a single business segment. No single territory other than the United States of America and Canada, the Company’s domestic market, accounted for 10% or more of assets or 10% or more of revenues in fiscal 2004, 2003 and 2002.

 

For fiscal 2004, 2003 and 2002, the Company’s revenues and long-lived assets are presented below by geographic area.

 

     Year Ended December 31,

(Amounts in thousands)


   2004

   2003

   2002

Revenues

                    

Domestic

   $ 155,683    $ 110,579    $ 63,460

International

     17,147      12,146      6,238
    

  

  

Total revenues

   $ 172,830    $ 122,725    $ 69,698
    

  

  

     As of December 31,

     2004

   2003

   2002

Long-lived Assets

                    

Domestic

   $ 20,627    $ 22,197    $ 23,871

International

     3,251