Align Technology 10-Q 2007
Washington, D.C. 20549
Commission file number: 0-32259
Align Technology, Inc.
(Exact name of registrant as specified in its charter)
Indicate by check mark whether the 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 the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The number of shares outstanding of the registrants Common Stock, $0.0001 par value, as of July 31, 2007 was 67,937,571.
Table of Contents
ALIGN TECHNOLOGY, INC.
Invisalign, Align, ClinCheck and ClinAdvisor, amongst others, are trademarks belonging to Align Technology, Inc. and are pending or registered in the United States and other countries.
thousands, except per share data)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
thousands, except per share data)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
ALIGN TECHNOLOGY, INC.
Note 1. Summary of Significant Accounting Policies
Basis of presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared by Align Technology, Inc. (the Company or Align) in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) and contain all adjustments, including normal recurring adjustments, necessary to present fairly Aligns financial position as of June 30, 2007, its results of operations for the three and six months ended June 30, 2007 and 2006, and its cash flows for the six months ended June 30, 2007 and 2006. The Consolidated Condensed Balance Sheet as of December 31, 2006 is derived from the December 31, 2006 audited financial statements. Certain prior period amounts have been reclassified to conform with current period presentation. These reclassifications had no impact on previously reported net earnings and financial position.
The results of operations for the three and six months ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007, and the Company makes no representations related thereto. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations, Quantitative and Qualitative Disclosures About Market Risk and the Consolidated Financial Statements and notes thereto included in Items 7, 7A and 8, respectively, of the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in Aligns Condensed Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates.
The Company follows Statement of Financial Accounting Standards No. 52, Foreign Currency Translation (FAS 52) for both the translation and remeasurement of balance sheet and income statement items into U.S. dollars. The Company analyzes the functional currency for each of its international subsidiaries on an annual basis, or more often if necessary, to determine if a significant change in facts and circumstances indicate that the primary economic currency has changed. Prior to January 1, 2007, all of Aligns subsidiaries use the U.S. dollar as its functional currency.
During the first quarter of 2007, the Company analyzed the various economic factors of its international subsidiaries in accordance with FAS 52 and determined that there has been a significant change in facts and circumstances to warrant a change in the functional currency for some of its European subsidiaries from U.S. dollars to the local currency. Effective January 1, 2007, the adjustment from translating certain European subsidiaries financial statements from the local currency in to U. S. dollars was recorded as a separate component of accumulated other comprehensive income in the shareholders equity section of its Condensed Consolidated Balance Sheet. This foreign currency translation adjustment reflects the translation of its balance sheet at period end exchange rates, and its income statement at an average exchange rate in effect during each period. As of June 30, 2007, the Company included $173,000 in its accumulated other comprehensive income in stockholders equity. See Note 12 Comprehensive Income (Loss) of the Notes to Condensed Consolidated Financial Statements for additional disclosures.
Aligns other international entities operate in a U.S. dollar functional environment, and therefore, the foreign currency assets and liabilities are remeasured into U.S. dollars at current exchange rates except for non monetary assets and liabilities which are remeasured at historical exchange rates. Revenues and expenses are generally remeasured at an average exchange rate in effect during each period. Gains or losses from foreign currency remeasurement are included in consolidated net profit (loss).
Accounting for Income Taxes
On January 1, 2007, the Company adopted the provision of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertain Income Taxes An Interpretation of FASB Statement No. 109 (FIN 48).
FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entitys financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes (FAS 109) and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption of FIN 48 had no impact on the Companys consolidated financial position, results of operations or cash flows for the three and six month periods ended June 30, 2007.
Recent Accounting Pronouncements
In February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115 (FAS 159). FAS 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. Under FAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred, e.g., debt issue costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of FAS 159, changes in fair value are recognized in earnings. FAS 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company in the first quarter of 2008. The Company is currently evaluating the potential impact, if any, of the adoption of FAS 159 on its consolidated financial position, results of operations and cash flows.
