Annual Reports

 
Quarterly Reports

  • 10-Q (Nov 2, 2017)
  • 10-Q (Aug 3, 2017)
  • 10-Q (May 4, 2017)
  • 10-Q (Nov 8, 2016)
  • 10-Q (Aug 4, 2016)
  • 10-Q (May 5, 2016)

 
8-K

 
Other

Align Technology 10-Q 2007

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

FORM 10-Q

(Mark One)

x

 

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

 

 

 

 

 

For the quarterly period ended March 31, 2007

 

 

 

OR

 

 

 

o

 

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

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

881 Martin Avenue
Santa Clara, California 95050

(Address of principal executive offices) (Zip Code))

(408) 470-1000

(Registrant’s telephone number, including area code)

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  o

 

Accelerated filer  x

 

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 registrant’s Common Stock, $0.0001 par value, as of April 30, 2007 was 66,498,942.

 




Table of Contents

ALIGN TECHNOLOGY, INC.

INDEX

PART I —FINANCIAL INFORMATION

 

3

ITEM 1

FINANCIAL STATEMENTS (UNAUDITED):

 

3

 

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

3

 

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

4

 

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

5

 

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

6

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

16

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

24

ITEM 4.

CONTROLS AND PROCEDURES

 

24

PART II—OTHER INFORMATION

 

26

ITEM 1.

LEGAL PROCEEDINGS

 

26

ITEM 1A.

RISK FACTORS

 

30

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

40

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

 

40

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

40

ITEM 5.

OTHER INFORMATION

 

40

ITEM 6.

EXHIBITS

 

41

SIGNATURES

 

42

 

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.

2




PART I—FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

 

 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Revenues

 

$

63,761

 

$

48,908

 

 

 

 

 

 

 

Cost of revenues

 

17,529

 

14,297

 

 

 

 

 

 

 

Gross profit

 

46,232

 

34,611

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

23,150

 

20,066

 

General and administrative

 

12,185

 

15,064

 

Research and development

 

5,693

 

4,694

 

Patients First Program

 

(1,796

)

 

 

 

 

 

 

 

Total operating expenses

 

39,232

 

39,824

 

 

 

 

 

 

 

Profit (loss) from operations

 

7,000

 

(5,213

)

 

 

 

 

 

 

Interest and other income, net

 

455

 

698

 

 

 

 

 

 

 

Net profit (loss) before provision for income taxes

 

7,455

 

(4,515

)

Provision for income taxes

 

(477

)

(249

)

 

 

 

 

 

 

Net profit (loss)

 

$

6,978

 

$

(4,764

)

 

 

 

 

 

 

Net profit (loss) per share:

 

 

 

 

 

Basic

 

$

0.11

 

$

(0.08

)

Diluted

 

$

0.10

 

$

(0.08

)

 

 

 

 

 

 

Shares used in computing net profit (loss) per share:

 

 

 

 

 

Basic

 

65,433

 

62,518

 

Diluted

 

69,331

 

62,518

 

 

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

3




ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)

 

 

March 31,
2007

 

December 31,
2006

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

56,209

 

$

55,113

 

Restricted cash

 

95

 

93

 

Marketable securities, short-term

 

9,384

 

8,931

 

Accounts receivable, net of allowance for doubtful accounts of $701 and $844 at March 31, 2007 and December 31, 2006, respectively

 

38,203

 

33,635

 

Inventories, net

 

3,725

 

3,090

 

Prepaid expenses and other current assets

 

7,624

 

7,227

 

Total current assets

 

115,240

 

108,089

 

 

 

 

 

 

 

Property and equipment, net

 

26,208

 

26,904

 

Goodwill

 

478

 

478

 

Intangible assets, net

 

12,979

 

13,824

 

Other assets

 

2,134

 

2,263

 

Total assets

 

$

157,039

 

$

151,558

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Line of credit

 

$

8,000

 

$

11,500

 

Accounts payable

 

6,761

 

5,034

 

Accrued liabilities

 

31,831

 

40,307

 

Deferred revenues

 

11,226

 

10,942

 

Total current liabilities

 

57,818

 

67,783

 

Other long-term liabilities

 

233

 

219

 

Total liabilities

 

58,051

 

68,002

 

 

 

 

 

 

 

Commitments and contingencies (Note 8)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock: $0.0001 par value; Authorized: 5,000 shares; Issued and outstanding: none at March 31, 2007 and December 31, 2006

 

 

 

Common stock: $0.0001 par value; Authorized: 200,000 shares; Issued: 65,894 and 64,899 shares at March 31, 2007 and December 31, 2006, respectively; Outstanding: 65,854 and 64,859 shares at March 31, 2007 and December 31, 2006, respectively

 

7

 

6

 

Additional paid-in capital

 

417,279

 

408,921

 

Accumulated other comprehensive income

 

98

 

3

 

Accumulated deficit

 

(318,396

)

(325,374

)

Total stockholders’ equity

 

98,988

 

83,556

 

Total liabilities and stockholders’ equity

 

$

157,039

 

$

151,558

 

 

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

4




ALIGN TECHNOLOGY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

Cash Flows from Operating Activities:

 

 

 

 

 

Net profit (loss)

 

$

6,978

 

$

(4,764

)

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

 

 

 

 

 

Depreciation and amortization

 

2,552

 

2,174

 

Amortization of intangibles

 

845

 

95

 

Stock-based compensation expense

 

2,522

 

2,205

 

Loss on retirement and disposal of fixed assets

 

29

 

5

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(4,650

)

(2,752

)

Inventories

 

(637

)

(164

)

Prepaid expenses and other current assets

 

(420

)

(1,463

)

Accounts payable

 

1,615

 

435

 

Accrued and other long-term liabilities

 

(8,389

)

234

 

Deferred revenues

 

292

 

(1,625

)

Net cash provided by (used in) operating activities

 

737

 

(5,620

)

 

 

 

 

 

 

Cash Flows from Investing Activities:

 

 

 

 

 

Purchase of property and equipment

 

(1,762

)

(2,145

)

Restricted cash

 

(3

)

(3

)

Purchases of marketable securities

 

(5,817

)

 

Maturities of marketable securities

 

5,364

 

 

Other assets

 

125

 

33

 

Net cash used in investing activities

 

(2,093

)

(2,115

)

 

 

 

 

 

 

Cash Flows from Financing Activities:

 

 

 

 

 

Proceeds from issuance of common stock

 

6,032

 

5,299

 

Payments on line of credit

 

(3,500

)

 

Employees’ taxes withheld and paid for restricted stock

 

(195

)

 

Net cash provided by financing activities

 

2,337

 

5,299

 

 

 

 

 

 

 

Effect of foreign exchange rate on cash and cash equivalents

 

115

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

1,096

 

(2,436

)

Cash and cash equivalents at beginning of period

 

55,113

 

74,219

 

Cash and cash equivalents at end of period

 

$

56,209

 

$

71,783

 

 

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

5




ALIGN TECHNOLOGY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

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”). Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in accordance with such rules and regulations. The December 31, 2006 balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. However, the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements reflect all adjustments necessary to present fairly the financial position of the Company as of March 31, 2007 and December 31, 2006, its results of operations for the three months ended March 31, 2007 and 2006, and its cash flows for the three months ended March 31, 2007 and 2006.

The results of operations for the three months ended March 31, 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 “Management’s 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 Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

The Condensed Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

Foreign currency

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.  Historically, all of Align’s 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.  For the three months ended March 31, 2007, the Company included a $97,000 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.

