愛齊科技 (ALGN) 2002 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Align Technology's third quarter results conference call. During the presentation all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session. At that time if you have a question, press the 1 followed by the 4 on your telephone. As a reminder this conference call is being recorded Thursday, October 24th, 2002.

I would now like to turn the conference call over to Tom Prescott, President and CEO. Please go ahead, sir.

Thank you, operator, and thank you all for joining us this morning to discuss the results of the third quarter and the positive trends we saw in that period, as well as providing an update on our progress in implementing the significant restructuring announced in July which was geared to achieving profitability by the end of 2003.

We will also discuss the growing adoption of Invisalign by our primary customers orthodontists as well as discussing our strategy to expand the market to reaching GP dentists that perform orthodontic procedures.

On the call with me today is Eldon Bullington our new Chief Financial Officer and Roger George, Vice President of Legal Affairs and General Counsel.

We will lead off with remarks of forward-looking statements that we may make on the call, then we will provide some details on third quarter results and a bit more guidance on the fourth quarter and next fiscal year, followed by a question and answer session.

I'll turn the call over to Eldon for remarks on the forward-looking statements.

Thank you. Good morning. Concerning any remarks we may make about future expectations, plans or prospects for the company during this call, or that were made in our earnings press release, those remarks may constitute forward-looking statements for purposes of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involve risks and uncertainties. A number of important factors could cause actual results to differ materially from those in the forward-looking statements. These factors, as well as other factors that could cause actual results to differ materially are discussed in more detail in Align Technology's registration statement on Form S1, our annual 10-K and quarterly 10-Qs, and other filings that we make from time to time with the Securities and Exchange Commission.

Thanks, Eldon. I'd like to welcome all of our shareholders and friends who have joined the call today. Many of you participated in our second quarter results call in late July, as well as the special conference call we held on July 10th to describe a wide ranging set of initiatives geared around achieving profitability before the end of 2003. Most of the initiatives discussed have been successfully completed and those remaining are on track or ahead of schedule.

I'd like to start out this morning by giving you a brief update on that progress.

The streamlining of our manufacturing network as we centralize in San Jose [ph], Costa Rica is nearly complete. As of this week the company is now completely manufactured - has now completed manufacturing transfer out of Pakistan and will be out of Sharza [ph] In the United Arab Emirates by mid-December. Some minor activities may continue into the next fiscal year as we dispose of assets and complete our exit. I do want to take a moment to recognize the contributions of our employees in Pakistan and the United Arab Emirates for despite the elimination of all their jobs they have demonstrated the professionalism and customer focused attitudes that have enabled this transition to occur on schedule with no adverse impact on our customers. Thus far the manufacturing team has conducted this transition in an exemplary manner. We have every expectation of completing this effort by the end of the year as originally scheduled.

The second major initiative was targeted at rationalizing our international sales structure to create a balance between near term growth prospects and investments. To that end we've essentially completed our resizing of our organizations and infrastructure in Europe and Latin America.

We are absolutely committed to those regions for the long-term. However our spending has gotten significantly ahead of our revenue ramp. Over the next year or so we will focus on building a solid core franchise in the most attractive countries, rather than to push for major regional expansion and large growth in new doctors trained. Our international customers have seen us renew our efforts to help them successfully adopt a Invisalign are hardened, but we're focused on building a successful profitable and sustainable enterprise. I believe it's important to repeat the strategic rationale behind taking these very significant actions.

Align has pioneered a new technology, launched a great new product and established a foothold in an enormous on debt market. It is essential to assure the right foundation is in place so that we may truly achieve the leadership position in this industry. A good foundation begins with sustainable profitable operating platform and excellent customer satisfaction. We're within sight of those goals.

As we achieve our near-term objectives, including profitability, we will pay off the enormous growth potential ahead and significantly accelerate the top line. We expect to dramatically expand this new category of treatment, and our vision is that one day Invisalign will be a highly valuable unique global brand. I'd like to shift the discussion to third quarter results. I'll provide brief summary and focus on some key drivers for these results and then ask Eldon to step through the numbers in a bit more detail.

Our overall revenues in the quarter grew to 18.6 million, an increase of 44 percent over the same quarter a year ago and up eight percent over last quarter.

Our revenues for the first nine months came in at 53 million, representing a 55 percent increase over the same period a year ago.