In September 2006, the FASB issued FAS Statement No. 157, Fair Value Measurements (FAS 157), which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The Company is currently evaluating the potential impact, if any, of the adoption of FAS 157 on its consolidated financial position, results of operations and cash flows.
Other recent accounting pronouncements issued by the FASB, including its Emerging Issues Task Force (EITF), the American Institute of Certified Public Accountants and the SEC did not or are not believed by management to have a material impact on our present or future consolidated financial statements.
Note 2. Patients First Program
On October 13, 2006, the Company entered into a formal agreement with OrthoClear, Inc., OrthoClear Holdings, Inc., and OrthoClear Pakistan Pvt. Ltd. (OrthoClear), together with certain individuals associated with OrthoClear (the OrthoClear Agreement) to end all pending litigation between the parties. As part of the OrthoClear Agreement, OrthoClear agreed to stop the importation of aligners into the United States and discontinue all aligner business operations worldwide. As a result, most OrthoClear patients were unable to complete their orthodontic treatment with OrthoClear. In an attempt to help minimize treatment disruptions for the OrthoClear patients and their doctors, the Company committed to make treatment available to these patients at no additional cost under the Patients First Program. Therefore, Align received no revenue for the program, while incurring significant expense. In the fourth quarter of 2006, the Company recorded a $8.3 million charge for the anticipated costs of completing the Patients First Program in accordance with FASB Statement No. 5, Accounting for Contingencies (FAS 5). This estimated amount was based on the number of OrthoClear cases registered under the Patients First Program as of December 31, 2006. In accordance with the Patients First Program terms and conditions, those registered cases were required to submit treatment forms by the deadline of March 30, 2007. In the first quarter of 2007, the Company reduced its Patients First Program accrual by $1.8 million to reflect a reduction of the Companys initial estimate to the number of cases actually received by the case submission deadline. During the second quarter of 2007, the Company completed the Patients First Program and shipped virtually all cases that
were registered and received. As of June 30, 2007, there were approximately 200 cases remaining to be shipped upon ClinCheck approval by doctors. The accrued Patients First Program balance as of June 30, 2007 was $1.6 million, and principally consists of estimated future warranty and case refinement costs.
Note 3. Marketable Securities
The Companys marketable securities as of June 30, 2007 and December 31, 2006 are as follows (in thousands):
For the three and six months ended June 30, 2007 and 2006, no significant gains were realized on the sale of marketable securities.
Note 4. Balance Sheet Components
Inventories are comprised of (in thousands):
Work in process includes costs to produce the Invisalign product. Finished goods primarily represent ancillary products that support the Invisalign system.
Accrued liabilities consist of the following (in thousands):
Note 5. Intangible Assets
The following is a summary of the Companys purchased intangible assets as of June 30, 2007 and December 31, 2006 (in thousands):
Non-compete agreements represent the fair value of intangible assets received in connection with the OrthoClear Agreement. These intangible assets are being amortized on a straight-line basis over the expected useful life of five years beginning in the fourth quarter of 2006.
Consultant relationships and other intangible assets represent the fair value of intangible assets acquired as the result of the acquisition of General Orthodontics, LLC (GO) in 2005. Upon the integration of GO, Align included GOs consulting services in its clinical education and training programs under the name of Invisalign Consulting Services (ICS). On March 29, 2007, the Company announced the discontinuation of ICS effective June 29, 2007. During the second quarter of 2007, the net carrying values of the consultant relationships and other intangible assets related to ICS were fully amortized.
The Company performs an impairment test whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Examples of such events or circumstances include significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for its business, significant negative industry or economic trends, and/or a significant decline in the Companys stock price for a sustained period. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analyses. There were no impairments of intangible assets during the periods presented.