Align’s 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 rate except for non monetary assets and capital accounts which are remeasured at historical exchange rates. Revenue and expense are generally remeasured at a monthly exchange rate that approximates the average exchange rate in effect during each period. Gains or losses from foreign currency remeasurement are included in consolidated net income (loss).

6




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 entity’s 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.  There was no impact to the Company’s consolidated financial position, results of operations or cash flows for the three month period ended March 31, 2007.

Reclassification

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.

Recent Accounting Pronouncements

In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including 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 fiscal 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 (“GAAP”), 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.  In addition, OrthoClear agreed, among other

7




things, to stop accepting new patient cases for treatment, consent to the entry of an exclusion order by the ITC prohibiting the importation of OrthoClear aligners into the United States, assign and transfer to Align all intellectual property rights with application to the correction of malocclusion and discontinue all design, manufacture, marketing and sales of removable dental aligners worldwide. In addition, certain OrthoClear principles also signed five year non-compete agreements. The Company evaluated this transaction under the provisions of EITF 98-3 “Determining Whether a Non-Monetary Transaction Involves a Receipt of Productive Assets or of a Business” (“EITF 98-3”) and concluded that this transaction is not a business acquisition and will be accounted for as an asset purchase.

In accordance with the terms of the OrthoClear Agreement, the Company made a $20.0 million one-time cash payment to OrthoClear Holdings, Inc. on October 16, 2006.  The non-compete agreements, received in connection with the OrthoClear Agreement, were valued at $14.0 million and are being amortized over 5 years beginning in the fourth quarter of 2006.  The remaining $6.0 million of the $20.0 million payment was recorded as settlement costs in accordance with EITF 04-01 “Accounting for Pre-existing Contractual Relationships between the Parties to a Purchase Business Combination” (“EITF 04-01”).  The intellectual property transferred to Align was determined not to have any alternative future use and therefore had no fair value.

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 Patient First Program terms and conditions, those registered cases were required to submit treatment forms by the deadline of March 30, 2007. Based on the actual case submissions received as of the case submission deadline, the Company reduced its Patients First Program accrual by $1.8 million in the first quarter of 2007 to reflect a reduction in the number of cases and associated costs that the Company would have incurred to fulfill its obligations under the program.  As of March 31, 2007, $2.8 million remained in accrued liabilities for this program. Align currently anticipates that the Patients First Program will be completed by the end of the second quarter of fiscal 2007.

Note 3.  Short-term Investments

The Company has the following short-term investments as of March, 31, 2007 and December 31, 2006 are as follows (in thousands):

 

Amortized
Costs

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Loss

 

Fair Value

 

March 31, 2007

 

 

 

 

 

 

 

 

 

U.S. Government notes and bonds

 

$

7,695

 

$

1

 

$

 

$

7,696

 

Corporate bonds

 

500

 

 

 

500

 

Commercial paper

 

1,188

 

 

 

1,188

 

Total

 

$

9,383

 

$

1

 

$

 

$

9,384

 

 

 

 

 

 

 

 

 

 

 

December 31, 2006

 

 

 

 

 

 

 

 

 

U.S. Government notes and bonds

 

$

4,880

 

$

2

 

$

 

$

4,882

 

Corporate bonds

 

2,951

 

 

 

2,951

 

Commercial paper

 

1,098

 

 

 

1,098

 

Total

 

$

8,929

 

$

2

 

$

 

$

8,931

 

 

As of March 31, 2007, all short-term investments have maturity dates less than one year. For the three months ended March 31, 2007 and 2006, no significant gains were realized on the sale of short-term investments.

 

8




Note 4.  Balance Sheet Components

Inventories comprise of (in thousands):

 

March 31,
2007

 

December 31,
2006

 

Raw materials

 

$

2,061

 

$

2,021

 

Work in process

 

1,231

 

763

 

Finished goods

 

433

 

306

 

 

 

$

3,725

 

$

3,090

 

 

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):

 

March 31,
2007

 

December 31,
2006

 

Accrued payroll and benefits

 

$

12,793

 

$

17,768

 

Accrued sales rebate

 

3,078

 

3,895

 

Accrued Patients First Program costs

 

2,814

 

6,800

 

Accrued sales and marketing expense

 

2,668

 

2,235

 

Accrued warranty

 

2,236

 

2,094

 

Other

 

8,242

 

7,515

 

 

 

$

31,831

 

$

40,307

 

 

Note 5.  Goodwill and Intangible Assets

In conjunction with the acquisition of General Orthodontics, LLC (“GO”) in the first quarter of 2005, the Company recorded $0.5 million of goodwill, which represents the difference between the purchase price and the fair value of the acquired net assets and the identified intangible assets. As required by FASB Statement No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), the Company performs its annual impairment test in the fourth quarter of the fiscal year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired.

The following is a summary of the Company’s purchased intangible assets as of March 31, 2007 and December 31, 2006 (in thousands):

 

 

 

 

March 31, 2007

 

December 31, 2006

 

 

 

Estimated
Useful Life
(in years)

 

Gross
Carrying
Value

 

Accumulated
Amortization

 

Net
Carrying
Value

 

Gross
Carrying
Value

 

Accumulated
Amortization

 

Net
Carrying
Value

 

Non-compete agreements

 

5

 

$

14,000

 

$

1,312

 

$

12,688

 

$

14,000

 

$

612

 

$

13,388

 

Consultant relationships

 

3

 

980

 

756

 

224

 

980

 

626

 

354

 

Patent

 

5

 

180

 

126

 

54

 

180

 

117

 

63

 

Other

 

3

 

55

 

42

 

13

 

55

 

36

 

19

 

Total

 

 

 

$

15,215

 

$

2,236

 

$

12,979

 

$

15,215

 

$

1,391

 

$

13,824

 

 

Non-compete agreements represent the fair value of 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. See Note 2 “Patients First Program” of the Notes to Condensed Consolidated Financial Statements for additional information.

Consultant relationships and other intangible assets represent the fair value of intangible assets acquired as the result of the GO acquisition in 2005. Upon the integration of GO, Align included GO’s 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 Invisalign Consulting Services effective June 29, 2007.  As a result, the net carrying values of the consultant relationships and other intangible assets related to ICS will be fully amortized over the remaining useful lives through June 29, 2007.

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

9




strategy for its business, significant negative industry or economic trends, and/or a significant decline in our 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. No intangible asset impairment was recorded for the periods presented.

The total estimated annual future amortization expense for these intangible assets as of March 31, 2007 is as follows (in thousands):

Fiscal Year

 

 

 

2007

 

$

2,364

 

2008

 

2,827

 

2009

 

2,800

 

2010

 

2,800

 

2011 and thereafter

 

2,188

 

Total

 

$

12,979

 

 

Note 6.   Legal Proceedings

Ormco

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 Company’s patents  (the “Align Patents”) through the manufacture and sale of Ormco’s and AOA’s Red, White & Blue appliances.  The Company’s 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) Ormco’s appeal of the decisions and orders of the District Court relating to Ormco’s 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 that order 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 CAFC’s 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 Ormco’s and AOA’s Red, White & Blue appliances were invalid.  Briefing on this appeal and cross-appeal is complete, and oral argument occurred on February 6, 2007.