This revenue growth was in line with our expectations, especially when considering our solid growth in case volume in the orthodontist market during the summer months, traditionally a time when doctors practices are jammed with young children and early teens getting braces on their teeth, sometimes delaying new orthodontic starts for adults and later teenagers until school starts again in the fall. We also made substantial progress in the GP dentist market, both in terms of training new doctors as well as generating case volume growth. This market segment is important to us both for the revenue opportunity it presents as well as its strategic linkage between GP practices and their ability to help us cost effectively access the tens of millions of customers, their patients, that are underserved in today's traditional orthodontic care model.

While many GPs may decide not to learn how to treat simple or complex cases of Invisalign, the increased knowledge and awareness of malocclusion by GPs and their staffs will help ignite dramatic growth in the overall market category. We believe Invisalign with our fundamentally superior value proposition will benefit very substantially from this growth.

To ensure we understand the drivers behind this revenue growth, we tracked a range of key metrics. One of those metrics is cases received on a daily, weekly and monthly basis. Starting with this quarter going forward we intend to provide you with our average cases received per business day as stated on a quarterly basis. Visibility in this information should give you a better understanding of our progress in building our base of submitting doctors and getting a greater share of their practice. Our average cases received per business day in Q3 was 200. That's 200 cases per day.

That compares with an average of 170 last quarter Q2. We see strong case growth continuing in and are comfortable we can achieve the top line growth given our earlier guidance. Additionally we'll seek to introduce other appropriate complementary metrics in the quarters ahead.

I should probably remind you that from the time we receive a new case from a doctor's office, it takes us about three weeks to turn it into a shipment of aligners, which creates reported revenue for the company.

Our actual cycle times are much less than that. However, that approximates the career average. As a result, our pipeline of cases received is almost a month ahead of our revenue recognition, so we generally have good visibility at the quarter ahead by the time we announce prior quarter results, like today.

Briefly turning now to gross margins, spending and net losses, as Eldon is going to describe in a moment, we're either on track or have our expectations in each of these areas.

I'm going to reference pro forma operating numbers here that are net of stock based compensation, or restructuring charges and let Eldon tie this into our reported cap numbers.

We were able to achieve 15 percent growth in gross margins quarter over quarter, taking us to 48.7 percent and on track to beat 50 percent by the end of Q4. The drivers behind this growth included implementation of several key programs driven by our technology manufacturing teams. CT scanning of impressions which was completed abit ahead of schedule. Software improvements delivered right on time and initial roll out of automotive forming in our [inaudible] Mexico wire facility. These programs will continue to generate additional leverage in upcoming quarters.

In addition, we also saw favorable absorption from increased volume. We continue to focus on reduced spending and affects bringing our total Q3 spending down to 19 million dollars, despite an increased investment in North American sales and marketing.

This overall decrease was driven by reductions in international and Santa Clara based infrastructure and head count.

As a result, our quarterly net loss declined by around three million dollars, to 10.1 million.

The combination of top line growth, gross margin expansion and careful management spending will continue to reduce these net losses. This will be especially visible in the first quarter of next year as most restructuring costs are behind us and the full impact of our strategic initiatives will be seen.

I'll come back at the end to make a few closing comments. However I'd like to now turn it over to Eldon.

Thanks, John. I'll dive right in and go over the pro forma and generally accepted accounting principles, vis-a-vis GAAP results, while trying to minimize any overlap what Tom just went through. Net revenues of 18.6 million for the third quarter of 2002 increased 44 percent compared to 12.9 million for the same quarter one year ago, while increasing sequentially by approximately eight [ph] Percent compared to 17.3 million for the second quarter of this year.

Included in those revenues are what we've in the past defined as noncore revenue, not directly attributable to the Invisalign system, was approximately $800,000. That revenue is predominantly training. Gross profit margins for the third quarter as reported under GAAP were 7.7 million or 41.4 percent of revenue. Cost of revenues for the quarter included approximately $800,000 of stock-based compensation, noncash event, and approximately $600,000 of one-time restructuring charges related to the phase out of our Pakistan and [inaudible] Facilities. Gross profit margins excluding stock-based compensation and restructuring charges were 48.7 for the third quarter compared to 21.8 percent for the same quarter one year ago, and 42.6 percent for the second quarter of this year.

Our continuing improvement in margins reflects the benefits of cost reductions and cycle time improvements in our manufacturing process and improved fixed cost absorption related to increase volumes. Total operating expenses as reported under GAAP were 24.4 million for the third quarter of 2002, compared to 24.7 million for the same quarter one year ago. And 25 million for the second quarter of this year.

Included in operating expenses for the current quarter were approximately 4.2 million, of noncash stock based compensation and approximately 1.2 million of restructuring charges related to the resizing of our international infrastructure and domestic support organizations.