The total estimated annual future amortization expense for these intangible assets as of June 30, 2007 is as follows (in thousands):
Note 6. Legal Proceedings
On January 6, 2003, Ormco Corporation (Ormco) filed suit against the Company in the United States District Court for the Central District, Orange County Division, asserting infringement of certain patents. Ormco is a division of Sybron Dental Specialties. In May 2006, Danaher Corporation acquired Sybron Dental Specialties. The complaint sought unspecified monetary damages and injunctive relief. On February 18, 2003, the Company answered the complaint and asserted counterclaims seeking a declaration by the Court of invalidity and non-infringement of the asserted patents. In addition, the Company counterclaimed for infringement of one of its patents, seeking unspecified monetary damages and injunctive relief. Ormco filed a reply to its counterclaims on March 10, 2003 and asserted counterclaims against the Company seeking a declaration by the Court of invalidity and non-infringement of the patent. The Company amended its counterclaim to add Allesee Orthodontic Appliances, Inc. (AOA), a wholly-owned subsidiary of Ormco, as a counterdefendant in regard to its counterclaim of infringement of the patent.
On February 1, 2006, the Company entered into a settlement agreement (the Settlement Agreement) with Ormco and AOA. In accordance with the terms of the Settlement Agreement, Ormco and AOA paid into escrow, pending the completion of the appellate process, $884,000 to resolve the issues of past damages, willfulness and attorneys fees for the adjudged infringement of two of the Companys patents (the Align Patents) through the manufacture and sale of Ormcos and AOAs Red, White & Blue appliances. The Companys receipt of the payments out of escrow is contingent upon the Court, in a final, non-appealable judgment, finding that Ormco or AOA infringes at least one of the claims in the Align Patents. If, however, the Court issues a final, non-appealable judgment of non-infringement, invalidity or unenforceability with respect to each asserted claim of the Align Patents, all funds in the escrow account will be returned to Ormco and AOA. The Settlement Agreement does not affect (a) Ormcos appeal of the decisions and orders of the District Court relating to Ormcos patents; or (2) our pending cross-appeal of the orders of the District Court relating to our patents.
There have been two appeals. After the permanent injunction was entered, Ormco and AOA appealed that injunction and the orders of the District Court on summary judgment on which the injunction was based. Oral argument took place on April 3, 2006. Following oral argument, the U.S. Court of Appeals for the Federal Circuit (CAFC) issued a ruling declaring two out of a total of seventy-one claims in our US Patent No. 6,398,548 and four out of a total of ten claims in US Patent No. 6,544,611 to be invalid as obvious. The CAFCs decision reverses the California District Court summary judgment order of validity.
The second appeal is from the final judgment. Once final judgment was entered, Ormco filed a Notice of Appeal from the final judgment and the Company filed a notice of cross-appeal. Ormco has appealed the ruling of the District Court that its patents are not infringed by the Company and that the asserted claims are invalid. The Company appealed the ruling of the District Court that certain claims of its 6,398,548 patent which were found to be infringed by Ormcos and AOAs Red, White & Blue appliances were invalid. Briefing on this appeal and cross-appeal is complete, and oral argument occurred on February 6, 2007. The Federal Circuit has not yet issued a ruling.
On May 18, 2007, Debra A. Weber filed a consumer class action lawsuit against Align, OrthoClear, Inc. and OrthoClear Holdings, Inc. (d/b/a OrthoClear, Inc.) in Syracuse, New York, U.S. District Court. The complaint alleges two causes of action against the OrthoClear defendants and one cause of action against Align for breach of contract. The cause of action against the Company, titled Breach of Third Party Benefit Contract references Aligns agreement to make Invisalign treatment available to OrthoClear patients, alleging that the Company failed to provide the promised treatment to Plaintiff or any of the class members. The Company intends to vigorously defend itself against this lawsuit.