Litigating claims of these types, whether or not ultimately determined in the Company’s favor or settled by the Company, is costly and diverts the efforts and attention of the Company’s management and technical personnel from normal

10




business operations.  Any of these results from litigation could adversely affect the Company’s results of operations.  From time to time, the Company has received, and may again receive, letters from third parties drawing the Company’s attention to their patent rights. While the Company does not believe that it infringes any such rights that have been brought to the Company’s 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. Additionally, the amendment will also increase the available borrowings under the existing revolving line of credit from $20 million to $25 million effective January 1, 2008. 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 quarter of 2007, the Company repaid $3.5 million of its outstanding borrowing on this credit facility.  As of March 31, 2007, the outstanding balance was $8.0 million bearing an interest rate of LIBOR plus two percent or 7.29%. The Company is in compliance with the financial covenant of this credit facility.

Note 8.  Commitments and Contingencies

Operating leases

As of March 31, 2007, minimum future lease payments for non-cancelable leases are as follow (in thousands):

Years Ending December 31,

 

 

2007

 

 

$

2,883

 

2008

 

 

2,654

 

2009

 

 

1,500

 

2010

 

 

467

 

2011

 

 

 

Thereafter

 

 

 

Total

 

 

$

7,504

 

 

Product Warranty

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 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 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 Company’s warranty accrual during the three months ended March 31, 2007 and 2006, respectively (in thousands):

 

Three months ended
March 31,

 

 

 

2007

 

2006

 

Balance at beginning of period

 

$

2,094

 

$

1,998

 

Charged to cost of sales

 

602

 

631

 

Actual warranty expenses

 

(460

)

(788

)

Balance at end of period

 

$

2,236

 

$

1,841

 

 

Note 9.  Stock-based Compensation

The Company accounts for stock–based 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.

11




Valuation assumptions

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:

 

Three Month Ended
March 31,

 

 

 

2007

 

2006

 

Stock Options:

 

 

 

 

 

 

 

 

 

 

 

Expected term (in years)

 

4.7

 

5.0

 

Expected volatility

 

72.4

%

77.0

%

Risk-free interest rate

 

4.7

%

4.6

%

Expected dividend

 

 

 

Weighted average fair value at grant date

 

$

10.84

 

$

5.47

 

 

 

 

 

 

 

Employee Stock Purchase Plan:

 

 

 

 

 

 

 

 

 

 

 

Expected term (in years)

 

1.3

 

1.3

 

Expected volatility

 

60.0

%

54.9

%

Risk-free interest rate

 

5.1

%

4.7

%

Expected dividend

 

 

 

Weighted average fair value at grant date

 

$

6.84

 

$

3.18

 

 

Summary of stock-based compensation expense

Stock-based compensation expense recognized in the Consolidated Statements of Operations for the three months ended March 31, 2007 and 2006 are 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 Company’s stock-based awards and employee stock purchases under FAS 123R for the three months ended March 31, 2007 and 2006:

 

Three Months Ended
March 31,

 

(In thousands)

 

2007

 

2006

 

Cost of revenues

 

$

234

 

$

148

 

Sales and marketing

 

857

 

679

 

General and administrative

 

1,103

 

1,088

 

Research and development

 

328

 

290

 

Total stock-based compensation

 

$

2,522

 

$

2,205

 

 

Stock Option 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.

12




Options

Stock option activities for the three months ended March 31, 2007 under the stock option plans are set forth below (in thousands, except per share data):

 

 

Total Shares

 

In-the-money Shares

 

 

 

Number of
Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Term
(in years)

 

Number
of Shares

 

Weighted
Average
Exercise
Price

 

Aggregate
Intrinsic
Value

 

Outstanding as of December 31, 2006

 

9,178

 

$

8.86

 

 

 

 

 

 

 

 

 

Granted

 

1,013

 

17.75

 

 

 

 

 

 

 

 

 

Cancelled or expired

 

(31

)

10.65

 

 

 

 

 

 

 

 

 

Exercised

 

(639

)

6.94

 

 

 

 

 

 

 

 

 

Outstanding as of March 31, 2007

 

9,521

 

$

9.93

 

7.5

 

7,252

 

$

7.29

 

$

62,152

 

Ending vested and expected to vest at March 31, 2007

 

9,166

 

$

9.88

 

7.5

 

7,004

 

$

7.26

 

$

60,213

 

Exercisable at March 31, 2007

 

6,286

 

$

9.26

 

6.7

 

5,063

 

$

6.71

 

$

45,066

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between Align’s closing stock price on the last trading day of first quarter of 2007 of $15.86 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 March 31, 2007. This amount changes based on the fair market value of Align’s stock.

The total intrinsic value of stock options exercised for three months ended March 31, 2007 and 2006 was $6.2 million, and $0.6 million, respectively. As of March 31, 2007, there was $18.5 million of total unamortized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 2.7 years.  For the three months ended March 31, 2007, total recognized tax benefit from exercised options was approximately $0.1 million.

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 Company’s closing stock price on the date of grant. As of March 31, 2007, the total fair value of vested restricted stock awards was $0.7 million. A summary of the nonvested shares for the three months ended March 31, 2007 is as follows (in thousands, except per share data):

 

 

Number of
Shares

 

Weighted
Average Grant
Date Fair Value

 

Weighted
Average
Remaining
Contractual
Term (in years)

 

Aggregate
Intrinsic Value

 

Nonvested as of December 31, 2006

 

419

 

$

8.71

 

 

 

 

 

Granted

 

303

 

17.78

 

 

 

 

 

Vested

 

(83

)

8.38

 

 

 

 

 

Forfeited

 

(5

)

9.94

 

 

 

 

 

Nonvested as of March 31, 2007

 

634

 

$

13.07

 

1.8

 

$

1,430

 

 

As of March 31, 2007, the total unamortized compensation costs related to restricted stock units was $7.2 million. These costs are expected to be recognized over a weighted average period of 3.4 years.

13




Employee Stock Purchase Plan

Align’s 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 March 31, 2007, there was $0.9 million of total unamortized compensation costs related to employee stock purchases. These costs are expected to be recognized over a weighted average period of 0.5 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 our unrecognized tax benefits are $0.4 million of uncertain tax positions that would impact the Company’s 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 Company’s unrecognized tax benefits for the three month period ended March 31, 2007.

The Company is subject to taxation in the U.S. and various states and foreign jurisdictions.  All the Company’s tax years will be open to examination by the U.S. federal and most state tax authorities due to the Company’s 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):

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

Net profit (loss)

 

$

6,978

 

$

(4,764

)

 

 

 

 

 

 

Weighted-average common shares outstanding, basic

 

65,433

 

62,518

 

 

 

 

 

 

 

Effect of potential dilutive common shares

 

3,898

 

 

Total shares, diluted

 

69,331

 

62,518

 

 

 

 

 

 

 

Basic net profit (loss) per share

 

$

0.11

 

$

(0.08

)

Diluted net profit (loss) per share

 

$

0.10

 

$

(0.08

)

 

For the three months ended March 31, 2007 and 2006, stock options and restricted stock units totaling 2.1 million and 6.9 million were excluded from diluted net loss per share because of their anti-dilutive effect.

14




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:

 

Three Months Ended
March 31,

 

(in thousands)

 

2007

 

2006

 

Net profit (loss)

 

$

6,978

 

$

(4,764

)

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

Foreign currency translation adjustments

 

97

 

 

Unrealized loss on available-for-sale securities

 

(1

)

(1

)

Comprehensive income (loss)

 

$

7,074

 

$

(4,765

)

 

Note 13.               Segments and Geographical Information

Segment

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 as a single business segment.