Total operating expenses net of stock based compensation and restructuring charges for the third quarter were 19 million, compared to 20.6 million in the same quarter one year ago and 20.1 million in the second quarter of this year.

Sequentially, we expect operating expenses will continue to decline over the next two to three-quarters, as restructuring activities are completed in the expected savings phase in.

To take a brief look at the composition of operating expenses, sales and marketing expenses for the quarter net of stock based compensation and restructuring charges were 9.6 million. Compared to 10.9 million for the same quarter one year ago. And 10.8 million in the second quarter of this year.

The decline in the third quarter expenses results primarily from the aforementioned international organization resizing, reduction in staff and selected deployment of marketing programs.

International spending reductions are partially offset by increases in media advertising and promotions. In the U.S. market, as we refocus on the domestic orthodontic and general practitioner markets. General and administrative expenses for the quarter net of stock-based compensation and restructuring charges were 7.2 million compared to 7.3 million in the same quarter one year ago and 7.1 million in the second quarter of this year.

We expect restructuring related savings in general and administrative expenses will phase in during the fourth quarter of this year driven by staffing reductions in the latter part of Q3. Research and development expenses for the quarter net of stock based compensation and restructuring charges were 2.1 million, compared to 2.4 million in the same quarter one year ago. And 2.2 million in the second quarter of this year.

Net loss for the third quarter is reported under GAAP was 16.9 million or 36 cents per basic and diluted share. Excluding stock based compensation and restructuring charges, net loss for the quarter was 10.1 million. Or 22 cents per basic and diluted share. EPS calculations were based on 46.9 million, weighted average shares outstanding.

Cash at the end of the quarter was approximately 23 million, and cash and short-term investments compared to approximately 35 million at the end of the second quarter.

Approximately two million of cash was utilized during the quarter for restructuring related expenditures.

As Tom discussed earlier on the call we believe the initiatives undertaken by the company to streamline manufacturing and resize our international sales and domestic support organization are on track.

Financial results for the third quarter support this view and we are within the guidance the company provided during the second quarter results call in July.

Looking ahead, we will spend a few minutes updating you on our view of Q4 and 2003 since our last call.

Fundamentally, we have no significant changes to the P and L guidance provided on our last call for the fourth quarter and 2003.

Fourth quarter revenue should be between 21 and 22 million, including noncore revenue of less than a million dollars. Gross margins are expected to be in the 50 to 52 percent range, reflecting continued cost improvement initiatives and volume efficiencies.

These gross margins reflect the impact in the range of three to 500,000 of restructuring charges that we will roll in the fourth quarter. Operating expenses are expected to be in the range of 22 to 24 million, including four to five million of restructuring charges, restructuring activities should be substantially complete during the fourth quarter.

In our last call, we had discussed a range of seven to nine million dollars of restructuring charges and a heavy skewing of those towards the third quarter.

In total, the restructuring charges will remain within that range, possibly towards the lower end of that range.

However, it is as you're seeing here, rather than the third quarter, the fourth quarter is when most of those will roll through in accordance with GAAP.

In our restructuring activities should be substantially complete during the fourth quarter. Exclusive of any potential financing activities or impact, cash should be in the range of 10 to 12 million at the end of the fourth quarter.

The fourth quarter will include approximately two to three million [inaudible] Charges related to restructuring activities.

As previously reported, 2003 revenues were projected to be in the 100 to 105 million range, with fairly linear revenue growth across the four quarters of the year. Gross margins are expected to grow steadily throughout the year, driven by cost improvements and higher volumes.

Gross margins are projected to improve in the 61 to 63 percent range by year-end. Averaging 58 to 60 percent for the full year.

Quarterly operating expense should continue to decline and level off in the 17 to 18 million range per quarter.

Full year operating expenses should be in the 68 to 72 million range for the year.

The company is expecting to operate at a loss for the first three-quarters of 2003 as indicated on our last call in July. The company expects to reach profitability by the fourth quarter of 2003.

The fourth quarter and 2003 projections discussed do not include noncash stock based compensation of approximately four million dollars for the fourth quarter and approximately 14 million for the full year of 2003.

Based on execution of the company's new strategy, revenue growth and reduced spending rates, cash burn rates should be reduced significantly over the next several quarters.

We expect to reach positive cash flow by year-end 2003.

As discussed during our second quarter earnings call in July, the company has been working on securing asset-based financing to bolster our operating cash position.