Litigating claims of these types, whether or not ultimately determined in the Companys favor or settled by the Company, is costly and diverts the efforts and attention of the Companys management and technical personnel from normal business operations. Any of these results from litigation could adversely affect the Companys results of operations. From time to time, the Company has received, and may again receive, letters from third parties drawing the Companys attention to their patent rights. While the Company does not believe that it infringes any such rights that have been brought to the Companys attention, there may be other more pertinent proprietary rights of which the Company is presently unaware.
Note 7. Credit Facilities
On March 7, 2007, the Company renegotiated and amended its existing credit facility with Comerica Bank. The amendment, among other things, reduced financial covenants to require only a quick ratio covenant. Effective January 1, 2008, the amendment will also increase the available borrowings under the existing revolving line of credit from $20 million
to $25 million. The amended credit facility matures on December 31, 2008 at which point all outstanding borrowings under this credit facility must be repaid. During the first half of 2007, the Company repaid $11.5 million of its outstanding borrowing on this credit facility. As of June 30, 2007, there were no outstanding borrowings against this credit facility. The Company is in compliance with the financial covenant of this credit facility.
Note 8. Commitments and Contingencies
On August 3, 2007, the Company entered into an amendment to the lease agreement of its European Headquarters located in Amsterdam, The Netherlands. Commencing June 1, 2007, the original lease agreement was amended to expand the Amsterdam facility to approximately 16,000 square feet of office space and will expire June 2012, with an option to renew for an additional five year term.
As of June 30, 2007, minimum future lease payments for non-cancelable leases are as follow (in thousands):
The Company warrants its products against material defects until the Invisalign case is completed. The Company accrues for estimated warranty in costs of goods sold upon shipment of products. The amount of accrued estimated warranty costs is primarily based on historical experience as to product failures as well as current information on repair costs. Actual warranty costs could differ from the estimated amounts. The Company regularly reviews the accrued balances and updates these balances based on historical warranty cost trends. Actual warranty costs incurred have not materially differed from those accrued.
The following table reflects the change in the Companys warranty accrual during the six months ended June 30, 2007 and 2006, respectively (in thousands):
Note 9. Stock-based Compensation
Summary of stock-based compensation expense
The Company accounts for stockbased compensation in accordance with Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-based Payment (FAS 123R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors and employee stock purchases related to the Employee Stock Purchase Plan (the Purchase Plan) based on estimated fair values over the requisite service period.
Stock-based compensation expense recognized in the Consolidated Statements of Operations for the three and six months ended June 30, 2007 and 2006 is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. FAS123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. The following
table summarizes stock-based compensation expense related to all of the Companys stock-based awards and employee stock purchases under FAS 123R for the three and six months ended June 30, 2007 and 2006:
The fair value of stock options granted and the option component of the Purchase Plan shares were estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:
(1) The Employee Stock Purchase Plan has purchase dates on the last trading days of January and July of each year. There were no Employee Stock Purchase Plan activities during the second quarters of 2007 and 2006.
Stock Incentive Plans
In May 2005, stockholder approval was obtained for the 2005 Incentive Plan (the 2005 Plan), which replaced the 2001 Stock Incentive Plan (the 2001 Plan). The 2005 Plan, which expires December 31, 2010, provides for the granting of incentive stock options, non-statutory stock options, restricted stock units, stock appreciation rights, performance units and performance shares. Employees, non-employee directors and consultants are eligible to receive grants under the 2005 Plan. The options are granted for periods not exceeding ten years and generally vest over 4 years with 25% vesting one year from the date of grant and 1/48th each month thereafter. The Plan Administrator may, however, grant options with different vesting schedules at its option. Options are to be granted at an exercise price not less than the fair market value of the underlying shares at the date of grant.
Stock option activity for the six months ended June 30, 2007 under the stock incentive plans is set forth below:
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between Aligns closing stock price on the last trading day of second quarter of 2007 of $24.16 and the number of in-the-money options multiplied by the respective exercise price) that would have been received by the option holders had all option holders exercised their options on June 30, 2007. This amount changes based on the fair market value of Aligns stock.