Geographical Information

Revenues and long-lived assets are presented below by geographic area (in thousands):

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

Revenues:

 

 

 

 

 

Domestic

 

$

54,343

 

$

42,165

 

Europe

 

8,449

 

6,058

 

Other International

 

969

 

685

 

Total revenues

 

$

63,761

 

$

48,908

 

 

 

As of March 31,
2007

 

As of December 31,
2006

 

Long-lived assets:

 

 

 

 

 

Domestic

 

$

38,911

 

$

40,744

 

Europe

 

803

 

745

 

Other International

 

2,085

 

1,979

 

Total long-lived assets

 

$

41,799

 

$

43,468

 

 

15




ITEM 2.                    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

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 our market share, our expectations regarding product mix and Invisalign Express, our anticipated cost of the Patients First Program, our expectation that we will return to normal product delivery by the end of the second quarter of 2007, our belief in the rate of “recapture” of OrthoClear cases in the future, 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 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 expectations regarding further expansion into North American and international markets, including Japan, 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 Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and in particular, the risks discussed below in below under the subheading “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.

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. 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.

We generate the vast majority of our revenues from the sales of the Invisalign system (which includes full Invisalign treatment and Invisalign Express) to orthodontists and GPs in the United States and Canada, our domestic market. Sales of the Invisalign system in our domestic GP channel and our domestic orthodontic channel represented approximately 47% and 34% of our total net revenues during the first quarter of 2007, respectively. Our domestic full Invisalign and Invisalign Express revenues represented 73% and 8% of our total net revenue during the first quarter of 2007, respectively. Our international revenues represented 15% of our total net revenue during the first quarter of 2007.

16




A number of factors, the most important of which are set forth below, may affect our results during the remainder of 2007 and beyond.

·                  Settlement with OrthoClear.   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.  In addition, OrthoClear agreed, among other things, to stop accepting new patient cases for treatment, consent to the entry of an exclusion order by the ITC prohibiting the importation of OrthoClear aligners into the United States, assign and transfer to Align all intellectual property rights with application to the correction of malocclusion and to discontinue all design, manufacture, marketing and sales of removable dental aligners worldwide.  Certain OrthoClear principles also signed five year non-compete agreements.  In accordance with the terms of the OrthoClear Agreement, the Company made a $20.0 million one-time cash payment to OrthoClear Holdings, Inc. on October 16, 2006.  The non-compete agreements, received in connection with the OrthoClear Agreement, were valued at $14.0 million and are being amortized over 5 years beginning in the fourth quarter of 2006.  The remaining $6.0 million of the $20.0 million payment was recorded as settlement costs.  The intellectual property transferred to Align was determined not to have any alternative future use and therefore had no fair value. Through the OrthoClear Agreement we achieved our primary objectives in the litigation as well as eliminated the costs and risks of protracted litigation. As a result of the OrthoClear Agreement, we expect our legal expenses will be reduced significantly in fiscal 2007 and our management and technical personnel will be able to refocus their energy and resources on our customers and product development.

·                  “Patients First Program”.  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 receive no revenue for any additional cases we start 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 Patient First Program terms and conditions, those registered cases were required to submit treatment forms by the deadline of March 30, 2007. Based on the actual case submissions received as of the case submission deadline, we reduced our Patients First Program accrual by $1.8 million to reflect the reduction in the number of cases and the anticipated costs that would have incurred to fulfill our obligations under this program. As of March 31, 2007, $2.8 million remained in accrued liabilities for this program.

Additionally, this program has 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.  Difficulties such as these in managing the deployment of this program, could cause us to lose existing customers or cause these customers to decrease the number of cases they start each quarter, face potential customer disputes or limit the number of new customers who purchase our products or services as well as result in lost or delayed revenue which could cause a decline in our revenues, gross margins and net profits and adversely affect our operating results. We currently anticipate that we will be able to complete the Patients First Program by the end of the second quarter of fiscal 2007. We expect that as we complete the Patients First Program cases, the incremental capacity and workforce created as a result of this program will be utilized by the anticipated increase in paid Invisalign cases and we anticipate a return to our normal product delivery times.

·                    Penetration into our Domestic Market.   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

17




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. In fact, in the first quarter of 2007, our domestic GP channel generated 47% of our total net revenue, while the orthodontic channel represented 34%.  We continue to believe that by focusing on increasing 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 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.  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.

Additionally, upon OrthoClear’s exit from the clear aligner business, we monitored whether OrthoClear doctors would now be submitting a comparable number of cases to Align or seek alternative methods of treatment. We believe that we are receiving and will continue to receive a majority of this case volume, or approximately 5,000 cases per quarter. However, we do not intend to continue to track these submissions going forward.

·                  Product Mix.  In the fourth quarter of 2006, we experienced a decline in the number of Invisalign Express cases compared to the third quarter of 2006. This decline continued in the first quarter of 2007 and we expect that Invisalign Express cases as a percentage of our revenues will remain consistent with the first quarter of 2007 for the remainder 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.

·                  Continued Product Leadership.   We are committed to investing in delivering new products, enhancing the user experience and introducing new product features to our existing products. 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. During 2007, we expect to extend the product features and functionality of ClinAdvisor and release it to an increasing number of practices.  In addition, we plan to introduce further software enhancements directed at our more experienced doctors 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 market share.

·                  Expansion of International Markets.   We will focus our efforts towards increasing adoption of Invisalign by dental professionals in key international markets, including Europe and Japan.  We continually evaluate cost effective ways to support our customers in smaller 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 a distributor in other smaller markets as well as consider expanding directly into additional countries on a case by case basis.   In 2006, our international channel represented approximately 16% of our total net revenue primarily as a result of growth in Europe.  In 2007, we expect to increase 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.

·                  Increasing 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

18




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 become increasingly dependant on IMS’s 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 1A—Risk Factors for risks related to our international operations.

Results of Operation

Revenues:

Invisalign product revenues by channel and other revenues, which represented training and sales of ancillary products, for the three months ended March 31, 2007 and 2006 are as follows (in millions):

 

Three Months Ended March 31,

 

Net Revenue

 

2007

 

2006

 

Net
Change

 

%
Change

 

Domestic:

 

 

 

 

 

 

 

 

 

Ortho full

 

$

19.4

 

$

14.4

 

$

5.0

 

34.5

%

Ortho Express

 

2.1

 

2.9

 

(0.8

)

-26.4

%

Total Ortho revenue

 

21.5

 

17.3

 

4.2

 

24.5

%

 

 

 

 

 

 

 

 

 

 

GP full

 

27.0

 

18.0

 

9.0

 

50.6

%

GP Express

 

2.8

 

4.5

 

(1.7

)

-39.6

%

Total GP revenue

 

29.8

 

22.5

 

7.3

 

32.2

%

 

 

 

 

 

 

 

 

 

 

International

 

9.2

 

7.0

 

2.2

 

31.9

%

Total Invisalign revenue

 

60.5

 

46.8

 

13.7

 

29.3

%

 

 

 

 

 

 

 

 

 

 

Other revenues

 

3.3

 

2.1

 

1.2

 

53.5

%

Total revenues

 

$

63.8

 

$

48.9

 

$

14.9

 

30.4

%

 

19




Case volume data which represents Invisalign case shipment by channel, for the three months ended March 31, 2007 and 2006 are as follows (in thousands):

 

Three Months Ended March 31,

 

Case Volume

 

2007

 

2006

 

Net
Change

 

%
Change

 

Domestic:

 

 

 

 

 

 

 

 

 

Ortho full

 

14.2

 

10.2

 

4.0

 

39.5

%

Ortho Express

 

2.8

 

3.8

 

(1.0

)

-26.0

%

Total Ortho volume

 

17.0

 

14.0

 

3.0

 

21.7

%

 

 

 

 

 

 

 

 

 

 

GP full

 

18.6

 

12.3

 

6.3

 

51.1

%

GP Express

 

3.8

 

6.2

 

(2.4

)

-37.6

%

Total GP volume

 

22.4

 

18.5

 

3.9

 

21.6

%

 

 

 

 

 

 

 

 

 

 

International

 

5.6

 

4.2

 

1.4

 

31.9

%

Total Invisalign volume

 

45.0

 

36.7

 

8.3

 

22.8

%

 

Our total net revenues increased by $14.9 million or 30.4% to $63.8 million in the three months ended March 31, 2007 compared to the three months ended March 31, 2006.