The facility the company has been pursuing is a combination of an asset-based revolving line of credit and equipment financing. Over the past couple of months continuing softness in the economy and loan losses in the banking industry have changed the landscape for asset-based financing. Lending institutions have become more cautious and raised asset security requirements substantially, on revolving lines of credit and equipment financing, lending institutions are reluctant to provide emerging companies what I would characterize as base working capital without terms or security that are prohibitive and to the point sometimes not in the best interests of our shareholders.

The company has received a nonbinding term sheet to prove a revolving line of credit that would provide in the range of five to seven million dollars of operating cash, secured by [inaudible] Assets with reasonable terms.

Given the increasingly constrained and less attractive borrowing market, asset based borrowing providing operating cash in the range of five to seven million in itself does not provide the desired level of funding for the company.

The target level of cash funding the company believes will provide appropriate working capital to and beyond positive cash flow is in the approximate range of 20 to 25 million dollars. In order to secure this level of cash, given the current lending environment, we now intend to pursue several funding alternatives including a small equity infusion of around 15 to 20 million dollars, coupled with the aforementioned of the revolving credit line and small amount of asset financing which together yield approximately five to $10 million.

We expect this activity to be completed during the first quarter of 2003.

Now let me turn the call back to Tom for a few final words.

Thanks, Eldon. In closing here, before we go to questions, we've made excellent progress in delivering the results we've previously committed to. We expect this commitment for solid execution to continue and we are focused on achieving profitability as soon as practicable. Our customers are enthusiastic supporters of Invisalign. Their patients are thrilled to experience great results first handled. Our employees are deeply committed to turning this great opportunity in the company performance. For my part, I look forward to this company's performance translating into shareholder value.

That's it for our prepared comments. Now we'll take some questions. Operator.

Thank you. Ladies and gentlemen, if you would like to register a question, please press the 1 followed by the 4 on your telephone. [Inaudible] If your question has been answered and you would like to withdraw your registration, please press the 1 followed by the 3.

If you are using a speaker phone, please lift your hand set before entering your request. Please wait for our first question.

The first question comes from Bruce Jacobs with Deutsche Banc.

Couple questions, if I could. Thanks, first off, for providing the cases information. That's helpful. I'm wondering if you could possibly give us some insight into how the GP channel is developing, either in terms of number of trained physicians or submitting physicians, anything at all that will allow us to gauge how that's developing and I guess as part of that will you be willing either now or in the future to talk at all about how the revenue was comprised between the different categories, GP, dentists, international, et cetera.

First of all, thanks, Bruce.

We will in the future try to peel that back a bit more. I think we've started with kind of the base level of visibility. And that's a start. But it's a reasonable question. And what we're trying to do is perhaps put together several other key indicators that would speak to several things. One, mix, and, two, adoption. And so we're wrestling with what are the right key metrics that will speak to that well that we can deliver each quarter to you that will give you the visibility you need. That's where we're going to go.

I can give you a bit of a perspective about our progress in terms of GPs. And again I think it's important from my perspective for you to remember that we really just got started doing the GP channel ourselves in June. We literally got our team on board by late May and had our first training with them. And they were feet at street for 19 new reps really the first week in June.

We really didn't have much productivity out of them in Q2. And we just started to see that in Q3. Our training continues and in fact we are - we're short of being comfortable with giving you volumes out of each channel. But we will in Q3 have trained 500 to 700 people and probably have certified - I think we've certified just under 700 new GPs in the quarter. We probably had somewhere in the neighborhood of 400 new GP submiters in the quarter. So out of something a little under 700 GPs trained, somewhere in the neighborhood of 400 submitted. And we are on track to do that or better in the fourth quarter.

So I think the number trained will probably be a bit greater. I don't want to speak yet to what the new submitter rate will be, but I think that probably should speak to the general back ground.

Where does that bring you in terms of the total trained and submitting GPs, can you give it cumulatively or should we view this as you're starting fresh with a new group you've trained yourself.

We look at this in a complete way. We're trying to support all the doctors that have been trained. This brings us through the end of Q3 to somewhere in the neighborhood of 4,100 certified GPs. And we are on track to do 5,000 or thereabouts for the year. So that says we'll do roughly another eight or 900 in Q4.

Of those 4,000, better than 50 percent of those are submiters now. And so roughly 50 percent of those are submitters and we see that continuing.

Last question on that topic. Submission rates, can you at all contrast the submission rates for the GPs with the early submissions from the orthodontists, how they compared.

I'm hesitant, Bruce, because it's early and there's probably some noise around the switch over from our former distributor to us, but I guess at a very base level I guess we'd say that we're encouraged that there's strong interest and an early trial at something that really hadn't been achieved.