The total intrinsic value of stock options exercised for three and six months ended June 30, 2007 was $17.9 million and $24.2 million, respectively. Total intrinsic value of stock options exercised for the three and six months ended June 30, 2006, was $0.2 million and $0.8 million, respectively. As of June 30, 2007, Align expects to recognize $17.4 million of total unamortized compensation cost related to stock options over a weighted average period of 2.6 years. The Company has recognized tax benefits from exercised options of approximately $0.4 million in the three and six months ended June 30, 2007. The tax benefits associated with these option exercises reduced income taxes payable with the offset credited to additional paid-in capital.
Restricted Stock Units
The Company grants restricted stock units that generally vest over 4 years with 25% vesting on the one year anniversary of the date of grant and 6.25% vesting quarterly thereafter. The fair value of each award is based on the Companys closing stock price on the date of grant. During the six months ended June 30, 2007, the total fair value of vested restricted stock unit awards was $0.9 million. A summary of the nonvested shares for the three and six months ended June 30, 2007 is as follows:
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between Aligns closing stock price on the last trading day of second quarter of 2007 of $24.16 multiplied by the number of nonvested restricted stock units) that would have been received by the award holders had all restricted stock units been vested and released on June 30, 2007. This amount changes based on the fair market value of Aligns stock.
The total intrinsic value of restricted stock awards vested and released for three and six months ended June 30, 2007 was $0.6 million and $2.0 million, respectively. There were no restricted stock awards vested during the three and six month
periods ended June 30, 2006. As of June 30, 2007, the total unamortized compensation cost related to restricted stock units was $7.0 million, which Align expects to recognize over a weighted average period of 3.1 years.
Employee Stock Purchase Plan
Aligns Employee Stock Purchase Plan (the Purchase Plan) consists of overlapping twenty-four month offering periods with four six-month purchase periods in each offering period. Employees purchase shares at 85% of the fair market value of the common stock at either the beginning of the purchase period or the end of the purchase period, whichever price is lower. The Company accounts for the Purchase Plan as a compensatory plan and has valued the shares in accordance with FAS 123R. The fair value of the option component of the Purchase Plan shares was estimated at the date of grant using the Black-Scholes option pricing model.
As of June 30, 2007, Align expects to recognize $0.6 million of total unamortized compensation cost related to employee stock purchases over a weighted average period of 0.4 years.
Note 10. Accounting for Income Taxes
The Company has unrecognized tax benefits of approximately $3.3 million as of January 1, 2007. Included in the unrecognized tax benefits are $0.4 million of uncertain tax positions that would impact the Companys effective tax rate if recognized. The application of FIN 48 would have resulted in a decrease in retained earnings of $2.9 million, except that the decrease was fully offset by the application of a valuation allowance. In accordance with FIN 48, the Company recognizes interest and penalties related to unrecognized tax benefits as a component of income taxes. Interest and penalties are immaterial at the date of adoption and are included in the unrecognized tax benefits. There was no change to the Companys unrecognized tax benefits for the three and six month periods ended June 30, 2007.
The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. All the Companys tax years will be open to examination by the U.S. federal and most state tax authorities due to the Companys Net Operating Loss and overall credit carryforward position. With few exceptions, the Company is no longer subject to examination by foreign tax authorities for years before 2002.
Note 11. Net Profit (Loss) Per Share
Basic net profit (loss) per share is computed using the weighted average number of shares of common stock during the period. Diluted net profit (loss) per share is computed using the weighted average number of shares of common stock, adjusted for the dilutive effect of potential common stock. Potential common stock, computed using the treasury stock method, includes options and restricted stock units.
The following table sets forth the computation of basic and diluted net profit (loss) per share attributable to common stock (in thousands, except per share amounts):
For the three and six months ended June 30, 2007, stock options and restricted stock units totaling 1.0 million and 1.9
million were excluded from diluted net loss per share because of their anti-dilutive effect. For the three and six months ended June 30, 2006, stock options and restricted stock units totaling 6.8 million and 6.6 million, respectively, were excluded from diluted net loss per share because of their anti-dilutive effect.