Revenues for the domestic orthodontic and GP channels were impacted favorably by overall increases in case volumes and a product mix shift towards full Invisalign. This product mix shift towards full Invisalign in our domestic markets 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. Additionally, our average selling prices also benefited from the change in product mix towards the higher priced full Invisalign cases.

International revenues increased $2.2 million or 31.9% in the three months ended March 31, 2007 compared to the first three months in 2006 primarily due to a significant increase in our international Invisalign case volumes.

Other revenues consist of training and sales of ancillary products, increased $1.2 million, or 53.5% in the three months ended March 31, 2007 compared to the three months ended March 31, 2006 primarily due to a $1.3 million increase in training revenues resulting from an increase in number of doctors trained.

For the second quarter of fiscal year 2007, we expect our total net revenues will increase compared to the first quarter of 2007. We anticipate, however, that a portion of this quarter over quarter growth will be due to the reduction in case backlog and product delivery times in the second quarter of 2007 and not entirely from case volume receipt increases in our domestic and international markets.  Increased backlog and delivery times resulted from the allocation of capacity to the Patients First Program during the fourth quarter of 2006 and the first quarter of 2007.  For fiscal year 2007, we expect our total net revenues will increase compared to 2006 primarily due to the anticipated volume increases in our domestic orthodontic and GP channels, as well as in international markets. We expect our average selling price to be flat to slightly lower compare to 2006 primarily due to increased participation in our volume based discount programs.

Cost of revenues:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Cost of revenues

 

$

17.5

 

$

14.3

 

$

3.2

 

% of Revenues

 

27.5

%

29.2

%

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

46.2

 

$

34.6

 

$

11.6

 

% of Revenues

 

72.5

%

70.8

%

 

 

 

Cost of revenues includes salaries for staff involved in the production process, costs incurred by IMS, a third party shelter service provider in Juarez, Mexico, the cost of materials, packaging, shipping costs, depreciation on capital equipment used in the production process, training costs and stock-based compensation expense.

20




Gross margin increased to 72.5% of net revenues in the three months ended March 31, 2007 compared to 70.8% in the three months ended March 31, 2006. The improvement in gross margin was primarily a result of the increase in case volumes resulting in improved overhead absorption combined with improved manufacturing efficiencies.

For the fiscal year 2007, we anticipate that our gross margin will be slightly higher compared to 2006 primarily due to impact of the expected increase in case volume and manufacturing efficiencies, including a full year effect of the relocation of the SLA mold operations to Juarez, Mexico.

Sales and marketing:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Sales and marketing

 

$

23.2

 

$

20.1

 

$

3.1

 

% of Revenues

 

36.3

%

41.0

%

 

 

 

Sales and marketing expense includes sales force compensation (combined with travel related costs and expenses for professional marketing programs), conducting workshops and market surveys, advertising, dental professional trade show attendance and stock-based compensation expense.

Sales and marketing expense increased $3.1 million in the three months ended March 31, 2007 compared to the first three months ended March 31, 2006 primarily due to a $1.4 million increase in expenses related to media advertising and marketing programs in the US and Europe, a $0.6 million in payroll related expenses due to increase in sales management headcount and $0.3 million increase in commission expense due to increase in sales volume also contributed to the increase in sales and marketing expenses.

For fiscal 2007, we expect sales and marketing expense to be higher than 2006, as we expand our sales force, increase our investment in media programs and provide clinical education.

General and administrative:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

General and administrative

 

$

12.2

 

$

15.1

 

$

(2.9

)

% of Revenues

 

19.1

%

30.8

%

 

 

 

General and administrative expense includes salaries for administrative personnel, outside consulting services, legal expenses and stock-based compensation expense.

General and administrative expense decreased by $2.9 million in the first quarter of 2007 compared to the same period in 2006 primarily due to a $4.5 million reduction in external legal fees as a result of the litigation settlement with OrthoClear in the fourth quarter of 2006. This decrease was partially offset by a $1.1 million increase in payroll related expenses primarily attributable to increase in headcount and a $0.8 million increase related to the amortization of the non-compete agreements we received in connection with the OrthoClear settlement agreement.

For fiscal year 2007, we expect that general and administrative expense will decrease from fiscal 2006 primarily as a result of the significant reduction in legal and other expenses following the settlement agreement we entered into with OrthoClear in the fourth quarter of 2006.

Research and development:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Research and development

 

$

5.7

 

$

4.7

 

$

1.0

 

% of Revenues

 

8.9

%

9.6

%

 

 

 

21




Research and development expense includes the personnel costs associated with software engineering, the cost of designing, developing and testing our products, conducting clinical and post-marketing trials and stock-based compensation expense. We expense our research and development costs as they are incurred.

Research and development expense increased $1.0 million in the three months ended March 31, 2007 compared to the three months ended March 31, 2006, due to a $1.0 million increase in payroll related expenses as a result of increases in temporary consulting services and employee headcount.

For fiscal 2007, we expect research and development spending to increase from fiscal 2006 as we continue to invest in research and development efforts to bring new products to market, conduct clinical research and focus on product improvement initiatives.

Patients First Program:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Patients First Program

 

$

(1.8

)

$

 

$

(1.8

)

% of Revenues

 

-2.8

%

%

 

 

 

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, we committed to make treatment available to these patients at no additional cost under the “Patients First Program”.  We will receive no revenue for the program, and will incur significant expense to complete these cases.  In the fourth quarter of 2006, we recorded an $8.3 million charge for the anticipated costs of completing this 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 Patient First Program terms and conditions, those registered cases were required to submit treatment forms by the deadline of March 30, 2007. Based on the actual case submissions received as of the case submission deadline, we reduced our Patients First Program accrual by $1.8 million in the first quarter of 2007 to reflect the reduction in the number of cases and the anticipated costs that would have incurred to fulfill our obligations under this program. We currently anticipate that we will be able to complete the Patients First Program by the end of the second quarter of fiscal 2007.

Interest and other, net:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Interest income, net

 

$

0.5

 

$

0.7

 

$

(0.2

)

Other income (expense), net

 

 

 

 

Total interest and other, net

 

$

0.5

 

$

0.7

 

$

(0.2

)

 

Interest income (expense), net, includes interest income earned on cash balances, and interest expense on debt.

Interest income, net for the three months ended March 31, 2007 decreased $0.2 million compared to the three months ended March 31, 2006. The decrease was due to additional interest expense related to the outstanding balance on our line of credit during the first quarter of 2007. Whereas, there was no outstanding borrowing against our line of credit during the first quarter of 2006.

22




Income tax provision:

 

Three months ended
March 31,

 

(In millions)

 

2007

 

2006

 

Change

 

Provision for income taxes

 

$

0.5

 

$

0.2

 

$

0.3

 

 

We recorded an income tax provision of $0.5 million and $0.2 million for the three months ended March 31, 2007 and 2006, respectively, representing effective tax rates of 6.4% and -5.5%, respectively.  Our effective tax rate for the remainder of 2007 may fluctuate based upon our operating results for each taxable jurisdiction in which we operate and the amount of statutory tax that we incur in each jurisdiction.