On the operating expense side, it seems to me that you're running even a little bit ahead of your expectations in terms of rationalizing the cost structure. Is that a reasonable conclusion to draw?

That is a very reasonable conclusion to draw. We could have had greater operating, we could have had lower launches, we chose to accelerate our GP initiative and to invest a little bit, more of those savings than we were going to, as we indicated back into North American sales and marketing, both into our ortho market channel as well as into GP. And I think we are comfortable with the broader statements we've made about op ex-and base spending take out, year over year. We said we would achieve broadly 15 to 20 million dollars worth of base cost reduction and even within that we have said we are reinvesting in North American sales and marketing and our goal there is not to just kind of save our way to prosperity but to drop some additional top line growth.

Thanks.

Next question comes from Adam [inaudible] With JP Morgan.

Hi. Let me commend you on your decision to report on case volume. On the gross margin line, that's somewhere where you seem to consistently deliver some upside for our expectations. We're in the high 40s now. The expectation is to exceed 60 by the end of next year. You've done a lot on the manufacturing efficiency side. So is that increase almost entirely attributable to economies of scale or are there other additional manufacturing efficiencies?

I want to make sure I understand the question. Is this the current performance to where we are, or is this the getting us to from where we are around 50 plus at the end of 2002, getting us to 60 plus at the end of 2003.

Right, the latter.

What I would say is probably 50 percent of the increment between 50 and 60 is very specific program driven and perhaps a little more than that. I would say probably 50 percent of that change will be leverage or absorption based on that volume increase. And again we manage against that expected track with capacity planning for pretty carefully so we won't get surprised. But I think we're pretty comfortable with those assumptions.

One other question regarding international. Scaled back considerably there. But is the infrastructure in place when and if you decide to [inaudible] U.S.. is there a threshold you have in mind at the U.S.. in which point geographic expansion might fit into your strategy

Absolutely. We made the choice - these were very hard decisions. What we've tried to explain to our customers, our commitment to them is they're going to get as good as support or as good as they had. What we fundamentally took out of the enterprise was administrative structure, management structure and the team was driving, entering new countries and training new docks. We tried to leave sales rep and people that touch customers to the extent we possibly could in place. And our goal is to help them continue to adopt individual line item growth. As we see our cost structure better in line with our revenue we're going to have and as the enterprise itself is profitable. We will have opportunities to go back country by country and expand our investment there and expect obviously better returns in terms of revenue growth and profit. But I believe we haven't shut down or left any countries, closed down the web site. We left the basin FRA structure, the base organization in place. What we've really done, and this was very hard and very difficult for the individuals involved that had bought into a building growth and we basically just had to check that and say not today. Now our job is to drive customer satisfaction and doctor - adoption by individual doctors in their practices we'll have a chance to come back in a year or two and look at greater investment and greater growth.

Thanks a lot.

Our next question comes from Wade King with Wells Fargo.

Tom, good morning. A couple questions and follow-up, please.

First, you suggested that about 41 hundred GP dentists trained and a little bit over half submitting. Can you give me a number submitting on the orthodontist side at this juncture

We have roughly out of 709 thousand total orthodontists in North America, we've certified roughly 7,800, 8,000, somewhere in that range. And we have somewhere in the neighborhood of 3,600, 3,800 that are submitting.

Very good. Are there any utilization metrics you could provide at this juncture? I'm sure specifically for the orthodontists, given the GP metrics would be very early and possibly less meaningful. But can you provide any metrics as such on utilization for us, number of cases, for example, per quarter, per submitting orthodontist?

We're hopeful that we can get comfortable laying out a data framework, introducing few additional elements that speak to two things: One, case volume and growth of that case volume, and two the dynamics around adoption and increased utilization.

Given certainly some of the churn in the GP in the early days and the transition from our former distributor to us, it's too early to speak to that there. We're trying to find a data framework that can speak to adoption in orthos and if we can get there, then we'll talk about that in the third quarter. If not we'll be there in the first quarter. But we're hoping we could provide the regular data framework for you going forward so you have a better idea of what's going on with adoption and increased utilization, because we see a fairly clear pattern and we just want to make sure when we commit to delivering some data to you we can do that every quarter, rain or shine.

Is your plan for next year to train a similar number of GP dentists, 5,000?

Yes.

Could you comment, please, on the breakout of adult versus pediatric cases. It's well known pediatric market is three-quarters of the market. And yet to date the physicians have been focusing on the adults and to some degree the late adolescent fully matured jaw market. Are there increasing of pediatric cases, maybe you could address at all the mild case volume versus more challenging cases as well.