Note 12. Comprehensive Income (Loss)
Comprehensive income (loss) includes net income, foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. The components of comprehensive income (loss) are as follows (in thousands):
Note 13. 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 Companys reportable operating segments. During all periods presented, the Company operated as a single business segment.
Revenues and long-lived assets are presented below by geographic area (in thousands):
In addition to historical information, this Quarterly Report on Form 10-Q 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 benefits of new products, product features, and software enhancements, including ClinAdvisor, and the expected impact these new products and product enhancements will have on doctor utilization and our market share, our expectations regarding product mix and Invisalign Express, our expectations regarding the existence and impact of seasonality, our expectation that our utilization rate will improve over time, our expectations regarding our average selling prices and gross margins in 2007, our expectations regarding the anticipated benefit of increased collaboration between orthodontists and general practitioner dentists (GPs) and the impact this collaboration will have on sales of Invisalign and on our revenue, our expectation that the percentage of revenue generated by general practitioner dentists will represent an increasingly larger percentage of our revenue, our intention to continue the integration of Invisalign into the curriculums of additional universities, our expectations regarding the benefit of increased consumer marketing programs, our expectations regarding increased case shipment volume in 2007, our expectation regarding the anticipated level of our operating expenses in 2007, 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 Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations, and in particular, the risks discussed below in Part II, Item 1A Risk Factors and in other documents we file with the Securities and Exchange Commission (SEC) . 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.
The following discussion and analysis of our financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and related notes included elsewhere in this Quarterly Report on Form 10-Q.
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. We received the United States Food and Drug Administration (FDA) clearance to market Invisalign in 1998, and we began commercial operations and sales of full Invisalign treatment in July 1999.
Each Invisalign treatment plan is unique to the individual patient. Our full Invisalign treatment consists of as many Aligners as indicated by ClinCheck in order to achieve the doctors treatment goals. Our Invisalign Express is a dual arch orthodontic treatment for cases that meet certain predetermined clinical criteria and consist of up to ten Aligners. Invisalign Express treatment is intended to assist dental professionals to treat a broader range of patients by providing a lower cost option for adult relapse cases, minor crowding and spacing or as a pre-cursor to restorative or cosmetic treatment such as veneers.
A number of factors, the most important of which are set forth below, may affect our results during the remainder of 2007 and beyond.
· Driving Utilization Growth. One of our key objectives is to continue to increase utilization, or the adoption of and frequency of use, of the Invisalign system (which includes full Invisalign treatment and Invisalign Express) by new and existing customers. We believe that a key lever for increasing utilization in the future is product performance. As a result, we are committed to investing in delivering new products, enhancing the user experience and introducing new product features to our existing products. Specifically, much of our research and development effort is aimed at developing and deploying GP-specific and Ortho-specific product platforms described more fully under Continued Product Leadership below. Although we expect that over the long term
our utilization rates will improve, we expect that period over period comparisons of our utilization rates will fluctuate. Factors that may cause these fluctuations include an increase in the number of newly certified/trained doctors in one period compared to another period and the impact of seasonality, specifically, during summer vacation/holiday periods in the United States and Europe. For the quarters ended June 30, 2007 and June 30, 2006 our utilization rates are as follows:
*Utilization = # of cases shipped / # of doctors cases were shipped to
· Continued Product Leadership. As stated above, in an effort to improve the user experience for our customers and increase utilization over time, we are currently in the process of developing and deploying GP-specific and Ortho-specific product platforms to improve the overall user experience for our doctors. In the second half of 2006, we announced a phased rollout of ClinAdvisor, a new suite of software tools designed to make Invisalign case selection and submission processes more efficient for doctors. ClinAdvisor is designed to help newly certified and less experienced doctors learn how to assess and select appropriate cases given their experience and skill level. The phased rollout of ClinAdvisor is now complete and it has been launched to our U.S. customers. We expect to integrate ClinAdvisor into our Certification Level 1 training program by the end of the third quarter of 2007. We also expect to extend the product features and functionality of the GP platform and release it to an increasing number of practices. In addition, we plan to introduce further software enhancements directed at our orthodontists that will provide these doctors with a robust set of tools for greater predictability, wider applicability and more control. We are also continuing to focus our research and development efforts on a next generation Aligner material as well as a compliance indicator which will help doctors and patients understand if the patients have worn their Aligners for enough time to effectively move their teeth. We expect these efforts to extend at least through 2008. By investing in developing these new products and continually enhancing our existing products, we expect to increase adoption and utilization by our doctors.