Liquidity and Capital Resources

We fund our operations from the proceeds of the sale of our common stock, from cash generated from sales of our product and occasional borrowing under available credit facilities. As of March 31, 2007 and December 31, 2006 we had the following cash, cash equivalents and short-term investments (in thousands):

 

March 31,
2007

 

December 31,
2006

 

Cash and cash equivalents

 

$

56,209

 

$

55,113

 

Restricted cash

 

95

 

93

 

Short-term Investments

 

9,384

 

8,931

 

Total cash, cash equivalents and short-term investments

 

$

65,688

 

$

64,137

 

 

Net cash provided by operating activities for the three months ended March 31, 2007 was $0.7 million, resulting primarily from our operating income of $7.0 million adjusted for non-cash items such as depreciation and amortization and stock-based compensation totaling $5.9 million. These increases in cash flows from operating activities were partially offset by a $6.8 million decrease in accounts payable and accrued liabilities, a $4.7 million increase in accounts receivable and a $0.6 million increase in inventory.

Net cash used by operating activities for the three months ended March 31, 2006 was $5.6 million, resulting primarily from operating losses adjusted for non cash items and a $2.8 million increase in accounts receivable as a higher percentage of revenues were shipped during the latter part of the first quarter, a $1.5 million increase in prepaid and other current assets and a $1.6 million reduction in deferred revenue.

Net cash used in investing activities was $2.1 million for the three months ended March 31, 2007, primarily due to a $1.8 million used for the purchase of capital assets and $0.5 million net purchase of short-term marketable securities. We used $2.1 million of our cash in investing activities for the three months ended March 31, 2006 to purchase capital assets.

Net cash provided by financing activities was $2.3 million for the year ended March 31, 2007 and primarily consisted of $6.0 million in proceeds from the issuance of common stock from exercise of employee stock options partially offset by $3.5 million in payment of our line of credit. For the three months ended March 31, 2006, net cash provided by financing activities entirely consisted of proceeds from the issuance of common stock, primarily from exercises of employee stock options.

Net proceeds from the issuance of common stock related to the exercise of employee stock options have historically been a significant component of our liquidity.  However, in 2006, we began granting RSUs which, unlike stock options, do not generate cash from exercise. As a result, we will likely generate less cash from the proceeds of the sale of our common stock in future periods. In addition, because RSUs are taxable to the individuals when they vest, the number of shares we issue to each of our executive officers will be net of applicable payroll withholding taxes which taxes will be paid by us on their behalf. During the first quarter of 2007, we paid $195,000 for executive officers payroll taxes as a result of RSUs vested during the period. 

On March 7, 2007, we renegotiated and amended our existing credit facility with Comerica Bank. The amendment, among other things, reduced financial covenants to require only a quick ratio covenant. Additionally, the amendment will also increase the available borrowings under the existing revolving line of credit from $20 million to $25 million effective January 1, 2008. 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 quarter of 2007, we repaid $3.5 million of our outstanding borrowing on this credit facility.  As of March 31, 2007, the outstanding balance was $8.0 million bearing an interest rate of LIBOR plus two percent or 7.29%.  We are in compliance with the financial covenant of this credit facility.

23




Contractual Obligations

As of March 31, 2007 there were no other material changes to our contractual obligations outside the ordinary course of business from those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

Critical Accounting Policies

Management’s discussion and analysis of our financial condition and results of operations is based upon our Condensed 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 reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2006.

·                            Recognition of revenues;

·                            Stock-based compensation;

·                            Long-lived assets, including finite lived purchased intangible assets;

·                            Patients First Program;

·                            Warranty expense; and

·                            Deferred tax valuation allowance.

There have been no significant changes in our critical accounting policies during the three months ended March 31, 2007 compared to what was previously disclosed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Recent Accounting Pronouncements

See Note 1 “Summary of Significant Accounting Policies” of the Notes to Condensed Consolidated Financial Statements for a discussion of recent accounting pronouncements.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Quantitative Disclosures

For quantitative and qualitative disclosures about market risk affecting us, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, which is incorporated herein by reference. Our exposure to market risk has not changed materially since December 31, 2006.

ITEM 4.  CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

Under the supervision and with the participation of our management, including our Chief Executive Officer and our

24




Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form10-Q. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of March 31, 2007 to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

Changes in internal control over financial reporting.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

25




PART II—OTHER INFORMATION

ITEM 1.                         LEGAL PROCEEDINGS

Ormco

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. 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, 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 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 and AOA’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 and AOA asserted. Fifth, the Court also granted our summary judgment motion that our patents are not unenforceable and granted Ormco’s and AOA’s summary judgment motion that Ormco and AOA 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 and AOA’s new evidence. Ormco and AOA 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 and AOA’s motion in part, finding certain claims of our 6,398,548 patent to be invalid in view of prior use evidence. On March 10, 2005, Ormco and AOA moved for reconsideration of the Court’s ruling that Claims 10 and 17 of our U.S. Patent No. 6,398,548 are not invalid.  On April 8, 2005, the Court ruled that it would adhere to its previous ruling that Claims 10 and 17 of our 6,398,548 patent are not invalid.

On March 28, 2005, we filed a motion for permanent injunction to prevent Ormco and AOA from selling the infringing Red, White & Blue system.  On May 26, 2005, the Court issued a permanent injunction (the “Permanent Injunction”) to enjoin Ormco and AOA from further infringement of Claims 10 and 17 of our 6,398,548 patent and Claims 1-3 and 7 of our 6,554,611 patent. On May 31, 2005, Ormco and AOA noticed an appeal to the Federal Circuit from the Permanent Injunction. 

On February 1, 2006, we 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 Align’s U.S. Patent Nos. 6,398,548 and 6,554,611 (the “Align Patents”) through the manufacture and sale of Ormco’s and AOA’s Red, White & Blue appliances.  Our 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

26




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) Ormco’s appeal of the decisions and orders of the District Court relating to Ormco’s 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 that order 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 CAFC’s decision reverses the California District Court summary judgment order of validity.

The 6,398,548 patent consists of seventy-one claims; only claims 10 and 17 were at issue in the appeal and CAFC ruling. These two claims are directed to a system of appliances and method of repositioning teeth from an initial to a final tooth arrangement where at least some of the appliances are marked to show order of use. These claims contain further limitations requiring instructions as to order in which the appliances are to be worn and use of the appliances in intervals of 2-20 days.

The 6,544,611 patent consists of ten claims directed to a system for repositioning teeth that includes one or more intermediate appliances and a final appliance, provided in a single package, as well as instructions which set forth the order in which the appliances are to be worn. The CAFC’s ruling pertains only to claims 1, 2, 3 and 7 in the patent.

The majority of the claims in the 6,398,548 patent, including claims that address methods of fabricating aligners, digital data sets or computer-generated models to fabricate appliances, are unaffected by the appeal and the CAFC’s ruling. The 6,544,611 patent does not contain claims related to digital data, computer-generated models, or methods of fabrication.

The second appeal is from the final judgment.  Once final judgment was entered, Ormco filed a Notice of Appeal from the final judgment and we filed a notice of cross-appeal.  Ormco has appealed the ruling of the District Court that its patents are not infringed by us and that the asserted claims are invalid.  We appealed the ruling of the District Court that certain claims of our 6,398,548 patent which were found to be infringed by Ormco’s and AOA’s Red, White & Blue appliances were invalid.  Briefing on this appeal and cross-appeal is complete, and oral argument occurred on February 6, 2007.