I'll comment from our perspective. I'm certainly not going to comment clinically, because there's a range of issues that orthodontist would speak to there, not a lay person.

I think your numbers are about right. I think if you, in terms of 75 percent or what we would call broadly kids and they would range from preteens to young teens to mid adolescents or late teens, what we're saying is clearly orthodontists are very comfortable with adults. There are very comfortable with late teens. They're increasingly comfortable with kind of mid adolescnet, especially girls, that are a little further down the growth curve and we have a whole series of initiatives that frankly our customers have driven around that that we are supporting for them. So what I would say is today we probably map into certainly not a big piece of that 75 percent but we map into maybe a third of the market. We could probably call served. And we're seeing a lot more excitement by our docs at getting good results with kind of mid teens.

Very good. Glad to see you're getting your report out of the way in times of the last Giant's game tonight. Take care.

Next question comes from Claus Vonstederhein [ph] With Deutsche Banc.

Can you go over the financing plans again. I'm especially wondering about the dilution, you said there was going to be some equity in it.

Perhaps we're early in that process. We have some time to work that. Our cash burn is going down pretty dramatically over the next couple of quarters. We are doing several things we're focused with our external advisors and the board about what the right path forward is there. And what is the best thing for our shareholders.

We are in that process intending to move forward with a scaled down asset based financing, as I think Eldon pointed to, described. We characterize it as net working capital support of five to 10, let's call it five to eight. So we don't need to do a large equity transaction. In fact, we would rather not do one, but if the choice is to do an equipment-based financing deal that comes with terms that are not in the best interests of shareholders, given the conditions of the broader debt market, then some small degree of dilution would be better for shareholders to accept in view of when we're acting in our interests then terms from a debt market that are prohibitive. So again we haven't sized that yet. But our goal here is to get a small amount of equity, a small amount of debt in here to provide this bridge to a very clear path of profitability that we can see. So our hope is to make this as minimal, since I'm the guy that said before we don't want to do any equity financing at all, I stand up here and say that absolutely that is the case. But I would rather have a small amount of dilution with a simple small equity infusion, paired with an AR transaction than to accept a broader debt package that came with very substantial issues and problems attached to it.

It makes sense. Can you at all quantify what the possible dilution would be on a worst case basis, something, anything so we might have an idea what might be in front of us?

I understand where you're coming from. And there are too many kind of variables at this point for me to project that. I would say in general our goal is to do a very smallish equity infusion, as we've described, overall debt facility than we originally projected. And so our goal here is to absolutely minimize any dilution we have. The original goal was to avoid it. That's our game plan. I don't feel, as we're working through with our board and external advisors, I'm comfortable in describing dilution. Again, there's lots of ways to look at it. But we're trying to do the minimum we feel we need to do in terms of putting some balance sheet support and liquid assets in place to support what we believe is a very clear and doable game plan to get the profitability with significantly reduced operating losses through the quarters of next year.

Thanks.

Thanks for nothing. I know I didn't answer your questions.

That's all right. I don't want to nail the company to the wall either.

Well you realize what the realities are of the debt market today.

Our next question is a follow-up from the line of Bruce Jacobs with Deutsche Banc. Please go ahead.

Just a few very quick follow-ups. Can you comment at all about what is happening with end user pricing?

I guess, I'd have to talk in qualitative terms. We don't have detailed quantitative terms. We've surveyed this quarterly and we don't have that in for this part of the year yet. But in general we see pricing fairly solid at the end user price for orthodontists. The dynamic, rather than the broader economy issues, the dynamics have seemed to affect end user pricing or competition in the marketplace and individual orthodontists that are going out and marketing to much more moderate and mild cases and pricing those cases in a way that they can find that value equation for them.

So we've had some orthodontists do low end simple crowding cases for $3,000 at the same time they'll quote a much more complex case for six or 7,000. So instead of a simple one size fits all, I think orthodontists with a lot of the experience and technology are starting to segment their market and attract a broader pool of patients into care. We see that for the orthodontists that have the greatest experience.

To refresh us. Your pricing, now, have there been any material changes? Again, just refresh us on your structure of your pricing to customers given their different case types and so forth.

No, we have had no changes, the same basic offerings in place. Orthodontists have a couple different ways they can buy the product from us. That has not changed.

And obviously you guys have been focusing on for some time looking at the leads generated by advertising and how many of those people are actually converted to cases. Have you actually, have you gotten anywhere on that in terms of understanding where you are on that, have you seen improvement, where do things stand in terms of conversion rates.

