We are short Align Technology (ALGN).

Background:  Align is essentially a one product company – 94% of their revenues are generated from the Invisalign clear aligner system, which is used to straighten teeth.  ALGN also maintains a second segment-  Scanners and Services: Align sells scanners and CAD/CAM services into the dental industry, but it comprises a small portion of its overall business.  Importantly, Invisalign dominates the clear aligner market with over 90% market share.  The only real competition over the last several years has been traditional brackets and wires and ClearCorrect which also manufactures and sells clear aligners.  Align and ClearCorrect have been in patent litigation for several years.

Align has established a dominant market share and substantial pricing power in the clear aligner market by establishing a series of patents that have prevented others from effectively competing in the market.  Align maintains over 350 patents surrounding its clear aligner system.  Management has not shied away when discussing the importance of protecting their product portfolio as Align has filed for over 500 patents in the last several years.

“we believe we have the right strategy to win for the long-term but we’re paranoid every day that somebody’s going to think of something we haven’t.  We think – we know there will be competitive entry.  We already have competitive entry for clear aligners.”

        Tom Prescott, Roth Capital Conference March 10, 2015

Short Thesis:

We believe the fundamental outlook for Aign is deteriorating and the current stock price does not reflect the impending risks to the business.  The combination of increasing costs and decelerating (declining over the last two consecutive quarters) growth in average selling prices are likely to lead to margin compression that will be difficult to reverse.  Upstart competitors (ClearCorrect in the US and Orthocaps in Germany) have undercut ALGN’s core product and it is inevitable that a flood of competition will enter the clear aligner market in 2017 after its key ‘325 patent expires.  Notably, there has been significant turnover at the executive officer level with five executives, including the CFO, departing in the last 2.5 years.  The current executive officers have been reducing insider holdings significantly, many to the point where they currently have no actionable holdings.  Finally, Danaher, which has long provided a “put” in ALGN’s stock price, has stated that they expect to enter the clear aligner market on their own by 2017.  Danaher’s subsidiary Ormco has a seven year “exclusive collaboration” with Align dating back to the 2009 agreement when Danaher took an 11% stake in ALGN following a lawsuit settlement stemming from Align violating Ormco’s patents.  Danaher sold 40% of their equity position in Align at the end of 2013.  We view the entry of Danaher and others as a significant threat to Align’s long-term business prospects.

ClearCorrect was founded by Dr. Willis Pumphrey and utilizes 3D printing technology to produce clear aligners that are similarly effective to Invisalign.  ClearCorrect, has challenged the validity of Align’s patents, specifically the ‘325 patent in North America.  This patent essentially protects the digital treatment planning for the aligner system.

http://www.google.com/patents/US6217325

ClearCorrect’s suite of products are roughly 30-40% cheaper than Invisalign.  ClearCorrect has avoided US patent law by sending data electronically to a vendor in Pakistan and then sending back the sequence of aligner designs to Texas, where they are produced using 3D printers.  While ALGN has aggressively litigated, ClearCorrect continues to operate and produce clear aligners in direct competition to Invisalign.  It is unlikely ClearCorrect will be shut down in our opinion.  We view ClearCorrect as a serious threat to Invisalign, and we think ClearCorrect has demonstrated how commoditized the Invisalign product will be with the use of 3D printing technology.  In our opinion, the clear aligner market will be flooded with competition when the key patents expire in 2017.  3D printing technology has made it too easy to replicate the Invisalign product.  Our guess is that ClearCorrect has been taking share from Invisalign in the last several quarters.  In 2013 and 2014, ClearCorrect increased its scale by growing capacity 30%.

http://investors.stratasys.com/releasedetail.cfm?ReleaseID=760286

In Germany, the court invalidated the ‘325 patent and we think upstart Orthocaps has obliterated Align’s business there.

http://blog.clearcorrect.com/post/Ortho-Caps-Invalidates-Two-Align-Patents-in-in-Germany.aspx

http://www.marketwatch.com/story/ortho-caps-gmbh-manufacturer-of-orthocaps-aligners-wins-favourable-decision-in-patent-dispute-from-federal-patent-court-in-germany-2014-05-09?reflink=MW_news_stmp

Finally, we find it interesting that AOA Access which appears to be using Ormco (Danaher’s subsidiary) global sales team has begun marketing a clear aligner product further strengthening the argument that Danaher will be a real competitor sooner than later.

https://www.aoaaccess.com/Products/Aligners/Clear-Guide

https://www.aoaaccess.com/AboutUs

We note that Invisalign Clear Aligner revenues have been decelerating meaningfully over the last few quarters as shown below.