Other matters

USPTO

Ex Parte Requests:

During fiscal 2005 and 2006, requests were filed with the United States Patent and Trademark Office (“USPTO”) by a San Francisco, California, law firm, acting on behalf of an unnamed party, requesting Ex Parte re-examination of our patents as follows:

U.S. Patent
No.

 

Request for
Reexamination
Granted?

 

Initial Office
Actions
Received?

 

Status

5,975,893

 

Yes

 

Yes

 

On January 26, 2006, a first office action was issued rejecting all claims of U.S. Patent No. 5,975,893 (the ‘893 patent). We responded to this initial office action. A Final Office Action was issued by the USPTO on June 23, 2006 rejecting the pending claims of Align’s response. On August 23, 2006, we filed an amendment and on February 14, 2007 we filed a supplementary amendment each in response to this Final Office Action, which included claims discussed in an interview with the Examiners. We are awaiting further action by the USPTO.

 

 

 

 

 

 

 

6,398,548

 

Yes

 

No

 

We filed a preliminary amendment and a supplementary preliminary amendment on July 16, 2006 and February 14, 2007, respectively. We are awaiting an initial office action.

 

27




 

6,309,215

 

Yes

 

Yes

 

On July 27, 2006, after submitting amendments, affidavits, declarations or other documents as evidence of patentability, we received an action entitled “Notice of Intent to Issue Ex Parte Reexamination Certificate” with respect to U.S. Patent No. 6,309,215 (the ‘215 patent). With this Notice, the USPTO has closed prosecution on the merits in reexamination and affirmed the patentability of all of our claims pending in reexamination in the ‘215 patent. While the ‘215 patent entered the reexamination proceedings with 16 claims, 26 additional claims were added in the reexamination by us and the ‘215 patent leaves the proceedings as a valid and enforceable patent with 42 claims. An Exparte Reexamination Certificate was issued on March 20, 2007.

 

 

 

 

 

 

 

6,705,863

 

Yes

 

No

 

We filed a preliminary amendment and a supplementary preliminary amendment on May 26, 2006 and February 14, 2007, respectively. We are awaiting an initial office action.

 

 

 

 

 

 

 

6,217,325

 

Yes

 

Yes

 

On July 25, 2006, we received an Office Action in U.S. Patent No. 6,217,325 (the ‘325 patent) confirming the patentability of 32 claims. While the ‘325 patent entered the reexamination proceedings with 26 claims, 15 additional claims were added by us in the reexamination. On September 25, 2006, we filed an amendment in response to the final Office Action with respect to the claims that were not allowed. We are awaiting further action by the USPTO.

 

 

 

 

 

 

 

6,722,880

 

No

 

N/A

 

On December 23, 2005, in a non-appealable, final Order, the USPTO denied the request for re-examination with respect to all twenty-one claims of U.S. Patent No. 6,722,880 (the ‘880 patent). Accordingly, the validity of all twenty-one claims of the ‘880 patent stand reaffirmed by the USPTO. On January 23, 2006, a Petition Seeking Review of Denial of Request for Re-examination of the ‘880 patent was filed by the same San Francisco, California law firm.

 

 

 

 

 

 

 

6,318,994

 

Yes

 

No

 

The USPTO has granted the requests for reexamination of the U.S. Patent No. 6,318,994. On February 15, 2007 we filed a preliminary amendment. We are awaiting an initial Office Action.

 

Inter Parte Requests made by OrthoClear

As part of the OrthoClear Agreement, OrthoClear agreed to take no further action with respect to the Inter Parte Requests.

Patent No.

 

Request for
Reexamination
Granted?

 

Initial Office
Actions
Received?

 

Status

6,629,840

 

Yes

 

Yes

 

In this initial Office Action dated June 13, 2006, the examiners confirmed the validity of eight of the eleven claims of U.S. Patent No. 6,629,840 (the ‘840 patent) without amendment and preliminarily rejected the remaining claims of the patents. The non-final initial Office Action presented us with the first opportunity to respond to the USPTO’s review and interpretation of the prior art. On September 13, 2006, we submitted a response to the initial Office Action. We are awaiting further action by the USPTO.

 

 

 

 

 

 

 

6,685,469

 

Yes

 

No

 

The USPTO has granted the requests for reexamination of U.S. Patent of U.S. Patent No. 6,685,469. We are awaiting an initial Office Action.

 

The re-examination proceedings on Patent Nos. 6,318,994, 6,398,548, 6,685,469 and 6,705,863 (collectively, the “Remaining Patents”) are currently pending but we have not received an Office Action.  We, however, filed Preliminary

28




Amendments adding additional claims regarding three of the Remaining Patents. While some of the pending re-examinations are in a preliminary stage, we believe that claims of the patents in re-examination will be determined to be patentable as currently written or as may be amended during the re-examination proceeding. However, there can be no assurance that we will prevail, and re-examination proceedings could result in some or all of the Remaining Patent claims (as well as the ‘893, ‘325 and ‘840 patent claims) having a narrower scope of coverage or even to being invalidated, which could have an adverse effect on us. As noted above, a Reexamination Certificate has been issued regarding the 6,309,215 patent and therefore this patent is no longer in reexamination.

Litigating claims of the types discussed in this Quarterly Report on Form 10-Q, 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.

29




PART II—OTHER INFORMATION

ITEM 1A.  RISK FACTORS

If we fail to grow our revenue while controlling our expenses, 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. Consistent with a company in an early stage of operations, we continue to incur significant operating expenses to:

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

·              execute our consumer marketing campaign and dental professional marketing efforts;

·              increase the capacity of our business enterprise systems and manufacturing operations;

·              execute clinical research and education plans;

·              develop technological improvements to our products and new product development;

·              continue our international sales and marketing efforts;

·              protect our intellectual property, including trade secrets; and

·              undertake quality assurance and improvement initiatives.

For instance, in an effort to raise the profile of Invisalign and match prospective patients with our most experienced dental professionals, we have in the past utilized consumer marketing campaigns involving television, radio and print media.  Marketing programs of this nature are expensive and may have limited success, if any, and may not result in revenue generation commensurate with their costs.

In addition, in an attempt to help minimize treatment disruptions for former OrthoClear patients and their doctors, we committed to make Invisalign treatment available to existing OrthoClear patients at no charge from Align through our “Patients First Program”.  As a result, we will receive no revenue for any additional cases we start under this program while incurring significant expenses as well as increased demands on our sales and customer service representatives and on our manufacturing processes. We currently anticipate that we will be able to complete the Patients First Program by the end of the second quarter of fiscal 2007. Our success will depend in part on our ability to effectively integrate the OrthoClear patients into our infrastructure with minimal impact on our existing and new doctors. In implementing this program, we experienced higher than anticipated demand from the Patients First Program as well as regular new patients.  As a result, many of our customers experienced slight delays in product processing times during the fourth quarter of 2006 and the first quarter of 2007 which we anticipate will continue during the second quarter of 2007.  Although we believe these delays are temporary in nature, these difficulties could cause us to lose existing customers or cause these customers to decrease the number of cases they start each quarter, face potential customer disputes or limit the number of new customers who purchase our products or services. This could cause a decline in our revenues, gross margins and net profits, and could adversely affect our operating results. See Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview”.

While we achieved profitability in the first quarter of fiscal 2007, we experienced a net loss in the third quarter of 2005 as well as each quarter of 2006. If we are to continue to achieve profitability in future periods, we will need to continue to increase our revenues, while controlling our expenses. While we generated positive operating cash flow in the first quarter of 2007, we experienced negative cash flow in 2006.  We cannot be certain that we will be able to achieve positive cash flow from operations, from period to period, in the future. Because our business is evolving, it is difficult to predict our future operating results or levels of growth, and we have in the past not been and may in the future not be able to sustain our historical growth rates. If we do not 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.