I'm not comfortable talking about rates but the short answer is we have seen improvement. We made a decision to do some more direct to consumer in October, which we've done. We expect to tail that down a bit in November, December, kind of notoriously bad times for trying to get through the crowded airways with a message of this sort. And kind of rekick that off early in the year, January or February. But we have seen increased conversion rates for a whole range of reasons and good positive results there.

And the last question I had, with respect to Mexico, I think I heard you say something about automation there. Can you just talk about where you are on the continuum here between being fully automated which obviously is your end goal?

We've made huge progress and have partially implemented now this full automated forming and numbering program. And it will pay huge dividends for us on our partner down there ELMX has done excellent work for us, the work force down there has worked with us and is very flexible. We're kind of step one on that. That will continue to roll out for the next three to nine months and the manufacturing team has done a great job and it's working beautifully. So we're completely on track there.

In terms of, have any thoughts on whether that will ultimately move and if so when from Mexico?

That equation is solely driven by volume and economics. And at such time that we think it makes sense to do something like that we will do that and invest additional capital versus the process we have in place today. But again all these other steps we're putting in place would support that track.

Thanks guys. I appreciate it.

Our next question comes from AJ Bower from Health Co. Please go ahead.

Can you talk about IP and the kind of barriers to entry and entering the market?

I think in general there's a whole range of - there's a set of IP that would make it very problematic for someone else to, even they could develop the competencies to do this, which would require substantial spending, head count effort. It would be a very big bet to achieve. The IP barriers are very substantial, additionally. So I think there's a whole interlocking set of method, practice and art that is constructed in a way that's well described in all of our filings. But if you go pull our information and then if you wanted actually go on line, there's a whole variety of ways you can pull up this kind of stuff out of the patent office. You can get a richer view that way.

I actually went to the K and I noticed the stipulation of dismisssal with ORM Co. that was in June of 2000 and I believe they agreed for a period of two years not to pursue any additional litigation. They claim they have some patents and they own these patents. And have they contacted you in terms of if your IP infringes or filed a lawsuit, what their progress is there, because the two years are now up.

Let me say briefly where I think we are and I'd ask Roger George, who is our general counsel here to speak for specifically. First of all, there's been no litigation of any kind of I might say there was no threat of any litigation of any kind. We've had discussions with them and as I look back at this I wasn't here then. So I don't know what went into the choices to either, with how to resolve an imagined problem or a real problem. But as I've satisfied myself and as our outside advisors have satisfied themselves and as our general counsel satisfied himself, we view that as a nonissue and we have discussions all the time with complementary partners in the industry and people we may or may not be adverse with at points in time. So what I'd say is that was probably a good solution at the time, but given the fact the company was headed towards an IPO, probably didn't want to deal with a perceived or real IP issue. In my view, there's no issue. And I guess I'd ask Roger to comment more specifically.

Good morning, AJ. Just to follow up with what Tom said. The folks at Ormco maintain an open channel of communication with us. I speak with their general counsel from time to time and we do discuss IP issues. Since the stipulation was executed, Ormco has had a couple of additional claims allowed by the patent office. At the same time many of our patent applications have been allowed since then and even issued and they're aware of those.

So we discussed cross licensing from time to time. And basically just make sure that each company is not infringing on the others without some kind of permission.

Because they claim that there is infringement. And I mean there's no lawsuit that's been filed. But if Ormco does have patents and this is a company that does generate cash and they need some growth, why would they not look towards this market and start entering the market targeting adults. GAC is already offering kind of invisible braces kind of not like exactly like Align but invisible braces but the competitive environment, what's to stop Ormco from entering?

What I would say in general, AJ, you should ask Ormco, you should ask GAC if you have questions about them. There's no product like this out there as a removable device. There have been clear brackets for a long time and those are products that are well accepted in their own right. They have pluses and minuses like any product would. But they're not removable appliances. And as a result, and GAC has come out with Mystique, and certainly 3M has Clarity. And there are a whole range of fixed appliances that are clear brackets.

So we view our collection of IP, and you should seek to satisfy yourself, as absolutely an enormous barrier for any of the important markets. And additionally, what stands behind that barrier, the IP barrier are the underlying competencies that are so difficult to develop. So IP is great to have. But it's almost equally important to have the skill the know how and the capability, the millions lines of code and the automated equipment and the scalable business that we've been able to prove.

. . So I think IP is great. We've got it. We're comfortable with it, period. But more to the point, we're practicing the competent sis reducing our costs and scaling a business that we've said in roughly 100 million dollars is going to be profitable and grow from there. What I'd say is anybody else that chooses to do that we'll have to face into the IP issues which are very substantial. And then secondly have to deal with developing the capability to even practice this. So we're very comfortable with that framework.