Align’s long-term guidance to the Street is for 15-25% revenue growth and 25-30% operating margins.  Over the last two years, Align’s margins had been trending nicely within the bandwidth of their long term projections.  After reporting in January, Align surprised the Street by missing previously lowered 4th quarter guidance.  Additionally, Align put out lower than expected 1st quarter guidance.

Align attributed the step down in gross margin and operating margin guidance to higher “investment” expenses.  Align stated that they will be increasing their direct sales force from approximately 370 to 470 reps, with North America reps growing from 205 to 250 in number.  Align noted other headwinds including foreign exchange, increased manufacturing costs and an implementation of an ERP system.  Finally, they blamed spending on new initiatives such as an obstructive sleep apnea product.

We note that Align’s average selling prices also declined in the 4th quarter and have now fallen for two sequential quarters.

The big question is whether Align’s first quarter guidance is “temporary” or a more permanent trend?  We believe Align’s weak guidance reflects deeper competitive issues driven from the lower price of ClearCorrect’s product in the US and Orthocaps in Germany and the UK.  We expect the stock to come under significant pressure given the robust current valuation as Align resets expectations throughout 2015 and beyond.

Valuation:

ALGN appears to us to be priced for perfection.  Presently, Align trades at 33x 2015 and 26x 2016 estimated earnings.  We note that Street expectations call for an improving margin and earnings outlook as the year evolves.

Align also appears expensive when compared to its publicly traded peers.

Insiders own very little actionable holdings

Interestingly, named executive officers have been aggressively reducing actionable holdings over the last year and a half.  If one looks at the history of CEO Tom Prescott’s insider transactions, one can see that he has made timely sales in the past.  In 2013, Prescott unloaded significant shares prior to reporting poor fundamentals in the 3rd quarter.  In the last year and a half, Prescott has been selling significant amounts of stock.  Today, it appears to us that none of the ten named executive officers want to hold equity as the actionable holdings are near the bare minimum.  In fact, five executives had zero actionable holdings as recently as November.

Last month, the VP of North America sales Chris Puco (which remember this is the person who is going to lead the charge in the latter part of 2015) has sold 100% of his holdings when they vested in February 2014.  After getting a replenishment of stock between December 2014 and February 2015 he had stock vest.  He immediately sold his entire position on February 24 of this year.  The VP of International  Raphael Pascaud has also sold almost all of his actionable holdings.

Bull Case

Bulls who own the stock cite that Align has continued to grow their patent portfolio and Align’s new G5 and G6 clear aligner solutions have patent protection much further out than 2017 which minimizes the “patent cliff.”  The G5 and G6 systems are used for more complex malocclusion cases where as the older Align clear aligner sets are more appropriate for low to moderate cases.  Also, investors boast there is pent up demand as the clear aligner purchase is a discretionary item.  With lower gas prices and consumer confidence rising, bulls argue consumers are more likely to purchase the Invisalign system.

In our opinion, the numbers speak for themselves.  There is clearly a trend of declining ASPs and rising costs that are squeezing margins.  In discussions with various Street analysts who cover the stock (11 of the 13 rate it buy) we guess that 2/3 of Invisalign cases are weighted towards the low to moderate cases, which would be the most impacted by the ‘325 patent expiration.

Conclusion:

We view Align as a compelling short idea at today’s levels.

Risks:

·         Align low balled 1st quarter guidance and will beat Street estimates causing appreciation in the stock

·         North America re-accelerates as sales representatives are added

·         International accelerates back to the 20%+ level

·         ClearCorrect is shut down for violating patents.