· Expansion of our Customer Base. We generate the vast majority of our revenues from the sales of the Invisalign system to orthodontists and GPs in the United States and Canada, our domestic market. For the six months ended June 30, 2007 and 2006, our Invisalign revenues as a percentage of total net revenue are as follows:
As specialists, orthodontists are a critical part of our business, and we expect that orthodontists will continue to treat the majority of complex cases and continue to drive research for expanding Invisalign applications. However, there exists a significantly greater number of GPs in North America than orthodontists. As the primary provider of dental care, 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. Largely due to the
fact that there are significantly more GPs than orthodontists, we expect that an increasingly larger percentage of our revenues will be generated by GPs. By increasing adoption and utilization rates among our existing GP customers, the overall market for Invisalign will increase, as patients who would not have otherwise sought orthodontic treatment are introduced to Invisalign by their GPs.
In addition, 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. We have also integrated the Invisalign technique into the curriculums of 38 university programs, including Harvard University, Columbia University, Temple University and the University of Texas at San Antonio. We expect additional dental schools to integrate the Invisalign technique into their curriculums in the future.
· Seasonal Fluctuations. Seasonal fluctuations in the number of doctors in their offices and available to take appointments have affected, and are likely to continue to affect, our business. Specifically, our customers often take vacation or are on holiday during the summer months and therefore tend to start fewer cases. This seasonal trend has caused and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates.
· Product Mix. During the first half of 2007, we experienced a decline in the number of Invisalign Express cases compared to the same period of 2006. We expect that for the remainder of 2007 Invisalign Express cases as a percentage of our revenues will remain consistent with the first six months of 2007. We believe that this shift in product mix began in the fourth quarter of 2006 after we removed the cancellation fees on full Invisalign cases prior to ClinCheck approval and clarified clinical protocols surrounding what is an appropriate Invisalign Express case. For the six months ended June 30, 2007 and 2006, our Invisalign revenues as a percentage of total net revenue are as follows:
· Increase Demand at the Consumer Level. In 2007, we expect to increase the overall marketing spend in the United States with a focus on programs designed to raise the profile of Invisalign and drive more consumers to our most experienced doctors. We anticipate that this increased consumer awareness of Invisalign will increase the market for our product.
· Growth of International Markets. We will focus our efforts towards increasing adoption of Invisalign by dental professionals in our key international markets, Europe and Japan. We continually evaluate cost effective ways to support our customers in smaller and less strategic markets. During the first quarter of 2007, we transitioned the sales of our product in part of the Asia-Pacific region to a distributor model. We will consider selling through distributors in other smaller or less strategic markets as well as consider expanding directly into additional countries on a case by case basis. In the first six months of 2007, our international channel represented approximately 15% of our total net revenue primarily as a result of growth in Europe. In 2007, we increased our consumer marketing efforts in key European markets. We expect our international revenue to continue to increase in absolute dollars, and we expect international revenue as a percentage of total net revenue will be comparable in the foreseeable future.