I'm assuming in your guidance there's no provision of any lawsuit or any kind of, if there was a lawsuit filed and you were found to infringe, there would be, there's no provision baked in for that.

The way you run a company here is you make sure that you, if we - if there was any chance we infringed, we have to resolve it. Because you don't want to go into a market saying there's willful infringement and you're just playing cute. That's when you get hurt.

We are absolutely comfortable and stand behind our IP completely and are competing in a marketplace vigorously. That's what we're doing.

But you will have to fight it because your bash balance is going to go down to 10 or 12 million next quarter.

AJ, we're going to bolster that cash balance in the actions we described. But to me, IP is a whole separate issue from working capital management. And funding small operating losses into next year. These are totally separate issues. We have zero concerns. There's a give and take in the marketplace. And part of the way people play sometimes is to litigate around - companies make good and bad decisions around patent hassles they choose to get into. We're fully prepared and capable of prosecuting our patent estate. And we are comfortable doing that. And we are planning for any contingencies we have to do in the cash reserves we've got. We aren't imagining somehow that we're going to have a patent hassle we get into, because we don't think there's any hassle on the horizon for us. We may choose to prosecute some of our own based on what we think people are doing in the marketplace dance around the edges of our estate. And again all that said, it goes into our overall working assumptions around maintaining the right kind of working capital and liquid assets balance for the enterprise.

Congratulations and I look forward to Q4 and I hope you get the line of credit.

Thanks very much, AJ

The next question comes from the line of Eric winger with winger investment management. Please go ahead.

Hello. How are you? Can you please clarify a little bit more about executive comp and the thought process behind the 16 million dollar for the nine months in '02 and I guess 14 million dollars you stated for proposed stock compensation, stock based compensation?

Let me briefly just describe in general, we really comment very fully and certainly will at the end of the year in our proxy statement comment fully on our practices and our policy and approach for our compensation committee and our board. Probably be more appropriate framework and more full data kind of framework to understand what we do and how we do it, both from options, bonuses and overall compensation for officers and employees.

But we're fairly conservative. I think part of what you're asking about is something that most new companies post IPO go through to work through dealing with so-called cheap stock, as a consequence of going through the IPO process. What I'd like to do is turn it over to Eldon to briefly talk about how we capture and talk about those stock based compensation costs in the context of our pro forma and GAAP accounting.

Eric, I'll address specifically what you mentioned relative to the stock based compensation, the numbers you quoted there.

And let's distinguish that from what I would call executive compensation or any form of incentive based compensation versus what those charges are.

And as in the past has been a fairly common practice amongst emerging companies when they're private is to issue stock options at basically a bargain level or below fair market value. And in the case of the numbers that we're mentioning, that's primarily what the situation is.

But stock options that were issued at the below fair market value and at the point in time that IPO you effectively have to comply with generally accepted accounting principles, you have to readjust the value of those options at fair market value and then you amortize that charge back to your P and L based on shareholders equity, basically over the vesting life of the assets.

So and that is a noncash event. So the numbers that you quoted are in fact the amortization of the primarily pre-IPO share stock compensation charges that are rolling back to the P and L, which we have quoted at approximately $5 million for the third quarter and then the values that we quoted going forward.

So that's not real time executive compensation, that is in fact the amortization of primarily pre-IPO shares that were issued at a bargain price.

That's a little bit unclear to me then how you are able to get a 2004 projection of that number. But -

It's pretty straightforward. Eric, the valuation took place in the past. And you project it and you roll it out based on a projection or amortization schedule. So it's primarily the amortization of an event that took place in the past and was estimated in the past. So you can do that with reasonable accuracy. As we stated in our earlier narrative.

Pretty standard practice for post IPO companies to work through that bolus of issued stock. As they were private that they have to resolve and amortize as they're now public.

If you're looking at a public company that certainly is several years past the IPO stage, you're typically not going to see this type of a charge. But it is certainly not an uncommon event to see stock-based compensation amortization taking place for a company that had an initial public offering in its recent past.

Okay. It's just an issue of magnitude. But thanks very much

Ladies and gentlemen, if there are any additional questions please press the 14 at this time.

I'm showing no further questions please proceed with your presentation or any closing remarks.

Thank you for your time this morning. We look forward to coming back in about several months and sharing with you what we believe will be a successful Q4 and the end to a great year and positioning us to achieving profitability in 2003. Thank you very much for your time today and have a great afternoon

That does conclude your conference call for today. We thank you for your participation and ask you please disconnect your line.