30




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:

·              changes in the timing of receipt of case product orders during a given quarter;

·              changes in product mix due to the introduction of Invisalign Express, a lower-cost alternative for treating less complex cases;

·              unanticipated delays in production caused by insufficient capacity;

·              any disruptions in the manufacturing process, including as a result of unexpected turnover in the labor force or the introduction of new production processes or as a result of natural or other disasters beyond our control;

·              the development and marketing of directly competitive products by existing and new competitors;

·              aggressive price competition from competitors;

·              costs and expenditures in connection with ongoing litigation;

·              inaccurate forecasting of revenues, production and other operating costs; and

·              investments in research and development to develop new products and enhancements to Invisalign.

To respond to these and other factors, we may need to make business decisions that could adversely affect our operating results such as modifications to our pricing policy, business structure or operations.  For instance, although we entered into a definitive agreement in October 2006 with OrthoClear whereby, among other things, OrthoClear agreed to discontinue all design, manufacture, marketing and sales of removable dental aligners worldwide, we experienced increased pricing pressure in 2005 and 2006 as a result of the commercial launch of OrthoClear’s product. Partly in response to this increased competition, in the fourth quarter of 2005, we changed our pricing structure and reduced our list price for full Invisalign treatment to $1,495 and expanded our volume based discount program to all doctors.  These programs were in effect in 2006, and had an adverse impact on our revenues, gross margins and net profit (loss).  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 revenues for a particular period fall below our expectations, we may be unable to adjust spending quickly enough to offset any shortfall in revenues. Therefore, our operating results for a given period may be adversely affected. 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 depend on the sale of Invisalign for the vast majority of our revenues, and any decline in sales of Invisalign or average selling prices would adversely affect revenue, gross margin and net profits.

We expect that revenues from the sale of Invisalign will continue to account for the vast majority of our total revenues for the foreseeable future. Continued and widespread market acceptance of Invisalign by orthodontists, GPs and consumers is critical to our future success. If orthodontists and GPs experience a reduction in consumer demand for orthodontic services, if consumers prove unwilling to adopt Invisalign as rapidly as we anticipate or in the volume that we anticipate, if orthodontists and GPs do not collaborate as we expect, if orthodontists or GPs choose to use a competitive product rather than Invisalign or if the average selling price of our product declines as it has in the past, our operating results would be harmed. Factors that could cause Invisalign not to achieve market acceptance at the rate at which we expect, as well as the risk related to declining average selling prices 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 and frequency of use of the Invisalign system by dental professionals. Invisalign requires orthodontists, GPs 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

31




July 1999, orthodontists and GPs may be reluctant to adopt it until more historical clinical results are available. Also, increasing adoption and cumulative use by orthodontists and GPs will depend on factors such as the capability, safety, efficacy, ease of use, price, quality and reliability of our products, our ability to provide effective sales support, training and service and the availability of competing products, technologies and alternative treatments. In addition, unanticipated poor clinical performance of Invisalign could result in significant adverse publicity and, consequently, reduced acceptance by dental professionals. Also increased competition from direct competitors could cause us to lose market share and reduce dental professionals’ efforts and commitment to expand their Invisalign practice. 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.

Our success depends upon the acceptance of Invisalign by a substantially larger number of dental professionals as well as potential consumers to whom we are now actively marketing. Invisalign represents a significant change from traditional orthodontic treatment, and consumers may be reluctant to accept it or may not find it preferable to conventional treatment. In addition, consumers 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 orthodontists, GPs and consumers 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, greater comfort and hygiene compared to conventional orthodontic products and price for Invisalign compared to competing 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 affected by general macroeconomic conditions in North America and internationally, which fluctuate and could be affected by unstable global economic, political or other conditions.

The orthodontists 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. 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. We expect, however, that the percentage of revenues generated by GPs will increase, largely due to the fact that there are significantly more GPs than orthodontists. As the primary provider of dental care, 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.

Declines in average selling prices of our products.

In response to challenges in our business, including increased competition, in November 2005, we reduced the list price of full Invisalign cases and in the third quarter of 2005 we introduced Invisalign Express, a lower-cost solution for less complex cases. In addition, in the fourth quarter of 2005, we expanded our volume based discount program to all doctors. As a result of these programs, the blended average selling price for our products declined in 2006 compared to 2005 and may further decline in 2007 as a result of greater participation in our volume discount program. Additionally in Europe, we introduced new pricing initiatives in the first quarter of 2006 which resulted in a lower average selling price in 2006.  If we are required to introduce any similar programs in the future, our revenue, gross margin and net profits (losses) may be adversely affected.

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 ClinCheck and are used to manufacture Aligner molds. In the first quarter of 2006, we completed the process of relocating our SLA mold fabrication operations from our Santa Clara, California facility to our third party shelter services provider, IMS, located in Juarez, Mexico. IMS also fabricates the Aligners and ships the completed products to our customers.  As a result of this relocation, our reliance on our international manufacturing operations will continue to increase. Our increasing reliance on international operations exposes us to risks and uncertainties that may affect our business or results of operation, including:

32




·              difficulties in hiring and retaining employees generally, as well as difficulties in hiring and retaining employees with the necessary skills to perform the more technical aspects of our operations, as well as staffing in numbers sufficient to implement the Patients First Program;

·              difficulties in managing international operations, including our relationship with IMS, our third party shelter services provider;

·              import and export license requirements and restrictions;

·              controlling production volume and quality of the manufacturing process;

·              political, social and economic instability;

·              acts of terrorism and acts of war;

·              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, we could experience production delays and lost or delayed revenue.

A key step in our manufacturing process relies on sophisticated computer technology that requires new technicians to undergo a relatively long training process.  If we are unable to accurately predict our volume growth, and fail to hire sufficient number of technicians in advance of such demand, the delivery time of our product could be delayed which could adversely affect our results of operations.

Training technicians to use our sophisticated computer modeling program that produces the electronic treatment forms that form the basis of ClinCheck takes approximately 90 to 120 days.  As a result, if we are unable to accurately predict our volume growth, we may not have a sufficient number of trained technicians to timely create ClinCheck treatment forms within the timeframe our customers expect.  Any delay in ClinCheck processing time could delay the ultimate delivery of finished Aligners to our customers.  Such a delay could cause us to lose existing customers or limit the number of new customers who purchase our products.  This could cause a decline in our revenue and net profits and could adversely affect our results of operations.

Our headquarters, ClinCheck setup and other manufacturing processes are all principally located in regions that are subject to earthquakes and other natural disasters.

Our digital dental modeling is processed in our facility located in San Jose, Costa Rica. The operations team in Costa Rica creates ClinCheck treatment plans using sophisticated computer software.  In addition, our Aligner molds and finished Aligners are fabricated by IMS, our third party shelter services provider located in Juarez, Mexico.  Both Costa Rica and Mexico are earthquake zones and may be subject to other natural disasters. If there is a major earthquake or any other natural disaster in a region where one of these facilities is located, our ability to create ClinCheck treatment plans or manufacture and ship our Aligners could be compromised which could result in our customers experiencing a significant delay in receiving their completed Aligners. In addition, our headquarters facility is located in the San Francisco Bay area.  An earthquake or other natural disaster in this region could result in a disruption in our operations.  Any such business interruption could materially and adversely affect our business, financial condition and results of operations.

33