· Reliance on International Manufacturing Operations. Our manufacturing efficiency has been and will be an important factor in our future profitability. Currently, two of our key production steps are performed in
operations located outside of the U.S. At our facility in Costa Rica, dental 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 ClinCheck and are used to manufacture Aligner molds. In addition, we use International Manufacturing Solutions Operaciones, S.R.L. (IMS), a third party based in Juarez, Mexico, for the fabrication and packaging of Aligners. Our success will depend in part on the efforts and abilities of management to effectively manage these international operations, including our relationship with IMS. In addition, we currently are and will continue to be dependant on IMSs and our ability to hire and retain employees generally, as well as hire and retain employees with the necessary skills to perform the more technical aspects of our operations. If our management and/or IMS fail in any of these respects, we could experience production delays and lost or delayed revenue. In addition, even if we have case submissions in the manufacturing backlog, if for these or other reasons we do not have sufficient number of trained dental technicians in Costa Rica to create the ClinCheck treatment forms or if IMS is unable to ship our product to our customers on a timely basis, our revenue will be delayed or lost which will cause our operating results to fluctuate. See Part II, Item 1ARisk Factors for risks related to our international operations.
· Patients First Program. In the fourth quarter of 2006, we entered into a formal agreement with OrthoClear, Inc., OrthoClear Holdings, Inc., and OrthoClear Pakistan Pvt. Ltd. (OrthoClear), together with certain individuals associated with OrthoClear (the OrthoClear Agreement) to end all pending litigation between the parties. As part of the OrthoClear Agreement, OrthoClear agreed to stop the importation of aligners into the United States and discontinue all aligner business operations worldwide. As a result, most OrthoClear patients were unable to complete their orthodontic treatment with OrthoClear. In an attempt to help minimize treatment disruptions for these patients and their doctors, we committed to make Invisalign treatment available to OrthoClear patients at no additional charge from Align. Therefore, we received no revenue for any additional cases we started under this program while incurring significant expenses. In the fourth quarter of 2006, we recorded an expense of $8.3 million for the anticipated cost of completing this program. This estimated amount was based on the number of OrthoClear cases registered under the Patients First Program as of December 31, 2006. In accordance with the Patients First Program terms and conditions, those registered cases were required to submit treatment forms by the deadline of March 30, 2007. In the first quarter of 2007, we reduced our Patients First Program accrual by $1.8 million to reflect a reduction of our initial estimate to the number of cases actually received by the case submission deadline.
Additionally, this program generated increased demands on our sales and customer service representatives and on our manufacturing processes, including increased headcount. In the fourth quarter of 2006, we hired approximately 100 additional dental technicians at our facility in Costa Rica. Training these technicians to use the sophisticated computer modeling program necessary to create ClinCheck treatment forms, takes approximately 90 to 120 days. Therefore, although we hired these additional technicians in the fourth quarter of 2006, these individuals were not able to provide meaningful contribution to our manufacturing process until the beginning of 2007. As a result of this manufacturing constraint, although we initially sought to implement the Patients First Program without impacting our existing customers, or new, paid Invisalign cases, the influx of Patients First Program cases, as well as a higher than expected number of paid Invisalign case submissions in the fourth quarter of 2006, caused a delay in product delivery time for some new cases by approximately 10 days and consequently created a backlog of cases in the fourth quarter of 2006 and the first quarter of 2007. As we returned to normal cycle times by the end of the second quarter of 2007, second quarter revenues benefited from a conversion of this backlog and not solely from organic growth. During the second quarter of 2007, the Patients First Program was completed and we shipped virtually all of the cases that were registered and received. As of June 30, 2007, there were approximately 200 cases to be shipped upon ClinCheck approval by doctors.
Results of Operation
Invisalign product revenues by channel and other revenues, which represented training and sales of ancillary products, for the three and six months ended June 30, 2007 and 2006 are as follows (in millions):
Case volume data which represents Invisalign case shipment by channel, for the three and six months ended June 30, 2007 and 2006 are as follows (in thousands):